From 1978 to 1992, the Chinese leadership adopted a series of market-oriented reforms to reinvigorate the domestic economy. Although the reforms initiated were wide-ranging, they did not follow any systematic blueprint. Most were pragmatic in nature and were aimed at improving the functioning of the system or at correcting a deficiency in it. The incremental and problem-solving approach to reforms was quite successful in invigorating the economy while avoiding severe shocks to the economy. Nevertheless, there were recurring episodes of macroeconomic instability as macroeconomic management was weakened by the un-evenness and incompleteness of the reforms. As a result, the authorities frequently resorted to administrative measures to restore macroeconomic balance. In late 1992, the Chinese leadership decided to break with the old planning system and to establish a fully market-based economy. This historic decision has led the leadership to formulate a comprehensive strategy to achieve this goal.

From 1978 to 1992, the Chinese leadership adopted a series of market-oriented reforms to reinvigorate the domestic economy. Although the reforms initiated were wide-ranging, they did not follow any systematic blueprint. Most were pragmatic in nature and were aimed at improving the functioning of the system or at correcting a deficiency in it. The incremental and problem-solving approach to reforms was quite successful in invigorating the economy while avoiding severe shocks to the economy. Nevertheless, there were recurring episodes of macroeconomic instability as macroeconomic management was weakened by the un-evenness and incompleteness of the reforms. As a result, the authorities frequently resorted to administrative measures to restore macroeconomic balance. In late 1992, the Chinese leadership decided to break with the old planning system and to establish a fully market-based economy. This historic decision has led the leadership to formulate a comprehensive strategy to achieve this goal.

Major Reforms During 1978 to Early 1992

The reform of the domestic economy in the period through 1992 may be divided into several phases. From 1978 to 1984, reforms were aimed primarily at revitalizing the rural economy, particularly the agriculture sector. The objective was not to overhaul the planning system but to improve the functioning of the economy through the judicious use of material incentives, the encouragement of private and local initiatives, and the application of market signals to improve the allocation and distribution of resources. Many of the reform measures harked back to the policies adopted to rehabilitate the economy in the early 1960s in the aftermath of the Great Leap Forward.16 The overwhelming success of the rural reform emboldened the leadership to adopt a wide-ranging set of measures to reform the urban industrial sector in the mid-1980s. However, because of their greater complexity, the urban reforms encountered persistent difficulties, and in 1988, the reform efforts came to a halt when attempts to accelerate the pace of price reform led to social unrest. A period of retrenchment and consolidation followed from 1989 to 1991, during which reform initiatives were few except in the area of price adjustments and the establishment of markets for various commodities. A synopsis of the major reforms undertaken during 1978 to 1992 appears in Appendix I.


Until 1979, agricultural production was organized under communes that were further divided into brigades and production teams, the latter being the basic unit of production. Production decisions were passed down from higher authorities and often did not take local conditions into account. Worker remuneration was based mainly on the income of the brigade and did not reflect individual productivity, although households were allowed small private plots on which they could produce goods for their own consumption or for sale at rural trade fairs. Under this system, agricultural growth in the pre-reform era was barely sufficient to keep up with population growth.

Under the reform initiated in 1979, procurement prices of agricultural products were raised significantly, private plots were enlarged, diversification and specialization of agricultural production was encouraged, and restrictions on rural markets and non-agricultural activities were relaxed. Experiments with various forms of incentives to individuals or households eventually led to the emergence of the household responsibility system (HRS) as the dominant arrangement by the end of 1982. Under this system, plots of collectively owned land were made available to households for a fixed period under contracts that obliged the household to supply a share of the production team’s mandatory production quota, to pay agricultural taxes, and to contribute to collective services.17 The household could dispose of the remaining output on the free market or by selling it to the state at negotiated prices.

The reforms were highly successful in raising agricultural production, which grew at more than twice the rate of the 1960s and 1970s. However, the success was achieved at the price of increasing fiscal subsidies because the authorities were unwilling to pass the higher procurement prices to the urban consumers. The subsidies reached a peak in 1984 because of a bumper harvest, and in 1985 the state switched from the mandatory purchase quota system to a procurement contract system to alleviate the fiscal burden.

The adoption of the procurement contract system, however, led to an immediate drop in grain production as farmers diversified into more lucrative cash crops. Furthermore, infrastructure investment had declined with the breakup of the communes, which used to mobilize labor for such projects. During the next several years, the state stepped up its investment in the agricultural sector, and procurement prices offered by state agencies were raised in the late 1980s and early 1990s. As a result, grain output rose to a new peak in 1990, prompting the introduction of a market price support mechanism because the market price of grain had fallen below the state procurement price and threatened farm incomes.

As noted above, one important cost of the agricultural reforms was the sharp rise in fiscal subsidies because of the lack of price pass-through from the farmers to the urban consumers. Eventually, in 1991 and again in 1992, large percentage increases in the ration prices of these goods were implemented for the first time in about 25 years, bringing the urban sales price up to the procurement price, but still leaving subsidies on distribution and processing costs. In 1992, grain prices were decontrolled in Guangdong and Fujian provinces, and by May 1993, grain prices had been decontrolled in about 2,000 cities and counties covering 80 percent of the country.

In the last three to four years, considerable attention has been focused on developing agricultural wholesale markets as a means of reducing the role of the state in agricultural production and procurement, and gradual progress is being made in developing forward and futures trading. In May 1990, a national trading center in grains was established in Zhengzhou, Henan Province. The center makes use of contract transfers and open buying and selling. Following this, rice markets were established in Jiu-jiang, Jiangxi Province, and Wuhu, Anhui Province. It is estimated that there were about 72,000 open local markets throughout the country in 1992.

Rural Enterprises

One of the most important outcomes of the agricultural reform was the unexpected boom in township and village enterprises (TVEs). As restrictions affecting nonagricultural activities were progressively rolled back, rural enterprises sprang up absorbing surplus rural labor and contributing to rising foreign exchange earnings. From the start, TVEs were allowed to retain profits and achieved significant productivity gains through reinvested earnings. In addition, they were initially given concessional tax treatment, supplemented by access to credit from the rural credit cooperatives. One notable departure from the past was the freedom granted to TVEs to sell their products at market prices. Another was the change in the wage system. Previously, wages were paid to production teams and were then distributed to individual members of the team. The newly established TVEs shifted to more direct and performance-based wage payments, which greatly improved individual incentives and productivity.

The key to the early success of the TVEs lay not in any change in ownership—they remain mostly owned by the collectives—but in the extent to which market forces were allowed to sculpt their development. First, the supervising government agency had every incentive to ensure the success of the enterprise, since it was a source of revenue. Second, the TVEs faced a hard budget constraint; the townships did not have the resources to support failing enterprises, the banks would similarly be disinclined to extend credit in the absence of government financing, and unlike SOEs, TVEs have no “captive” markets for their products or inputs. Indeed, during the initial period of the rectification program in 1988–91, bank credit to TVEs was largely suspended, and many of them closed causing considerable loss of employment. Third, they were not obliged to provide social support services to the same extent as were state enterprises, were able to employ according to need, and could determine their own wage levels.

The rapid growth of the TVEs has led to a dramatic change in the economic landscape, particularly in the countryside, where they were estimated to total about 19 million and to employ more than 100 million workers in 1992 out of a total rural labor force of about 430 million.18 It is estimated that they contributed to about half of rural GDP and accounted for about one-third of farm incomes. The gross value of industrial output of TVEs was estimated to be about one-third of the country’s total in 1992.

Prices and Mandatory Planning

Since most prices were controlled by the state with only infrequent changes until 1979, domestic prices did not reflect either relative scarcities or prices on international markets. In general, prices of agricultural products and basic consumer goods were kept low to protect welfare. Relative prices were structured to concentrate profits in industries producing finished products to extract fiscal revenue to support the budget. Relative prices had little effect on the allocation of resources as industrial products and raw materials were allocated by mandatory planning. Price reform has consisted of adjustments to administered prices as well as partial liberalization.

The first steps of this price reform involved substantial adjustments to agricultural procurement prices and were followed by increases in the prices of many nonstaple food items, although the prices of grain and edible oil sold under ration were not changed until 1991. The next major stage in the transition toward a more liberal pricing structure was the development of the two-track pricing system. First introduced in the rural areas, under this system farmers would sell their products (especially grain) up to the quota amount to the state at the state-fixed price, and could then sell the above-quota amount on the open market or to the state at negotiated prices. For several years the system was largely confined to agriculture and a few enterprises on an experimental basis.

In 1984, this two-track pricing was extended to cover a widening range of commodities, and over time the proportion of goods subject to mandatory planning was gradually reduced. By 1988, 53 percent by value of retail sales was transacted at market prices,19 28 percent took place at fixed prices, and the remainder was subject to “state guidance.” Progress on price reform subsequently slowed under the rectification program, which initially witnessed a recentralization of price control.

The prices of industrial materials have also been partially liberalized, although to a lesser extent than consumer goods at the retail level. The two-track system contributed to increased efficiency by providing clearer signals for production decisions at the margin than plan prices. However, these gains were offset first by the incentives for enterprises to negotiate high levels of inputs and low levels of output, and second, by the scope for corruption that the system offers. Such persistent distortions led the authorities to decide to phase out the two-track system, and as a first step, the prices of several industrial raw materials were unified in 1991, as the authorities took advantage of the excess supply condition that had led market prices to fall close to or below the state price. No timetable has yet been set for the complete abolition of the system, but in September 1992 the authorities announced the liberalization of the prices of a large number of industrial inputs representing over four-fifths of all such commodities previously under control. For the remainder, the role of mandatory planning could be expected to be eroded by the continuation of two processes: increases in the prices of goods allocated under the plan,20 and reductions in the proportions of goods allocated in this way.

As implementation of price guidelines has generally been left to provincial governments,21 the intensity of price control varies across regions of the country; for instance, some provinces had decontrolled many nonstaple food prices by 1988. The authorities are also shifting away from direct price controls into “indirect” price management through the use of buffer stocks of certain basic commodities at the provincial level. First used for grain, this device was extended to other foodstuffs and some raw materials in an effort to contain inflation to targeted levels. A further consequence of devolving price-setting powers to local governments—rather than to the market—has been the emergence of market fragmentation, with a tendency for interprovincial barriers to develop against the movement of goods that remain subject to mandatory planning.

State-Owned Enterprises

Until reforms were initiated, the SOEs had little autonomy. Their production, pricing, and investment decisions were subject to the planning process, they transferred all surplus funds to the state budget, and they relied on the budget for subsidies to cover losses and grants for investment. Few incentives were available to workers or management; wages were set by centrally determined scales, and the managers’ main responsibility was to fulfill production quotas.

Early reforms aimed to increase enterprise autonomy and accountability. After some initial experimentation, in 1983 it was decided to introduce a variant of the responsibility system that had evolved in the rural areas. Automatic profit transfers to the budget were phased out in favor of direct taxation, and from 1986 the Government reduced the extent of day-to-day intervention through the introduction of contracts for large and medium-sized enterprises.22 Under this contract responsibility system (CRS), targets were specified for the enterprise over a three- or four-year period for its performance, its production quota to the state, and financial obligations to the Government—ordinarily taxes and dividends. Although this may have had a positive impact on enterprise efficiency, it also undermined the tax system, since the notional rate of corporate tax (55 percent) was rarely applied; instead most enterprise income took the form of contractual obligations. Moreover, to soften the impact of the increased borrowing for financing enterprise investment, loan amortization (as well as finance charges) was made tax deductible. The first generation of these contracts, signed by at least 90 percent of the enterprises, was in place by 1988.

To accompany these changes, a bankruptcy law was enacted in 1986 and became effective in 1988, but until recently it was hardly used against state-owned enterprises. In 1988 the authorities also enacted an Enterprise Law, which seeks to transform the SOEs into fully autonomous legal entities that are responsible for their own profits and losses. Detailed regulations giving effect to the broad provisions of the law were issued in July 1992.

Although the initial impact of the reforms was a recovery in the output of the SOEs, price controls persisted, production quotas for sale to the state remained part of the contracts, the SOEs had access to certain amounts of cheap raw materials, credit was readily available for investment or working capital, the budget continued to provide support for loss-making enterprises, and little advantage was taken of reforms to wage and employment practices. In short, the SOEs continued to face a soft budget constraint. In addition, they faced an uneven competitive environment in that marginal tax rates varied substantially, costs differed according to each enterprise’s access to raw materials at state-fixed prices, and sales receipts depended on the proportion of output that could be sold on the free market.

The incompleteness of the reforms jeopardized macroeconomic management, with SOEs contributing to the rapid rate of credit expansion in the late 1980s and early 1990s, reflecting mounting demands on the state budget to cover enterprise losses, low revenue buoyancy, the accumulation of large inventories of unmarketable goods (either because of excess production or low quality), and the associated growth of interenterprise arrears. To address these problems, the authorities during 1991 announced some 20 measures, 12 of which were to improve the operations and external environment of the SOEs, and the others were aimed at facilitating the operation of market forces on the SOEs. Some measures, such as reducing mandatory planning, were further steps toward a market economy, but others, such as preferential access to credit and tax concessions, continued existing interventionist policies. Indeed, during the rectification program of 1988 and 1989, a large number of SOEs were given preferential access to credit and raw materials under a “mutual pledge” or “double-guarantee” system, which obliged them to deliver specified amounts of their output to the state.

Experiments were started in the late 1980s with new forms of contracting that would separate taxes from profit, end the deduction of loan amortization, and establish a lower uniform tax rate (33 percent as opposed to 55 percent). Under the new generation of contracts in 1990–91, the authorities chose to retain the existing form of contracting, although it was found that many enterprises were unwilling to undertake commitments for more than one or two years because of their financial difficulties.

Employment, Social Benefits, and Housing

Under the traditional employment system, the state assigned workers to enterprises that were obliged to provide jobs. The workers were guaranteed lifetime employment and were provided with housing, medical and retirement benefits, and a basic salary that depended on the worker’s years of service. Such a system is highly rigid and resulted in overstaffing in most enterprises, with virtually no labor mobility and little correspondence between the remuneration of workers and their productivity. Hence, to make the enterprises financially accountable and to judge them by strictly economic criteria, it was necessary to change the old system of employment, social benefits, and housing so that enterprises were not burdened with social responsibilities. In the second half of the 1980s, the authorities began experimenting with reforms in these areas; however, progress was relatively slow, thus hindering reform of the enterprise system.

The labor contract system was first introduced in 1986 for all newly recruited workers in the state-owned enterprises.23 On the expiration of the contract, both the enterprise and the employee are free to choose whether to continue or terminate the contract. Under this system, the terms and conditions of employment are determined by a contract signed between the employee and the enterprise. However, progress in introducing the system was slow, and as of the end of 1992, it was estimated that the system covered only about 16 million workers or about 21 percent of the total number of employees in the SOEs.

To enforce a hard budget constraint on enterprises without adverse social consequences, an adequate social safety net has to be developed. An unemployment insurance scheme was set up in 1986 to provide benefits to the unemployed. To be eligible, the unemployment must have resulted from the following causes: (1) bankruptcy of the enterprises; (2) restructuring of the enterprises; (3) termination of labor contract; or (4) firing because of violation of rules.24 In addition to cash relief, the unemployment scheme also provides training to the unemployed and assistance in setting up their own businesses. At present the unemployment insurance covers more than 70 million employees in the state-owned enterprises. In some regions, it extends to employees in collective firms, joint ventures, and private enterprises.

Traditionally, housing is an integral part of the employment system and is distributed to workers at a highly subsidized rate on an administrative basis. Such a system discourages the mobility of labor because the worker will generally not be able to keep his apartment if he leaves his work unit. This means that he will only move if the new employer is able to provide similar housing. This is a major constraint on labor mobility and the establishment of a labor market.25

Experiments with housing reform have been under way for several years in Yantai, Bengbo, Shenzhen, and Shanghai. In 1991, the pace of housing reform was speeded up with the announcement by most municipalities of major increases in rents. According to a recent household expenditure survey, the level of rent is equivalent to only 1 percent of the average household expenditure compared with 20-30 in most developed countries. The rent reform aims to increase rents over a five-year period so that the level of the rent will be equivalent to about 6 percent of household expenditure and sufficient to cover the following five cost elements: maintenance, administrative cost, depreciation, interest charges, and return on capital.

Fiscal Reform

In the pre-reform era, fiscal policy had almost no role in macroeconomic management, its function being largely confined to facilitating the administrative allocation of resources. It achieved this by regulating the rate of capital accumulation and by aiming to keep household incomes in line with the availability of consumer goods. Tax policy was not of great consequence since there were no individual or enterprise income taxes; instead, enterprises were obliged to remit all profits to the state.

The most far-reaching reforms in the fiscal area came during the mid-1980s in the area of enterprise taxation as described above. As noted by Blejer and Szapary (1989), the contract responsibility system introduced for the state enterprises implied that (1) the marginal tax rate varied widely among enterprises (declining as above-target profit rose); (2) the average tax rate faced by enterprises declined over time as inflation was underestimated in the first generation of contracts; (3) as a result, the long-term income elasticity of enterprise tax fell below unity; and (4) a strong discretionary element was introduced as enterprises sought to negotiate more favorable tax contracts. The current arrangements can be regarded as a transitional stage en route to a fully transparent tax system. Although there has been little further reform of the system since 1988, experiments with alternative arrangements have taken place.

In one major step of simplification, the taxation of all foreign enterprises and joint ventures was brought onto an equal footing in 1991, and the intention is eventually to unify the taxation of all foreign-funded and domestic enterprises. In other areas of taxation, the Government is presently reforming the tax administration system, the income tax for domestic enterprises, the personal income tax, and the value-added tax.

The adjustments in 1991 and 1992 in the prices of grain and edible oil—which accounted for the major part of food subsidies—will have a significant budgetary impact. However, a large subsidy element will remain until the retail price is adjusted to cover all costs, including processing and distribution. Similarly, the adjustments in energy prices have led to a reduction in government subsidies to loss-making enterprises. However, further adjustments are necessary before the fiscal subsidies can be completely eliminated.

Resource sharing between the center and provincial governments has received considerable attention. One objective is to preserve an adequate degree of fiscal control for the central government and another is for the center to have more resources at its disposal to implement the priorities of the central government, including transfers to provinces in deficit. The contracts signed with the provinces in 1988 implicitly contained a pro-cyclical bias, such that expenditures were likely to increase when revenue earnings in the provinces were high.26 Although a new generation of contracts should have become effective in 1991, thus far the existing contracts have been extended. Meanwhile, in 1992, the authorities experimented with a system of separate taxation in nine provinces and municipalities with the aim of delineating more clearly the taxes that accrue to the central government or to the provinces and those that are shared.

Financial Sector

Banking System

Until 1978, the banking system had only a limited role, acting as the means of providing the credit needed by the enterprises to implement the physical plan. As enterprises acquired greater responsibility for implementing their own investment programs (with diminishing access to budgetary funds), greater scope opened up for involvement by the banking system. However, for the first few years of the reform period, there was little change from a banking system in which the People’s Bank of China acted as a monobank, functioning as both central bank and commercial bank. At the same time there were three other specialized banks whose activities were sharply demarcated into agriculture, state construction, and foreign exchange management.

In 1984, the People’s Bank was established as a central bank, and its commercial banking functions were transferred to a newly created bank. At the same time, the specialized banks were gradually allowed to engage in general banking activities including, from 1986, foreign transactions. Thus, although considerable specialization remained, the basis for a competitive environment began to be laid as new banks at the provincial level and two comprehensive banks were set up.

After the major reforms of the mid-1980s, the pace of reform in the financial sector slowed appreciably from 1988 under the rectification program. Considerable recentralization took place, the role of directed credit became more important, and there was some loss of competition within the banking sector with more uniformity in interest rates and a sharpening of the demarcation lines between the specialized banks. In late 1990 and 1991, some of the rigidities were eased: the restrictions on lending to nonpriority sectors were relaxed (allowing TVEs renewed access to credit), and provincial branches of the People’s Bank were allowed some discretion in allocating credit among banks.27 There is also a growing interbank market that operates largely at the municipal and provincial levels.28 Nevertheless, the central bank still played an important role in intermediating funds between surplus and deficit provinces and between branches of banks.

Nonbank Financial Institutions

The nonbank sector has grown considerably throughout most of the period since 1978. Trust and investment companies (TICs), whose activities include domestic currency loans, direct investment, and trust business (in which the TIC acts as an intermediary in lending between two enterprises), expanded rapidly after the mid-1980s. So rapid was this growth that the Government temporarily restricted their operations to investigate their financial condition. With a few exceptions, they were judged to be in sound financial condition and their operations were soon normalized. This episode illustrates the inadequate development of the supervision of financial institutions (including banks). Other financial institutions have been established, engaged in leasing, insurance, and securities transactions, and some finance companies were formed by enterprise groups to handle a range of financial services for these groups.

International trust and investment corporations have operated since 1979, including a number at the provincial level, particularly in the coastal regions. Their function is largely to raise funds from foreign sources to finance foreign-funded enterprises through loans and equity participation; they have been the primary source for most international bond issues made by China during the 1980s.

Securities Markets

The first issues of securities in 1981 were exclusively treasury bonds sold involuntarily to enterprises and individuals. In the case of bonds for individuals, the yields were set slightly higher than the interest rates on bank deposits of comparable maturity. The Government later began to issue bonds whose proceeds were earmarked for key investment projects. Experiments with the issuance of enterprise “shares” began in 1982 for private enterprises and in 1985 for state enterprises.29

The development of a secondary market in government securities has been encouraged by the authorities since 1988, and in 1990, it was enhanced by the establishment in Beijing of a national electronic trading system (STAQ) that links several cities across the country. The development of the treasury bond market was given a boost in 1991 when the Ministry of Finance switched from the administrative placement of bonds to marketing the bonds through underwriting by financial institutions.

In 1990–91, securities exchanges were opened in Shanghai and Shenzhen, which permitted trading in government and enterprise bonds, as well as shares of joint-stock companies. Initially, only Chinese residents were allowed to trade in the enterprise shares. However, in early 1992, foreigners were allowed access to these exchanges to procure and trade in special issues of enterprise shares (“B” shares). Attempts by local governments to open more securities exchanges in 1992 have been resisted by the central authorities, which are concerned about the lack of experience and expertise in operating such exchanges. In late 1992, the central authorities set up two regulatory bodies to oversee and supervise the development of the securities industry. In addition, a national securities law has been drafted and is under consideration by the legislative agencies.

Monetary Policy Instruments

Prior to the reforms, monetary policy was implemented through a credit plan—the financial counterpart of the physical plan specifying output targets—and a cash plan, which took into account various factors affecting the demand for currency. Because of the fixity of prices, the demand for money (currency) was highly correlated with cash incomes. An excess supply of money had little impact on prices or the balance of payments and manifested itself in the form of an involuntary increase in savings deposits.

The changing institutional structure of the financial system and the gradual increase in the openness of the economic system have enhanced the importance of monetary policy in demand management. The principal instruments of monetary policy include direct controls on credit and interest rates, and indirect instruments, notably reserve requirements and lending to banks by the People’s Bank. However, since indirect instruments of monetary policy have yet to be fully developed and deployed, the credit plan continues to be the principal instrument of monetary policy. Changes in interest rates and in reserve requirements are of secondary importance.

Extending the Reform Agenda: 1992 and Beyond

A new phase in the reform and opening up the Chinese economy began in 1992 with a marked acceleration in the pace of reform. The process was initiated early in the year during Deng Xiaoping’s trip to south China in which he made some important pronouncements and called on the country to accelerate its growth and pursue more vigorously its policy of reform and opening up. It culminated in October at the Fourteeth National Congress of the Communist Party of China, when the party endorsed the views that he had expounded and called for the establishment of a “socialist market economy.” In March 1993, the goal of establishing a socialist market economy was enshrined in the country’s constitution during the first session of the Eighth National People’s Congress.

This section discusses the plans and strategies proposed by the authorities to broaden and deepen the reform process to transform the economy into a fully market-based economy. Unlike the previous section, the discussion here is thematic, proceeding from the most general and abstract to the particular and specific. It first reviews the plans to strengthen the legal and regulatory framework and to reform the role and functions of government and the macro-economic framework. It then proceeds to discuss the initiatives announced to establish markets and deepen reforms in specific sectors of the economy. Box 3 contains a chronology of reforms implemented since early 1992.

Legal and Regulatory Framework

The legal and regulatory framework is one of the weakest areas in China’s economy today. Unlike a central planning system that operates mainly on administrative decrees and directives, a market system requires an elaborate legal and regulatory framework to set the “rules of the game” within which market participants can operate competitively and freely. Many new laws and regulations have to be drafted and older ones annulled, amended, or revised in several areas of the economy to reflect the new requirements of a market economy. In addition, the legislature has to be strengthened to create the necessary institutions to monitor and supervise the markets and to establish an impartial judiciary to arbitrate disputes. The challenge in this area is to effect a clear separation between the different institutions of the state on the one hand and to define as precisely as possible the rights and obligations of the various participants in a market economy on the other.

In 1992, the authorities announced that the work on drafting legislation was to be speeded up. During the past year and a half, several important economic laws have been enacted. These include a patent law, a copyright law, a tax administration law, the Import and Export Commodities Inspection Law, and a trademark law. The State Council also promulgated several important regulations to give effect to laws that had been passed previously. These included the Regulations on Changing the Operating Mechanism of Enterprises, Regulations on the Formation of Shareholding Companies, a code for the implemention of a new accounting system for enterprises, and the Interim Provisions on the Management of the Issuing and Trading of Stocks. Other important economic legislation being drafted or revised comprise a central bank law, a general banking law, a securities law, an insurance law, enterprise and personal income tax laws, a contract law, a real estate law, and a company law. In June 1992, the central government delegated to the Shenzhen municipal government the legislative power to formulate and enact new laws to promote economic reforms with the aim of speeding up the legislative work in the country.

On the regulatory side, the State Council set up a Securities Exchange Commission and a Securities Supervision and Administration Commission in 1992. Other institutional measures to be implemented include the adoption of a new accounting framework that is more suited to a market system, the reform of bank supervision, the establishment of public auditing firms, and the formation of law firms to provide legal services to the business sector. A new accounting system for enterprises was implemented beginning on July 1, 1993, which is of special importance because it will provide a more accurate picture of the performance of enterprises. The accounts of the enterprises wilt also be subject to audit by public auditing firms instead of the supervising ministries.

Role and Functions of Government

An important aspect of economic restructuring is to redefine the role and functions of government in the economy. In particular, the government should withdraw from its traditional tight control of enterprises. It should instead focus on establishing an effective macroeconomic management system; developing and improving the economic infrastructure to enable markets to operate efficiently; establishing and improving the social security system; and providing services to economic agents. It is also essential to change the parochial attitude of the local governments to break down the internal barriers to trade and to movements in labor and capital and encourage the establishment of national markets.

In 1992, the authorities announced that a major restructuring of the administrative system would be implemented over the next three years to make the role and functions of the Government conform to the requirements of a socialist market economy. In general, those ministries and agencies that were in charge of mandatory planning and the supervision of enterprises would be either restructured, merged, or abolished. In March 1993, the National People’s Congress approved a plan to streamline the government bureaucracy. The number of ministries and departments under the State Council was reduced from 86 to 59. As a complement, the civil service is to be restructured, with the number of staff reduced by one-third and the remainder subject to major redeployment to make their work relevant to the needs of a market economy. The State Planning Commission is being revamped to shift the focus of its work away from the traditional task of physical planning toward macroeconomic planning and the development of long-term economic plans.

Macroeconomic Management

The reform of the system of macroeconomic management is recognized as a key task of the Government during the coming years. Since 1978, China has experienced at least three major episodes of macroeconomic instability during which emphasis on deepening reforms was subordinated to the restoration of macroeconomic stability through economic and administrative means. Hence, a key objective of macroeconomic policy is to maintain a stable environment for the pursuance of reform and the opening-up policy.

Although the system of macroeconomic management has been reformed since the mid-1980s to incorporate elements of indirect instruments, it still relies to a large extent on administrative methods and instruments. Such a system is incompatible with the principle that the behavior of economic agents should be guided by market forces. The authorities have begun to implement a plan to restructure the Government to reduce the role of physical planning in the economy and the direct supervision of enterprises by government ministries. The intention is to rely mainly on indirect instruments to manage the economy. However, indirect instruments of monetary and fiscal policy are effective only if enterprises are faced with a hard budget constraint and banks behave competitively and are sensitive to their cost of funds. The reform of the macroeconomic management system implies therefore not only the development of new instruments of monetary and fiscal policy but the successful restructuring of the enterprises and the financial institutions.

Chronology of Reform Initiatives, 1992–July 1993

In the monetary area, the People’s Bank has announced its intention to move away from the credit plan toward greater reliance on indirect instruments of monetary policy, including open market operations, interest rates, reserve requirements, and re-lending to banks. To prepare for the eventual use of open market operations, the authorities are taking steps to develop the instruments and the interbank markets. A modern payments system is being established that will enable the banks to manage their funds more efficiently. This will in turn enable the People’s Bank to influence monetary conditions by affecting the liquidity of the banking system.

To strengthen the role of the budget in macroeconomic management, the authorities are taking steps to correct the structural weakness in the fiscal system, particularly the lack of revenue buoyancy, the erosion in the central government’s share of fiscal revenue, and the high subsidy payments. Over the years, the budget has been weakened by a progressive narrowing in the tax base, which is highly dependent on the state-owned enterprises, and the adoption of the contract responsibility system.30 To broaden the tax base and improve the elasticity of the tax system, a new enterprise income tax is to be introduced that will subject all domestic enterprises to a uniform tax rate of 33 percent and require the payment of amortization and dividends from after-14 decision-makingtax profits.31 Other tax reforms under consideration include the introduction of a new personal income tax, the reform of indirect taxes, and the strengthening of tax administration. To strengthen the central government’s control over fiscal revenue, the current revenue-sharing contracts with the provinces will be replaced by the establishment of separate taxation for the local and central governments. On the expenditure side, the high subsidy payments are expected to diminish over time as controlled prices, particularly of coal and grain, are adjusted further. On a more analytical aspect, the authorities are also reforming budgetary procedures and adopting a new budget format that is more suited to macroeconomic analysis.

Establishment of Markets and Related Infrastructure

A major task during the coming years will be to establish the environment and facilities for developing national markets in all types of commodities and services. Since 1978, local markets have developed spontaneously as a result of the liberalization in the agricultural and industrial sectors. For instance, free markets in food and consumer goods can be found in all urban areas. However, the development of national and regional markets has been hampered by the inadequate legal and regulatory framework, poor economic infrastructure, particularly transportation, telecommunications, and the payments system, and the protectionist tendency of local authorities.

In recent years, the authorities have actively organized and established wholesale markets at the regional and national level, such as the garment market in Shengyang; the clothings market in Suzhou; the meat market in Chengdu; the sugar market in Guangzhou; and the vegetable and grain market in Shandong province. National and regional trading centers have been established for various commodities and services. These include the national grain trading center established in Zhengzhou in 1990; the nonferrous metals exchange in Shenzhen (1992) and the metals exchange in Shanghai (May 1992); the securities exchanges in Shanghai (December 1990) and Shenzhen (May 1991); the petroleum market in Nanjing and Shanghai; the cereals and edible oils market in Shanghai; and the national foreign exchange trading center in Beijing.

In general, the authorities are involved in providing the facilities and setting up the legal and regulatory framework to ensure that the markets work efficiently and fairly. Policies were adopted in 1992 to promote the development of the service sector, which is essential to the smooth functioning of markets. In particular, a market economy requires the professional services of accountants, auditors, property valuation experts, lawyers, management consultants, marketing agents, commercial artists, and so forth. To overcome the infrastructure problem, the authorities are undertaking major investments in transportation and telecommunications. A modern payments system is also being established.

Price Reform

The Chinese authorities have made considerable progress in the area of price reform. Since 1984 when the authorities introduced a dual-track pricing system, China has succeeded in transforming its price system from one in which most prices are set by the state to one in which they are determined by a combination of administrative and market forces. Nevertheless, the price system has remained complex, and the dual-track pricing system tends to encourage corruption and rent-seeking behavior by enterprises. Also, the subsidies to consumers and enterprises have become a heavy burden on the budget. The authorities have recognized that the completion of price reform will greatly facilitate reforms in other areas of the economy, particularly enterprise and fiscal reforms.

In 1992, the authorities announced a speeding up in the pace of price reform. In particular, the time frame for the elimination of the two-track pricing system would be compressed to the next three-five years instead of over the decade. Major adjustments were made to the price of many commodities including grain, flour, coal, steel, cement, gas, and transportation services. Furthermore, in the wake of an acceleration in the pace of enterprise reform, the number of producer goods subject to mandatory price control was reduced from 737 to 89. The authorities also reduced the share of output of coal and other products subject to mandatory planning. As a result, the proportion of producer goods subject to price control was reduced to 20 percent and that of consumer goods to 10 percent in 1992 (Table 6). At present, only seven types of agricultural products, including grain, cotton, and tobacco, still fall under state control. As noted above, by May 1993, controls on grain prices had been lifted in about 2,000 cities and counties covering about 80 percent of the country.

Table 6.

Proportion of Output and Sales at Fixed, Guided, and Market Prices

(In percent)

Sources: China Price Yearbook, 1990; and data provided by the Chinese authorities.


Of all the major reforms introduced since 1978, perhaps the most successful and complete is the change in the organization of agriculture. Since 1983, the household responsibility system has remained the principal organizational form of farming. This system has now been written into the country’s laws to assure the farmers that it will not be changed arbitrarily. As in recent years, future reforms will focus on the distribution and pricing system through the establishment of national and regional wholesale markets and the realignment and liberalization of prices. By 1992, a three-tier system of national trading centers, regional wholesale markets, and local open markets had been established throughout the country. With regard to the pricing system, it was reported that about 70 percent of all agricultural products were set by the market at the end of 1992 and only 17 percent continued to be subject to prices fixed by the state. By mid-1993, controls on grain and other food prices had been lifted in most parts of the country.

Enterprise Reform

Perhaps the most difficult task ahead is the successful transformation of the state-owned enterprises (SOEs) into autonomous, competitive, legal entities that are responsible for their own finances. As described above, experiments with enterprise reform have been under way since 1983, and SOEs now enjoy much greater autonomy than in the past. However, the autonomy is not complete as enterprises are still subject to administrative interference from their supervising ministries, and, furthermore, the greater autonomy has not been accompanied by a corresponding hardening of the budget constraint. The weakness of the state enterprise sector was demonstrated vividly during the last macroeconomic cycle (1988–91), when the financial difficulties of the SOEs forced the authorities to relax the stance of monetary and fiscal policy to resuscitate the economy. Even in 1992 when the economy was experiencing robust growth, it was reported that about one-third of the SOEs were making losses that put a strain on the financial system. Hence, one of the priorities of the authorities is to speed up enterprise reform with the aim of pushing the SOEs into the markets and making them autonomous and responsible for their profits and losses.

Enterprise Regulations

To make enterprises truly autonomous, the authorities need to sever the link between the SOEs and their supervising ministries. In July 1992, the authorities published the “Regulations on Transforming the Operating Mechanism of State-Owned Enterprises.” These regulations are intended to give effect to the “Enterprise Law,” which was enacted in 1988 to harden the budget constraint of state-owned enterprises by transforming them into autonomous legal entities responsible for their own profits and losses. The regulations spell out 14 decision-making rights that enterprises should enjoy, including the right to decide what to produce and how to price and market their products, how to invest their funds, the right to hire and fire workers and to decide on wage policy (see Box 4). In return for these rights, enterprises are expected to be accountable for their performance, and inefficient ones are expected to restructure or to be closed in accordance with the bankruptcy law. The role of the state as owner of the enterprises is delegated to the State Asset Management Bureau. The new regulations have been promulgated and are in the process of being implemented by the various government departments and provincial authorities. However, according to recent reports, implementation of the regulations has been resisted.

Shareholding System

An important experiment in enterprise reform that has major ramifications for the ownership structure of enterprises and that has received widespread interest is the shareholding system. Under this system, enterprises are allowed to restructure themselves into limited liability companies by issuing shares. The shareholding system (or corporatization) provides for a clear separation between the ownership and management of the enterprises and is therefore a way of restructuring the traditional relationship between the Government and the enterprises under its control. It is estimated that several thousand enterprises are participating in this experiment. Because of the great interest in the shareholding system, the authorities have issued several codes and regulations on the formation of such enterprises, including the system of management and accounts. A company law has been drafted and is under consideration by the legislative authorities.32

Enterprise Regulations

Enterprises shall enjoy the following rights:

  • To make production and business decisions;

  • To set their own prices;

  • To market their own products;

  • To purchase materials;

  • To import and export:

  • To make investment decisions;

  • To decide on use of retained earnings;

  • To dispose of assets in accordance with production requirements;

  • To form partnerships and mergers;

  • To assign labor;

  • To have personnel management;

  • To set wages and bonuses;

  • To determine internal organization;

  • To refuse arbitrary levies and charges.

The development of the shareholding system has been boosted by the establishment of stock exchanges in Shanghai and Shenzhen to list the shares of approved joint-stock companies.33 The stock markets have grown dramatically in the last two years, with the number of shares listed rising from 15 to 113 (of which 21 are “B” shares) by mid-1993 and the combined capitalization was estimated at about Y 100 billion in 1992. Two regulatory agencies were set up to oversee the development of the industry in 1992. In April 1993, a national electronic trading system (NETS) was established in Beijing to allow trading in legal persons shares. A new securities law is being drafted to unify the rules and regulations in the country. At present, the two securities exchanges are operating under their own separate rules and regulations.

In the view of the authorities, the shareholding system can be an effective vehicle for restructuring enterprises. Except for large enterprises in strategic sectors of the economy such as defense and high technology, most SOEs could eventually be converted into shareholding companies with the state retaining a majority or significant share. This would allow the state to exercise effective control over the companies while permitting the enterprises to adopt modern management practices and to raise funds, in both local and foreign currencies, for restructuring and growth. In 1992, a large state-owned enterprise was converted into a shareholding company and listed on the New York Stock Exchange. Plans are under way to list the stocks of nine other companies on the Hong Kong Stock Exchange.

Enterprise Groups

Another experiment that is being encouraged is the formation of large enterprise groups with the aim of rationalizing the industrial structure by taking advantage of economies of scale and promoting the optimum use of resources. Unlike many former centrally planned economies, China’s economy is highly cellular, as each locality was encouraged to be fully self-reliant during the pre-reform period. Furthermore, enterprises within one branch of an industry were normally not allowed to diversify into related fields. As a result, from a national perspective, there is much duplication, a lack of specialization, and strong local barriers to interregional trade. The aim of the authorities is to break down the departmental, regional, and ownership barriers in the economy and create large conglomerates that are efficient and competitive internationally. In the past two years, the Government has selected 55 large enterprise groups (out of an estimated 1,600 such groups) for restructuring to strengthen the role of the parent or core enterprise within each group, particularly its management of the subsidiary enterprises. Preferential treatment such as trading rights or the right to diversify into other fields of activity are being provided to these 55 enterprise groups to encourage their development into competitive conglomerates.

Loss-Making Enterprises

The authorities are taking special measures to deal with the loss-making enterprises according to the nature of their losses and the current low level of development of the social safety net. It is estimated that about 70 percent of the losses of state-owned enterprises are policy induced, mainly because of price control.34 If these enterprises are to be financially independent, it is necessary to liberalize the prices of the goods and services they produce. As noted above, price controls were lifted on 593 types of production materials in September 1992. It is intended to liberalize the prices of coal and other energy products over the next three-five years to avoid major disruption to the rest of the economy. In the interim, the losses of those enterprises will continue to be subsidized through the budget.

For the remaining enterprises that are experiencing losses because of poor management, the authorities are providing fiscal and financial incentives for them to restructure or move into other lines of production. Several thousands of the smaller enterprises have been either closed or merged with more profitable ones to rationalize their operations. In the commercial sector, many state-owned stores have been leased out to private individuals. In some cities, experiments are being carried out to allow foreign investors to buy into and restructure existing loss-making state-owned enterprises.35 Finally, the authorities are cautiously applying the bankruptcy law to the enterprises; it was reported that 66 enterprises were declared bankrupt in the first half of 1992.36

Surplus Labor and Tertiary Sector Development

The problem of surplus labor is one of the most difficult issues in reforming the enterprise system. It is estimated that the redundancy in the government and state-owned enterprises may be as high as 20 million workers out of a total work force of 104 million.37 To avoid massive unemployment, the authorities are encouraging the development of the tertiary sector to absorb the surplus labor. Under the old planning system, tertiary activities were considered unproductive and were therefore not encouraged; as a result, many of the services that are essential to the smooth functioning of a market system were neglected. Since the onset of the reform process, the tertiary sector has grown from about 21 percent to 27 percent of GNP, but it is still small in comparison with the average of 60 percent in most developed countries. In July 1992, the authorities announced several policies to stimulate the development of this sector, including encouraging the use of foreign capital and know-how; transforming most tertiary businesses into profit-oriented enterprises; encouraging staff in government organizations and SOEs to resign and establish businesses in the service sector; decontrolling the prices of most products and services; and providing financial and tax incentives.38 The authorities view the tertiary sector as having great potential for absorbing surplus labor because this sector is generally more labor intensive, comprising, for instance, retailing and wholesaling, catering, teaching, consulting, and social services. It is envisaged that the tertiary sector will play a role similar to that played by the township and village enterprises in absorbing the surplus labor in the agricultural sector during the 1980s.

Employment, Social Security, and Housing

To speed up enterprise reform, the authorities have recognized that they will also need to accelerate the reform of employment, social security, and housing. In 1992, they announced that reform of the employment system would be accelerated. A modified version of the labor contract system is being encouraged for adoption by all enterprises as soon as possible.39 Under this modified system, all employees, including managers, technicians, and operators, must sign a contract with their enterprises to decide their duties, rights, and benefits. The maturity of the contracts can either be fixed or open ended. Under this system, certain distinctions among employees such as permanent versus contract and cadres versus workers will be abolished. A professional grading system will be introduced and all employees will be recruited through examinations. As a complement to the labor contract system, a labor arbitration system is being developed to mediate in labor disputes. To replace the system of job assignment by the state, employment agencies are being established to help place the new entrants in the labor force.

To extend the social safety net, the authorities are formulating new regulations and plans to improve the benefits and expand the coverage of the unemployment insurance system in the near future. In particular, unemployment benefits will be provided to all involuntary unemployment regardless of cause, and the coverage will be extended to employees in collectively owned and foreign enterprises. Further, to facilitate enterprise restructuring, some of the funds will be used both to provide training for the surplus labor in the SOEs and to develop new jobs.

In the past, retirement benefits were provided by enterprises out of current revenue. In recent years, retirement funds have been set up whereby workers and employers are required to contribute a certain percentage of the payroll toward the funds.40 At present, such funds are established at the municipal level in most cities and counties and at the provincial level in about 12 provinces. The intention is to establish a unified national retirement fund at an appropriate time in the future. The retirement funds have improved the conditions for labor mobility and have relieved enterprises of the burden of providing for their retired workers.

To encourage the development of a housing market, the authorities have announced a program of rent adjustment aimed at reducing the subsidy element in housing. This development should lead to the commercialization of the housing sector. Encouragement of the sale of housing is another component of the housing reform. In the last few years, many real estate companies have been established that contruct. apartments for sale at market prices. However, most of the sales are to overseas residents (for example, residents of Hong Kong). The sale of housing to domestic residents is made difficult by the low wages (reflecting the payment of subsidies in kind) and the general lack of housing finance. To overcome this problem, some municipal authorities have set up housing funds—to be funded from the issuance of savings bonds and the sale of existing housing—to construct low-cost housing and expand the housing stock. In some cities, financial institutions are being established aimed at developing mortgage financing. A major source of funds for such institutions is the savings from retirement funds that are being established across the country.

Land Use System

Reform of the land use system is a major element in the overall strategy to establish a market economy. In the past, land was allocated free of charge to users on an administrative basis. Since 1987, when the land use right for a piece of state-owned land in Shenzhen was auctioned to a foreign investor, a lively real estate market has developed. The Government has enacted several laws in the last few years to regulate the real estate industry.41 Under the land administration law, since all land belongs to either the state or the collectives, the state is encouraged to implement a system of land use rights based on the leasehold system. Such land use rights are transferable, and enterprises (domestic and foreign) that acquire the land use rights are allowed to develop, use, and administer the land. The maximum term for the use of land is 70 years for housing, 50 years for industrial purposes, and 40 years for commercial purposes.

So far most of the sale of land use rights for industrial purposes has been by public bidding or negotiated agreements; however, in the past year, the authorities have been encouraging the auction of land use rights, particularly for commercial and residential development. By September 1992, it was estimated that about 3,100 plots of land with a total area of 13,500 hectares had been transferred. The revenue from the sale of land use rights (estimated at Y 50 billion in 1992) accrues mainly to the local governments and is likely to become a major source of funds for urban renewal because most of the land use rights in the cities are still under the state.42 In Shanghai, for instance, it was reported that the municipal authorities collected Y 2.7 billion from the sale of land use rights in 1992. About 85 percent of the revenue is retained by development companies to be used for infrastructure development and the rest is used to compensate the original occupants of the land.

Financial Reforms

China’s financial system has become more diversified since 1984 with the emergence of many new financial institutions providing a variety of instruments and services to customers. Notwithstanding all these changes, the state banks have continued to be regarded essentially as administrative organs of the state responsible for mobilizing and providing funds to finance important activities of the public sector, including those of the state-owned enterprises. As a result, the specialized banks were obliged to provide policy-based loans that were not based on commercial criteria.43 Furthermore, because of the decentralized structure of the banking system, the banks were susceptible to local political pressure to provide loans for investment projects and to give credits to loss-making enterprises to keep them afloat.

In late 1992, the authorities announced plans to reform the banking system to transform the specialized banks into competitive, autonomous, and self-accountable commercial entities. Regulations to apply the Enterprise Law to the banking system are being drawn up. The main components of the reforms are (1) separating commercial from policy-based lending; (2) separating quasi-fiscal from commercial operations so that all loans will be provided at market interest rates and any interest subsidies will be provided through the budget; (3) funding long-term loans for investment projects from long-term funds; and (4) encouraging banks to improve their loan assessment and portfolio management. A new accounting system consistent with international standards is being implemented, and the supervision system of the People’s Bank over the banking system will be reformed to focus on banks’ prudential management of risk.44 Key aspects of the banking reforms are expected to be incorporated in the banking laws that are being drafted.

Another element of banking reform is the establishment of a modern payments system and the development of a national interbank money market that will allow the People’s Bank to conduct open market operations. At present, the interbank market is fragmented into numerous locally based markets organized through financial intermediaries sponsored by the local branches of the People’s Bank. Also, because of the decentralized structure of the banks, the interbank market consists mainly of borrowings between branches of banks. Most banks rely on the People’s Bank for refinancing and only turn to the interbank market as a last resort, which in part reflects the distortion in interest rates. Because of the weakness in the regulatory framework, the interbank market, which grew rapidly in 1992, has been marked by many irregularities in lending practices. In early 1993, the People’s Bank introduced new regulations to strengthen supervision over the interbank market. One objective of the interbank market reform is to encourage banks to reduce their reliance on the People’s Bank for refinancing and to centralize and improve their management of funds. The People’s Bank is also planning to allow greater flexibility for interest rates, and it has introduced short-term bills that can be used as instruments for open market operations.

In the nonbank financial sector, the authorities are promoting the establishment of institutions to provide medium- and long-term funding for investment purposes. As noted above, the equity capital market is developing rapidly with the spread of the shareholding system and the establishment of securities exchanges in Shanghai and Shenzhen and two national electronic trading systems in Beijing. In the past year, the treasury bond market has received a setback because of a failure to adjust interest rates sufficiently in the face of rising inflation. A strong capital market will help to reduce the vulnerability of the banking system by providing enterprises with an alternative source of long-term funding; at the same time, households can invest their longer-term savings in higher yielding assets. The authorities are taking steps to strengthen the regulatory framework in this sector.

Nonstate Sector

The success of China’s reform efforts thus far is attributable in large measure to the impressive growth of the nonstate sector during the past decade and a half, particularly of the township and village enterprises (see above) and the joint ventures (see Section IV). Although less conspicuous, there has also been a boom in individual and private businesses, concentrated mainly in the urban areas. It is estimated that by 1991, there were about 140,000 privately owned companies (which produced Y 100 billion worth of goods) and 15.3 million individual businesses employing 24.7 million people. In 1991, 7.72 million—89 percent—of the retail sales outlets in China belonged to private companies or individually employed businesses. The nonstate sector has contributed to the reform process not only through its strong performance but also by absorbing surplus labor and providing competition to the state enterprises. The encouragement of the nonstate sector is regarded as an integral part of the overall reform strategy.

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