Economic Reforms

China embarked on reforms in the late 1970s without a detailed blueprint of the ultimate goals or the steps that would be taken. The approach can best be described as incremental and experimental with considerable responsibility assumed by local governments.⁴ Reforms were often introduced on an experimental basis in some localities—on many occasions at the initiative of local governments—and then applied more widely after they were judged successful. They typically followed a two-track approach under which existing allocation mechanisms were retained while new ones were adopted at the margin and came to assume an increasingly important role.⁵ Under domestic price liberalization, for example, firms were permitted to sell increasing amounts of output at market-determined prices as the proportion sold at controlled prices was progressively reduced. In the external sector, market-determined exchange rates were permitted alongside official rates and the share of transactions at market-determined rates was gradually increased before the rates were ultimately unified.

Market-oriented reforms were introduced into a backward rural economy that had made limited economic progress under central planning. When reforms started in 1978, as much as 70 percent of the labor force was in agriculture and most of the population lived in rural areas. Poverty rates were high by international standards and average per capita income was very low. Reflecting the legacy of planning, the economy was relatively centralized with the central government controlling key production and allocation decisions;⁶ in addition, most prices, including those for foreign exchange, were administratively controlled. As a result of an extremely inward-looking approach, foreign trade and investment were relatively insignificant and the economy was, to a large extent, “closed.” Unlike many other transition economics, however. China did not face severe macroeconomic imbalances at the start of reforms, nor was it undergoing the kinds of political transitions many of these countries simultaneously embraced.

Three main waves of economic reform can be identified:

• Phase I—Agricultural and rural reform (1978–84), China’s economic reforms began in agriculture in the late 1970s, following the upheavals of the Great Leap Forward and the Cultural Revolution. Key measures included the leasing of land to farmers under the household responsibility system, higher procurement prices for key crops, and introduction of the two-track price system. The reforms led to a surge in agricultural production and productivity, contributing to higher savings and investment, and the release of large amounts of labor for employment in emerging rural industries, notably town and village enterprises. Reforms also began in other areas but were not as dramatic in scope or effect. Most notably, open economic zones were established in coastal regions to attract foreign investment and promote exports, and to serve as laboratories for bolder market-oriented reforms. Tentative steps were taken to scale back the planning system for industrial state enterprises, and experiments were initiated to link bonuses more closely to performance and to establish tighter links between wages and productivity.

• Phase II—Broadening of reforms (1984–91). The success of rural reforms led to a gradual broadening of reforms, most notably to state industrial enterprises in urban areas, and the gradual dismantling of the central planning system. Important measures included experiments to grant state enterprises more autonomy in production and employment decisions (the contract responsibility system) and the extension of the two-track system to industrial prices. In addition, other types of enterprises such as urban collectives began to gain importance. In the financial sector, the monobank system was dismantled and the Peoples Bank established as the central bank. In the fiscal area, reforms in 1984 allowed enterprises to retain a larger share of profits, and an enterprise tax system was introduced to replace profit transfers to the budget. The trade and exchange system also began to be liberalized as the number and scope of open economic zones were expanded, and the foreign trade plan scaled back. Key measures included the establishment of “swap centers” for trading retained foreign exchange⁷ and the formation of local foreign trade corporations. The reforms helped to sustain and broaden growth following the earlier surge in agricultural production and led to the emergence of a dynamic nonstate sector. Difficulties in macroeconomic control, however, eventually gave rise to inflationary pressures, necessitating a tightening of macroeconomic policies. The late 1980s represented a period of “rectification” during which reforms were slowed or reversed in an effort to help reestablish macroeconomic stability.

• Phase III—Deepening of reforms (since 1992). The rectification program succeeded in reducing inflation but at the expense of slower growth and a partial reversal of reforms. Following Deng Xiaoping’s 1992 tour of the Southern Provinces and his call for the country to accelerate reform, progress resumed with a new vigor. Even though Deng’s exhortation led to a boom in fixed investment and the reemergence of inflationary pressures, it culminated in a new reform strategy, adopted during the Third Plenum of the Fourteenth Central Committee in 1993. The Third Plenum articulated the goal of creating a socialist market economy, envisaged as one in which market forces would play the primary role in resource allocation within the context of continued dominant state ownership. A key focus of the strategy was to strengthen the institutions and infrastructure for macroeconomic control and increase the market orientation of the economy through wide-ranging reforms of central banking and the financial sector, the fiscal system, and the exchange and trade system. In addition, the strategy provided a framework for the acceleration of state enterprise reform with the objective of converting state enterprises into modern corporations with independent managers (“corporatization”). In line with the strategy, progress in many areas has been made in the last few years.

In the financial sector, there has been legislation to strengthen the operational autonomy of the People’s Bank of China, commercialize the state banks, and encourage the development of new market-based financial institutions. Measures have also been taken to deepen financial markets and develop the tools for indirect monetary policy management; steps have also been taken to improve prudential supervision and oversight of the financial system. Recent initiatives include the gradual shifting of policy-directed lending to three newly created “policy banks,” the development of a nascent interbank money market with market-determined interest rates, and the initiation of open market operations on a limited scale. At the same time. China’s stock market—opened early in the decade—has been developing slowly.⁸

Major reforms have also been undertaken in the fiscal system to improve tax administration and introduce stable and transparent tax rates. In addition, the system of intergovernmental fiscal relations has been improved by replacing the complex system of contract-based revenue-sharing arrangements with one based on a clearer delineation of tax assignments and tax-sharing between central and local governments. The reforms have been accompanied by a new budget law to streamline budgeting procedures and to limit local governments’ ability to run budget deficits. As a result, there have been some improvements in the fiscal system, but difficulties remain, reflected in continued weakness in budget revenues and a large number of off-budget fiscal activities (see below).

The last few years have also witnessed major reforms in the exchange system, including the unification of the exchange rate and lifting of remaining restrictions on payments for trade-and non trade-related current transactions, culminating in the establishment of current account convertibility at the end of 1996. Since the unification of the exchange market in January 1994, the exchange rate of the renminbi has been kept broadly stable vis-à-vis the U.S. dollar and China’s strong external position has been reflected in a sharp rise in international reserves. Progress has also been made in lowering tariff rates, easing nontariff barriers, and expanding foreign trading rights, although further reforms in all three areas will be required to establish a liberal and open trade regime. Reflecting the further expansion in the number and scope of open economic zones, there has been a sharp increase in foreign direct investment inflows and significant increases in the number of foreign funded and joint-venture companies. Other capital flows, however, have remained subject to controls and external debt has remained moderate.

Under the framework of the Third Plenum, state enterprise reform has been moved to the top of the agenda and directed toward establishing a modern enterprise system. This aim is to be achieved through a clear separation of the state’s ownership of enterprises from their management, accompanied by greater autonomy and accountability, and harder budget constraints. Moreover, enterprises are to be relieved of their heavy social functions.⁹ The strategy has subsequently been elaborated with the principle of “seizing the large and releasing the small.” According to this approach, dominant, but not necessarily exclusive, state ownership is to be maintained for the 1,000 or so largest enterprises, while nonstate ownership and control will be permitted in the case of smaller ones.

Sources of China’s Growth

Since the beginning of economic reforms, China’s growth rates have been among the highest in the world and stronger than under the central planning regime. This section examines the factors underlying the performance including the contribution of factor inputs (extensive growth) and improvements in productivity and efficiency (intensive growth). Whether growth is intensive or extensive has important implications for its sustainability, as growth based mainly on rapid capital accumulation will quickly run into diminishing returns.¹⁰

There has been a large literature on China’s growth performance during the reform period.¹¹ These studies indicate that the main explanations for the rapid growth rate are relatively high saving and investment rates (averaging around 35 percent of GDP): improvements in the structure of incentives and ownership; a relatively well-trained labor force; and the gradual opening of the economy to foreign trade and investment, as well as linkages with Hong Kong, China and Taiwan Province of China, which account, in particular, for a large share of direct investment in mainland China (Box 9). China is also seen as having benefited from the “advantages” of backwardness, notably the potential for significant productivity improvements related to the transfer of resources out of low-productivity agriculture into manufacturing.

Growth accounting studies by staff at the IMF and the World Bank that have attempted to quantify the contributions of these factors have found that increases in labor and capital inputs made an important contribution to growth during the reform period, but that a relatively large proportion of growth (at least 40 percent) is explained by forces other than increases in factor inputs, such as improvements in productivity and efficiency¹² (Table 30). The apparently large growth “residual” that these studies find could reflect a number of possible factors.

Table 30.

China: Alternative Estimates of the Sources of Economic Growth

Sources: Zuliu Hu and Mohsin S. Khun, “Why Is China Crowing So Fast?” Staff Papers, IMR Vol. 44 (March 1997), pp. 103–31; World Bank. China 2020: Challenges in the 21st Century (Washington, 1997).

¹Numbers may not add to 100 because of rounding.

Table 30.

China: Alternative Estimates of the Sources of Economic Growth

	Hu and Khan		World Bank
	(1996)		(1997)
	1953–78	1979–94	1978–95
	(In percent a year)
Growth rates
Output	5.8	9.3	9.4
Physical capital input	6.2	7.7	8.8
Labor input	2.5	2.7	2.4
Human capital input	…	…	2.7
Residual	1.1	3.9	4.3
	(In percent)1
Proportions of output
growth accounted for by
Physical capital input	65.2	45.6	37.0
Labor input	16.8	12.8	7.5
Human capital input	…	…	8.6
Residual	18.0	41.6	46.0

Sources: Zuliu Hu and Mohsin S. Khun, “Why Is China Crowing So Fast?” Staff Papers, IMR Vol. 44 (March 1997), pp. 103–31; World Bank. China 2020: Challenges in the 21st Century (Washington, 1997).

¹Numbers may not add to 100 because of rounding.

View Table

Table 30.

China: Alternative Estimates of the Sources of Economic Growth

	Hu and Khan		World Bank
	(1996)		(1997)
	1953–78	1979–94	1978–95
	(In percent a year)
Growth rates
Output	5.8	9.3	9.4
Physical capital input	6.2	7.7	8.8
Labor input	2.5	2.7	2.4
Human capital input	…	…	2.7
Residual	1.1	3.9	4.3
	(In percent)1
Proportions of output
growth accounted for by
Physical capital input	65.2	45.6	37.0
Labor input	16.8	12.8	7.5
Human capital input	…	…	8.6
Residual	18.0	41.6	46.0

Sources: Zuliu Hu and Mohsin S. Khun, “Why Is China Crowing So Fast?” Staff Papers, IMR Vol. 44 (March 1997), pp. 103–31; World Bank. China 2020: Challenges in the 21st Century (Washington, 1997).

¹Numbers may not add to 100 because of rounding.

Mismeasurement of output growth. One possibility is that there may have been an overstatement of China’s real economic growth, owing to underdeflation of nominal output. One study, in particular, has suggested that China’s growth during the reform period has been overstated, owing to the failure of official data to distinguish adequately between price and volume changes, especially in the nonstate sector.¹³ However, using available estimates of the size of the possible error (around 1 percentage point a year), growth would still be relatively rapid by international standards, and there would continue to be an important role for influences other than increases in capital and labor inputs in accounting for growth. Moreover, any correction to the official GDP data for underdeflation would need to be accompanied by corresponding adjustments to the investment and hence the capital stock estimates, leaving the proportion of growth not explained by factor inputs broadly unchanged.

Sectoral reallocation of resources. Another potentially important explanation for the growth residual is productivity improvements related to the reallocation of resources from low to high productivity sectors. The key sectoral reallocation since the start of reforms has been from agriculture to manufacturing, with the share of employment in agriculture declining from around 70 percent in 1978 to 50 percent recently. According to World Bank estimates, the transfer of labor out of agriculture contributed on average around 1 percentage point a year to growth during 1978–95, with a particularly large contribution during the first wave of agricultural reform. Resource reallocation thus appears to account for a significant proportion of unexplained growth and, given the continued relatively large role of agriculture, is a potentially important source of future productivity gains.

General improvements in productivity. Improvements in productivity related to the emergence of the nonstate sector and the increasing market orientation of the economy are other potentially important sources of China’s rapid growth. Within the industrial sector, there has been a large decline in the state enterprises’ share of output as the nonstate sector has emerged as the leading engine of growth. Studies have generally found that productivity growth in nonstate firms has been faster than in their state counterparts, implying that reallocation of resources to the nonstate sector could explain a significant share of growth.¹⁴ Preliminary results confirm the importance of such an effect, with resource reallocation from the state to the non state sector estimated to have contributed as much as ½ of I percentage point a year on average to growth. An interesting finding in this regard is that the share of China’s growth not accounted for by factor inputs has tended to increase over time, rising to at least one-half in 1990–94 (Table 31). While the increase in the early 1990s may to some extent be due to cyclical factors, it may also reflect the gradual spread of market-oriented reforms and, in particular, the benefits of the opening of the economy. These are seen as boosting growth beyond the direct effects of sectoral reallocations, leading to a relatively large growth residual.

Table 31.

China: Sources of Growth During the Reform Period.

(In percent a year)

Source: Zuliu Hu and Mohsin S. Khan. “Why is China Growing So Fast?” Staff papers, IMF. Vol. 44 (March 1997), pp. 103–31.

Table 31.

China: Sources of Growth During the Reform Period.

(In percent a year)

	1979–84	1985–89	1990–94
Growth of Output	8.0	8.8	11.5
Physical capital input	7.1	8.6	7.5
Labor input	3.0	2.8	2.1
Residual	2.5	2.7	5.8

Source: Zuliu Hu and Mohsin S. Khan. “Why is China Growing So Fast?” Staff papers, IMF. Vol. 44 (March 1997), pp. 103–31.

View Table

Table 31.

China: Sources of Growth During the Reform Period.

(In percent a year)

	1979–84	1985–89	1990–94
Growth of Output	8.0	8.8	11.5
Physical capital input	7.1	8.6	7.5
Labor input	3.0	2.8	2.1
Residual	2.5	2.7	5.8

Source: Zuliu Hu and Mohsin S. Khan. “Why is China Growing So Fast?” Staff papers, IMF. Vol. 44 (March 1997), pp. 103–31.

The main conclusion is that China’s growth performance during the reform period, which remains impressive even after adjustment for possible underde-flation of the nominal data, has reflected a number of factors. While significant increases in capital and labor inputs have been very important, productivity gains resulting from sectoral reallocation, market-oriented reforms, technical progress, and external opening have also clearly played a key role. As growth has not been driven primarily by the rapid accumulation of capital, diminishing returns are not an immediate threat to sustainability. Indeed, the continued relatively large absorption of resources by the state sector and agriculture implies the possibility of significant further productivity advances as reforms are deepened.

The Unfinished Agenda

Notwithstanding impressive achievements in terms of growth and structural transformation, China’s transition to a market-based economy has been marked by recurrent cycles in economic activity and inflation, weaknesses in state enterprises and the financial sector, and poorly performing budget revenues. In addition, despite initial progress, income disparities have tended to widen, contributing to internal migration pressures and the emergence of a “floating” population that is officially estimated at around 100 million. The problems have reflected in large measure the partial nature of reforms, in particular the failure to make significant progress in restructuring state enterprises; a tax system that has relied heavily on the shrinking state sector, while providing generous concessions to nonstate firms; and an uneven pattern of development, accentuated by the promotion of open economic zones. Addressing these challenges decisively is the key element of China’s unfinished reform agenda.¹⁵

Macroeconomic cycles. Since the initiation of economic reforms, China has undergone four major cycles in economic activity during which inflation temporarily rose to relatively high levels (Figure 33).¹⁶ While differing in important respects, the cycles have tended to be generated by surges in aggregate demand (especially fixed investment), excessive credit creation, and price liberalization.¹⁷ The cycles have been accentuated by problems of macroeconomic management in an economy where local governments have exerted considerable influence over economic policies and the financial sector, and where the instruments of macroeconomic policy have been inadequate and blunt; in these circumstances, success in controlling inflation has tended to be accompanied by a sharp slowing of growth.

China: Macroeconomic Cycles in the Reform Period

(In percent)

Source: State Statistical Bureau. China.

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China: Macroeconomic Cycles in the Reform Period

(In percent)

Source: State Statistical Bureau. China.

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China: Macroeconomic Cycles in the Reform Period

(In percent)

Source: State Statistical Bureau. China.

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The institutional and economic reforms pursued in the last few years have sought partly to strengthen the effectiveness of central authorities’ control over macroeconomic policy and to broaden the range and increase the market orientation of policy instruments. Much progress has been made in these areas, contributing to the recent success in reducing inflation from a peak of over 20 percent in 1994 to the low single digits early this year, without causing a major disruption of growth. Nevertheless, this successful stabilization has brought to the fore the pressures posed by a partially reformed state enterprise sector that has been experiencing rising losses in recent years. The challenge of sustaining appropriately restrained macroeconomic policies needs to be supported by further progress in market-orientated reforms, especially in the state enterprises, and by relieving banks of the implicit and explicit pressures to support loss-making state enterprises.

Financial sector reform. A safe, sound, and market-oriented financial system is a key objective of the authorities’ reform program. A key component of the strategy is to commercialize China’s state banks and provide them with greater autonomy in lending decisions. This is expected to lead to a more efficient allocation of credit and facilitate the use of indirect monetary control instruments. At the same time, the authorities are seeking to strengthen balance sheets; address the outstanding stock of nonperforming loans¹⁸ through appropriate provisioning and, where necessary, injection of public capital; and the development of an appropriate supervisory framework to ensure prudent lending practices and deal with troubled institutions. The authorities have designated 1997 as the year of supervision and are currently strengthening accounting and loan classification standards to better assess the health of the banking system and its capital adequacy. In addition, both off-and on-site supervision are being strengthened, including through the development of the necessary skills and manpower.

State-enterprise reform. An important outstanding issue in China’s transition is the poorly performing state-enterprise sector. Although this sector has accounted for a shrinking share of GDP, it continues to absorb a disproportionately large share of bank credit—around two-thirds—and remains a major employer of urban labor.¹⁹ Progress in other areas, notably in the financial sector, hinges importantly on a breakthrough in state-enterprise reform and on tackling the chronic loss-making enterprises that have placed a burden on the financial sector. In this connection, the current approach goes significantly beyond earlier reform efforts by simultaneously addressing key issues such as corporate governance, alternative ownership forms, divestiture of social services, and mergers and bankruptcies. Moreover, the approach involves a potential downsizing of the overall scope of state activity to a limited number of areas that can feasibly remain under state control, and allows for a potentially significant increase in nonstate ownership, especially in smaller enterprises.

Lack of disaggregated data precludes a clear assessment of the progress under the new approach. However, anecdotal evidence suggests that there has been increased momentum in many areas, in particular in experiments involving small enterprises, with many of these becoming shareholding cooperatives. In addition, some headway has been made in divesting firms of social functions through the creation of local government social welfare units and unemployment and retraining programs. On the other hand, progress in the difficult area of hardening budget constraints and dealing with loss-making enterprises (especially larger ones) has continued to be slow. Although increasing somewhat, bankruptcies have remained limited and formal layoffs of redundant labor have been small.²⁰

Fiscal system. China’s reform experience has been characterized by a marked weakening in budget revenues.²¹ In common with many other economies that are emerging from central planning systems, there has been a sharp and sustained decline in general government budgetary revenues since the initiation of reforms, from over 35 percent of GDP in 1978 to around 11 percent in 1996. The reduction has reflected not only the gradual separation of state enterprises from the budget, which is desirable, but also a worrying tendency to move genuine fiscal operations to extrabudgetary funds; in addition, the tax system has performed poorly on account of its heavy dependence on the declining state sector. Notwithstanding the weakness in revenues, however, China’s fiscal deficit has remained relatively small (around 2 percent of GDP on average) as there has been a corresponding cutback in budgetary spending. The implications of the weakness in budget revenues have been difficult to assess owing to the large number of extrabudgetary funds²² and policy-directed lending through the banking system. The weakness appears nevertheless to have complicated macroeconomic control and may increasingly limit the public resources available for the reform process. Higher budget revenues are currently being sought through improvements in tax administration, efforts to capture more fully the dynamic nonstate sector in the tax net, including through the scaling back of tax exemptions and concessions, and bringing extrabudgetary funds into the budget. A strengthening of the lax system is also under consideration.

Regional disparities. Following improvements early in the reform period, income disparities have widened in a number of dimensions, most notably between rural and urban areas and across regions. Major contributing factors include the relatively weak performance of agriculture following initial gains early in the reform period, the concentration of some poorly performing state enterprises in rural areas, and longstanding restrictions on labor mobility. At the same time, generous tax concessions in open economic zones have accentuated disparities by encouraging an uneven pattern of development, particularly in coastal areas. In response, the authorities are seeking to increase public investment in rural areas, in particular in transportation and infrastructure, and are scaling back preferential policies in order to redirect foreign investment to interior provinces. Consideration is also being given to the development of a fiscal grants mechanism to redistribute income from richer to poorer provinces. A major poverty alleviation effort, initiated in 1993, is intended to lift the remaining 50–60 million rural poor out of poverty by the year 2000.

* * *

China’s economic performance since the initiation of market-oriented reforms in the late 1970s has been impressive by any measure. In addition to achieving rapid growth. China has undergone significant structural transformation and opening to the world economy, and a dynamic nonstate sector has emerged as the leading engine of growth. The strong performance has reflected the interaction between the dynamic forces of economic liberalization, on the one hand, and those of economic development, on the other. Together, these have transformed China from a very poor country al the end of the 1970s to a much wealthier one today.

Needless to say, significant challenges remain in completing the transition to a fully market-based economy and achieving income levels comparable with those in the newly industrialized economies in Asia. The key requirement is a decisive breakthrough in state-enterprise reform, which will be an important determinant of whether China can continue to enjoy the rapid rates of productivity growth experienced during the first two decades of reform. State-enterprise restructuring will also influence importantly the prospects for sustaining macroeconomic stability and the pace of reforms in other areas, especially the financial sector. A strengthening of budget revenues is also critical to ensure that adequate fiscal resources are available for the reform effort. The authorities’ intention to address the widening disparities in income that have emerged during the reform period can help ensure that the benefits of prosperity are more widely shared and contribute to broader support for the reform effort.