Abstract

The purpose of this paper has been to review the evolution of market-oriented reforms in China, assess the impact on the economy, and draw policy implications for framing future reform strategy. A number of factors are pertinent in explaining China’s experience with reforms over the past decade and a half. First, the initial macroeconomic conditions were relatively favorable. Growth had been maintained in the pre-reform period—albeit by means of very high investment—while inflation and the balance of payments had been kept under tight control. Moreover, China started its reform with virtually no external debt and was thus able to maximize the benefit of the sustained inflow of foreign resources in support of its reform efforts from official development assistance, commercial borrowing, and foreign direct investment. In the latter regard, China’s unique relationship with Hong Kong and Taiwan Province of China has been critical in aiding the flow of physical, financial, and other intangible resources.

The purpose of this paper has been to review the evolution of market-oriented reforms in China, assess the impact on the economy, and draw policy implications for framing future reform strategy. A number of factors are pertinent in explaining China’s experience with reforms over the past decade and a half. First, the initial macroeconomic conditions were relatively favorable. Growth had been maintained in the pre-reform period—albeit by means of very high investment—while inflation and the balance of payments had been kept under tight control. Moreover, China started its reform with virtually no external debt and was thus able to maximize the benefit of the sustained inflow of foreign resources in support of its reform efforts from official development assistance, commercial borrowing, and foreign direct investment. In the latter regard, China’s unique relationship with Hong Kong and Taiwan Province of China has been critical in aiding the flow of physical, financial, and other intangible resources.

Second, the pre-reform political order remained largely intact. Despite internal contention, no fundamental change occurred in the political system, allowing the leadership to concentrate its efforts on economic construction once consensus was reached on the goals and priorities. Third, although any profound change in ownership structures was resisted, the need for market forces to be allowed to operate was accepted. This led to the emergence of such entities as the township and village enterprises and other arrangements that simulated the institutions of a market economy. Fourth, a pragmatism existed in the approach to reform that encouraged experimentation by provinces and local authorities. Indeed, in many cases, reforms consisted of the ratification and generalization of developments that occurred at the provincial level. The evolution of the household responsibility system is a clear example, but other areas, including external trade reform, can also be viewed in this light. Fifth, the very high rates of domestic saving during the reform period were an important source of noninflationary financing of the high rates of investment that were realized.

China has unquestionably made considerable progress in reforming its economy. This reform has contributed to an economic performance marked by rapid growth of output based primarily on improvements in factor productivity; progressive diversification of the economic structure; opening of the economy to the rest of the world; and an impressive export performance. A factor contributing to the impressive growth performance has been regional development policies—an essential element of which has been the progressive decentralization of decision making.

The rapid growth of the economy also reflects in part the dynamism of the nonstate sector comprising the township and village enterprises, the private businesses, and the foreign-funded enterprises. This sector of the economy has been growing at twice the rate of the state-owned sector, and it is projected that by the end of the decade it could account for up to 75 percent of the volume of economic activity. The nonstate sector has contributed to economic reforms in at least two important ways. First, the strong growth in productivity and the concomitant high rate of enterprise saving in this sector has to a large extent compensated for the inefficiencies of the state sector, thus contributing to overall financial stability. Second, the nonstate sector has provided the authorities with a variety of models indicating possible ways to reform traditional institutions and practices so that they function more in accordance with market principles.

The impact of reform is clearest in three areas: the agricultural sector, the related growth of rural enterprises, and the external sector, particularly the growth of exports. Three explanations are possible. First, particularly in agriculture, the extent of the change from pre-existing conditions was sharper and more comprehensive than in other areas. Although formal ownership did not change, the land allocation system was overhauled, incentive structures were considerably strengthened, and many restrictions were removed. Second, perhaps most striking in the TVEs and to a certain extent in the growth of exporting activity, progress was most evident where market forces were allowed the greatest play. Third, in each of these areas, China was in effect resurrecting institutions and skills that had lain dormant for more than a generation. In agriculture, current techniques are based on those used for many generations; all sectors are benefiting from a strong entrepreneurial tradition; and the growth of the coastal regions rests on the comparative advantage of location, a low-cost labor force, and their close relationship with the overseas Chinese diaspora.

Least progress can be observed in those areas in which the approach has been tentative and incomplete, either because of the complexity of the issues involved or because the most determined efforts were made to preserve existing institutions. This feature is most evident in the state enterprise sector where, despite the gradual exposure to market forces, many industries remained subject to mandatory planning and nonmarket pricing. These industries have been protected from market forces by a soft budget constraint motivated by the political goals of maintaining employment opportunities and social stability. Reforms are also incomplete in the financial sector, where progress has been retarded by the slow pace of enterprise reform, the weakness in the fiscal situation, and an inadequate legal and regulatory framework.

A further negative effect of the gradual approach to reforms, however, in which the institutional infrastructure necessary to underpin market-based macroeconomic management has remained underdeveloped, has been a weakening of macroeconomic control manifested in periodic outbreaks of instability characterized by high inflation and/or external imbalances. In responding to these the authorities have had to revert to administrative means of control and to delay reform.

What are the implications for the future reform strategy? It is clear that China has reached the point at which it can no longer avoid a more comprehensive approach. China’s leadership has recognized that various sectors of the economy are interconnected and that a broadly based reform strategy on both external and domestic fronts is needed. Reform of the state enterprise sector is crucial, owing to the growing macroeconomic tensions created by its financial needs and the pressure of competition from foreign-funded enterprises and the TVEs. Improving the environment in which the enterprises operate requires comprehensive, simultaneous action in a number of areas, including the price system, enterprise taxation, the financial system, monetary policy, and the social safety net. Due attention should also be paid to the development of a legal and regulatory framework appropriate to a market-based economy. At the same time, China’s strategy of opening to the rest of the world implies the need for domestic markets to be more closely linked to world markets, and for the development of China’s large domestic market. Finally, the achievement and maintenance of macroeconomic and financial stability primarily through the use of indirect instruments is central to the successful implementation of systemic reforms. This too will be possible only in the context of a comprehensive reform of China’s economic institutions.

It is clear that with the renewed political commitment to reforms, China is now well on its way to realizing its full economic potential. How much it actually achieves will depend on the decisiveness and perseverance with which the newly articulated reform strategy is pursued.

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