China's Economic Reform: Past, Present and Future

Jinglian WU
Perspectives, Vol. 1, No. 5

Achievements and Problems

The current Chinese economic reforms have resulted in significant progress in the last twenty years. An important sign of these progresses has been the diminishing importance of the state sector. Formerly the state sector dominated the Chinese economy. Today, the proportion of the state sector in overall economy has decreased sharply. (See tables 1 and 2 below.) Before us unfolds the embryo of a market economy based on a mixture of ownership forms.

Table 1: Composition of National Industrial Output (%)

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1978 1985 1990 1999

State-owned 77.6 65 54.6 28.5

Collective-owned 22.2 32 35.6 38.5

Private 0.2 3 9.8 33.0

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Source: Statistical Yearbook of China; China Economic Information Network (www.cei.gov.cn), January 31, 2000.

Table 2: Composition of National Retail Sales (%)

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1978 1985 1990 1999

State-owned 54.6 41 39.5 24.3

Collective-owned 43.3 37 31.7 18.2

Private 2.1 22 28.8 51.5

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Source: Statistical Yearbook of China; China Economic Information Network (www.cei.gov.cn), January 31, 2000.

Along with the change in ownership forms, the Chinese economy has grown rapidly over the last twenty years. China's status in the international economic and trading system is also steadily advancing. These achievements have gained international recognition.

On the other hand, the achievements of China's economic reforms are still limited. If we look at the mechanism of economic resource allocation, the major obstacle to reform still has not been overcome.

The Fourteenth National Congress of the Chinese Communist Party (CCP) has clearly pointed out that the nature of the economic reform is to change the mechanism of resource allocation, so China can move from a planned economy to a market economy in which the market plays a critical role in the allocation of resources. Presently, although the state sector produces only about one third of overall GDP, it is still the major user of scarce economic resources. Reform of state-owned enterprises (SOEs) has been far from satisfactory, and the old system maintains its influence and continues to impede the establishment and perfection of the new market economic system. Therefore, we cannot say that the market has started to operate as the primary allocator of economic resources. For example, the state sector, although contributing to only one third of China's GDP, consumes two thirds of the country's capital resources.

The failure to carry out market-oriented reforms has been the major factor in the generation of many economic and social problems in China. For instance, the problem of "repetitive construction" has generated a great deal of official attention and public discussion. At the root of the problem is the failure to reform the state sector in a fundamental way. To date, capital resources are still largely allocated by the government through administrative fiat.

We can see such problems in many other areas as well. For example, the inefficiency of the state sector leads to a vulnerable monetary system. In another example, the sluggishness of the market is partly the result, from the supply side, of the malfunction of SOEs and the unfavorable environment for non-state-owned enterprises. I also want to mention agricultural problems that seem to be irrelevant to industry and commerce. How can we pull the farmers out of poverty? According to development economics, the key to solving this problem is to transfer the 150 to 200 million excess laborers in rural areas to non-agricultural sectors. Nevertheless, during the last ten years of our reforms, there appears to have been a suspension or even reversal of such transfers. For example, the number of farmers in rural areas not only did not decline but actually increased significantly in recent years. This is because the rate of new labor absorption in SOEs has turned from positive to negative. In addition, some township and village enterprises in the inner provinces have become paralyzed or even defunct, and some cities have also started to send peasant workers back to the countryside. The crux of the problem is that SOEs lack entrepreneurial vigor, while the vigor of the non-state-owned sector has not yet been brought into full play. There are two aspects to the problem. On the one hand, the reform of state-owned enterprises and the restructuring of the state sector are proceeding at a slow pace. On the other hand, the non-state-owned sector has not had a chance to develop fully.

So why is there such a situation? I think the reason lies in the core of the old state-owned economic system as reflected in the concept of "state syndicate," proposed by Lenin in his State and Revolution. The key feature of the old system is the unification of the three entities -- the party, the government and the economy. The interest relationship arising from this unification is deeply rooted and complicated. Some people, particularly the social and political elites, have tremendous interest in maintaining the old system. If those people with vested interests in the old system cannot regard the interest of the entire society as of primary importance, they will use all kinds of excuses, including political ones, to hinder the progress of reform and restructuring. As such, the reforms face enormous resistance.

Reformers of the Eastern European countries, when assessing their past experience, point out that one of the most important reasons why their reforms were unsuccessful or abandoned halfway was the insurmountable resistance that they encountered when they tried to reform the state sector. I recently went on a trip to Hungary. Our Hungarian friends, including those reformers with whom we have been familiar since the 1980s, told me about their sad experiences. One must wonder why, by the 1980s, the Hungarians could not continue their economic reforms which once looked promising. Apparently some top party and government leaders hindered the reform of SOEs and suppressed the development of the non-state sector with their political power. By granting subsidies, loans and other preferential treatment to the old system, these leaders maintained and reproduced the unity of the party, the government and the economy.

In the same way as the Eastern European countries, China also encountered enormous difficulties and resistance in reforming its state sector. In the second half of the 1980s, our central government, under the guidance of Deng Xiaoping, attempted to shift the strategic focus of the reform from the countryside to the cities, and from the non-state sector to the state sector. In 1984, the Third Plenum of the Twelfth CCP National Congress promulgated the well-known Decisions of the Central Committee of the Chinese Communist Party on Economic Reform. However, these decisions were not implemented smoothly, and in 1987, the implementation completely stopped.

Breakthroughs and Retreats

Since Deng Xiaoping's trip to the south in 1992, China's reform has seen significant breakthroughs in both theory and policy. Subsequent to the Fourteenth CCP National Congress which set the goal of market reform in 1992, the Third Plenum of the Fourteenth CCP National Congress marked the shift of the economic reform from a "quantity growth reform" to an "overall advancement." At the same time, in order to establish the framework of a socialist market economy by the end of the 20th century, the Third Plenum highlighted the importance of reforming the SOEs in addition to macroeconomic reforms of taxes and finance. In the past, due to excessive emphasis on SOE deregulations rather than the restructuring of SOEs, the SOE reform was not effective. For some SOEs, not only did managerial and financial conditions not improve, the situation actually worsened. In view of this situation, the Third Plenum concluded that the direction of the SOE reform should not be deregulation; instead, it should be institutional innovation. After the Third Plenum, we started, on a trial basis, to establish the modern corporate system in some SOEs.

People soon discovered, however, that it is very difficult to convert SOEs into modern corporations as long as the state sector remains dominant and the government maintains control over a overwhelming majority of corporations. Therefore, a plan was proposed to open and revitalize small SOEs and to adjust strategically the structure of the state sector. Based on past experience, the Fifteenth CCP National Congress in 1997 and the Fourth Plenum of the Fifteenth CCP National Congress in 1999 made a series of theoretical innovations and policy resolutions on SOE reforms.

The Fifteenth CCP National Congress rejected the Soviet-style view that the quality of the socialist state was proportional to the size of the state sector, and that the more SOEs, the better. The Fifteenth CCP National Congress clearly stipulated that the basic economic system at the initial stage of socialism is a core of public ownership complemented by other forms of ownership. The Congress called for adjusting and perfecting the ownership structure of SOEs and establishing a long-term economic system based on the principle of "Three Benefits." This policy includes three parts. First, the domain of the state sector shall be narrowed. State capital should withdraw from fields irrelevant to the state economic lifeline. Secondly, we shall develop multiple forms of public ownership that can help us improve productivity. And finally, we shall encourage the development of the non-public sector such as private enterprises so as to make it an important part of the socialist market economy. The Fifteenth CCP National Congress modified the guiding principle of reform from revitalizing SOEs and the state sector, to developing multiple forms of ownership structure. As Lenin put it, "the way we look at socialism has completely changed."

In the following four aspects, the Fourth Plenum of the Fifteenth CCP National Congress solidified the policies of SOE reform and state sector adjustment laid out by the Fifteenth CCP National Congress. First, four industries are to be under state control. These industries involve national security, natural monopoly, important public goods and services, and key enterprises of high technology. This gives the state sector a definite set of boundaries. Secondly, except for a few enterprises that require a state monopoly, others shall diversify their share ownership. The entry of non-state shareholders will be very beneficial to the improvement of corporate governance. Thirdly, not only did the Fourth Plenum repeat the policy of revitalizing small SOEs as stipulated by the Fifteenth CCP National Congress, but it also expanded the policy to cover medium SOEs. The small and medium SOEs, most of which are presently in straits, constitute more than ninety percent of all SOEs. To revitalize them will not only help relieve local governments at various levels but also inject vigor into various industrial and commercial sectors. Finally, all companies are required to set up modern corporate governance structures and ensure that there is a system of checks and balances between shareholders and senior managerial staff. Some corporations established during the "modern corporate system experiment" in the last several years exist only in name. The crux of the problem is that these "corporations" do not have in place an effective corporate governance structure and a system of checks and balances between the owners of the company and the managers. The requirements laid down by the Fourth Plenum of the Fifteenth CCP National Congress will aid SOEs in establishing efficient systems of corporate governance.

The above plans, we should say, elucidate clear ideas and correct principles for our reform. The question now is implementation. In recent years, however, there has been a disturbing trend in which some people in charge neglect economic restructuring and enterprise reform, and fail to focus on establishing a new ownership structure and an efficient corporate governance system. Instead, these people are merely relying on "guanxi" for enterprise and ultimately personal gains. For example, in response to the declining demand resulting from the East Asian Financial Crisis, the Ministry of Finance is mobilizing RMB 300-400 billion investment funds each year through government bond issuance and tax increases in an attempt to increase demand and stimulate economic growth. Although it is necessary to use fiscal instruments to cope with economic cycles, this approach will lead to various micro- and macro-repercussions if it evolves into a solution for rescuing SOEs in the long run. First, the "crowding out" effect will eventually lead to heavier tax burdens, and the dependence on government fund maneuvering will hinder the improvement of economic efficiency. Secondly, this approach in the long run will place an unbearable burden on the government's fiscal coffer or even cause economic and social unrest. Finally and most importantly, if SOEs continue to rely on government funding and ignore restructuring and reform, the old system will be reproduced and strengthened.

Solutions

What are our solutions under these circumstances? I think we should uphold the reform policies formulated at the Fifteenth CCP National Congress and its Fourth Plenum and try our best to deepen our reforms. There are two major tasks.

First, we should adjust the ownership structure of the SOEs while emphasizing their strategic restructuring. The most important part of the first task is to open up gradually the small and medium SOEs (including township and village enterprises) while focusing on the restructuring of large SOEs. Large SOEs should be limited to industries that are associated with national security or public goods and services. As the proportion of state shares in SOEs gradually goes down and the proportion of non-state shares climbs up, we need to convert the large and medium enterprises into modern corporations that meet international standards and also our own Company Law.

To proceed with the first task, we should first change the current situation where the state is the only shareholder or holds a majority of shares in most corporations. We should diversify corporate shareholdings. Secondly, we should conduct capital and management restructuring by setting up the standard system of corporate governance that consists of shareholder meetings, a board of directors and a management team. The shareholders elect the board, which should include a certain number of independent directors. Directors bear fiduciary duties towards the corporation and are obligated to act in the best interest of the corporation. The board of directors monitors and motivates the management team through its nominating, compensation and auditing committees. Thirdly, the system should ensure that the management team has the freedom to work on daily managerial and operational matters independently of the shareholders and the elected board. At the same time, to motivate the management team, compensation packages consisting of salaries, bonuses and stock options should be utilized on the basis of management performance. Finally, for publicly traded companies, the system should pay particular attention to safeguard the interests of all shareholders, especially those of medium and small shareholders.

Looking at the ongoing SOE restructuring in the petrochemical, telecommunications, power and metallurgy industries, we find the restructuring and reform of SOEs to be an arduous project. There are quite a few difficult problems that we have to resolve. For example, on the issue of corporate form and corporate governance, we have to deal with not only systemic issues inherited from the planned economy, but also those institutional problems that emerged in the past twenty years. To combat the problems of SOEs, we should, for instance, establish incentive mechanisms based on management performance. Also, we should change the government's role in relation to business enterprises, and let the market play the major role in allocating labor, capital and financial resources rather than have administrative agencies do the job. The government should focus on establishing regulations and maintaining market order. All of these measures hurt the vested interests of the old system. For example, the change in the functions of the government would diminish the power of the officials who are in charge of labor, capital and financial resources under the old system. Therefore, it is inevitable that some people would oppose the reform based on one excuse or another.

Since the problems of SOEs relate closely to the vested interests of the old system, it is going to be extremely difficult to resolve them both economically and politically. Nonetheless, these problems have been dragging on for too long and the SOE reforms have been put off for too long. It is no good continuing to avoid facing these accumulated problems and thus failing to come up with a fundamental solution. What we can do is carefully managing reform in an attempt to reduce pain and losses. Especially in the face of China's imminent entry into the World Trade Organization (WTO), there is even less time for our corporations to reform in order to survive and succeed in international competition. We ought to make the best use of our time and promote reforms according to the approaches set out by the Fifteenth CCP National Congress and its Fourth Plenum. We should not miss this historic opportunity.

Some misunderstandings must be disposed of before reform can be carried out effectively. For example, if we continue with the old Soviet-style dogma that state ownership is the highest form of public ownership and also the goal of socialism, we would only regress rather than progress. There are also people who advocate government intervention in corporate production, pricing and resource allocation on the ground that the market economy still needs government regulation. These people fail to understand that government regulation differs from corporate governance by shareholders at the micro-level. We must replace the government's direct intervention in microeconomy with a new regulatory system that is suitable to a market economy.

Recently, in the face of China's potential entry into the WTO, some people have been blindly optimistic in thinking that China will benefit from the WTO membership regardless, while some others are excessively pessimistic. However, there has been very little discussion on how to revitalize our corporations, and even less on the specific actions that we should take. The lack of meaningful discussions is very dangerous.

Our second major task is to promote the development of the non-state sector. After twenty years of economic reform, a primitive form of market economy based on a multitude of ownership structures has emerged in China. The current problem is that the traditional discriminatory and hostile business environment against non-state enterprises, especially privately owned enterprises, still exists, which stifles the development of the non-state sector. Governments at all levels must support all enterprises, including those converted from SOEs and those founded by private individuals, on an equal basis, and the government should foster a favorable business environment with fair market competition and the "survival of the fittest." In this regard, the government's responsibilities include, first, educating all party cadres with the guiding principles of the Fifteenth CCP National Congress to ensure a firm understanding on the utmost importance of multiple forms of ownership to China's economic development. Secondly, the government needs to clear up regulations and policies, abolishing any regulation that violates the spirit of the Fifteenth CCP National Congress or our constitution, especially those regulations and policies that discriminate against non-state enterprises. Thirdly, the government should establish a financial system with multiple forms of financial institutions and improve the banking and non-banking financial services to non-state enterprises, creating a better financing environment for these enterprises. Fourthly, the government needs to strengthen taxpayers' monitoring of government bodies, abolish exorbitant taxes and levies, and alleviate the heavy burden on business enterprises. Fifthly, the government should set the market rules of fair competition and enforce the law in an impartial way. And finally, the government needs to become clean, honest and more efficient, and it should improve its services to business enterprises.

The crucial part of our second major task is to establish a fair market order and the rule of law. Historically, China lacks a tradition of the rule of law. After the establishment of the People's Republic of China, under Soviet-style central control, people became accustomed to a system where there is no clear boundary between the party and the government, nor between the government and business enterprises. It is difficult for the government to level the competition ground, set fair and transparent rules of the game, and enforce the law in an impartial way. Nevertheless, without the rule of law, we cannot hope to establish a modern market economy. We have to eliminate all obstacles in order to build a country truly governed by the rule of law, as required by our constitution.

To our delight, some areas of China have successfully implemented the party's policies and hence have brought about economic boom, full employment and social stability. This is the case, for example, in most parts of Zhejiang Province. If we go there and study these areas, the reasons why they have achieved such accomplishments will become clear to us. It is not because these areas have received certain preferential treatments from the central government, but because they diligently implemented the party's policies, particularly in the areas of SOE reforms and the development of multiple forms of ownership structure. In other words, these areas established a sound institutional basis for economic development. If this region of our country can carry out the task of reform, so can other regions with the same or even better conditions. From this perspective, China's future is very promising.***

(The author is a Senior Research Fellow at the Development Research Center of China's State Council. This article is based on a speech given at a conference on China's economic reform in Beijing on February 26, 2000. It is translated from Chinese by Shirley ZHANG, Ding WU and Joy YING.)

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The Modern Market Economy and the Rule of Law

Yingyi QIAN
Perspectives, Vol. 1, No. 5

This essay is about the relationship between the market economy and the rule of law. My assertion is that the fundamental rule of game in a modern market economy is the rule of law.

1. Three Types of Economic System: Planned Economy, Traditional Market Economy and Modern Market Economy

Just about everyone in China is in favor of market economy now. But we are far from being able to claim that we have constructed a mature market system in China. Nor can we assert that our economists or leaders already have a good understanding on how a market economy works. On the contrary, our understanding of the modern market economy has long been tainted by the history of a planned economy as well as a petty-peasant economy. In today's world, there are good market economies as well as bad ones, and there are more cases of the latter than of the former. Historically, an overwhelming majority of countries had bad market economies for very long periods of time. Indeed, in the history of mankind, the transition toward the modern market economy is only a recent phenomenon.

What, then, is the institutional foundation of a modern market economy as opposed to a planned economy? One difference between a market economy and a planned economy lies in the mechanism of resource allocation: a market economy relies on market prices to allocate resources, whereas a planned economy uses administrative commands of planned quantities. At a deeper level, the core of a market economy is a free enterprise system, while the essence of a planned economy is state ownership of firms.

There are, however, more than one kind of market economy. For purpose of this article, I will identify two types of market economy: the traditional market economy and the modern market economy. Market economy is nothing novel: it came into existence long before the planned economy. A traditional market economy is not just characterized by small-scale market activities. From the perspective of the new institutional economics, a traditional market economy has two important characteristics. First, contracts between economic agents are enforced mainly through reputation mechanisms rather than by a neutral third party such as the state. Secondly, the state is not constrained institutionally vis-¨¤-vis business enterprises and individuals. In other words, there is no distance between the government and the market.

Economic historians such as Douglass North and Nathan Rosenberg attributed the rise of the West to a fundamental transformation of the relationship between the state and the business enterprises to an "arm's length type;" that is, the government started to distance itself from private individuals and business enterprises. Since the Glorious Revolution in 1688, the English royal power has gradually retreated from commercial activities. Henceforth, the relationship between the state and the economy has fundamentally changed. The rule that emerged to stipulate the relationship between the state and the economic agents was the rule of law. This change in the state-market relationship is the origin of the modern market economy based on the rule of law.

The Fourteenth Congress of the Chinese Communist Party (CCP) stipulated the concept of "socialist market economy," and the Fifteenth Congress of CCP further endorsed the principle that "non-public ownership of enterprises is an important part of the economy" and "the country is governed according to law." To date our economists still have not fully integrated these three principles into their thinking of the economic reform. We should be aware that the very essence of the modern market economy is an independent and autonomous enterprise economy based on free transactions and operated under the rule of law. In contrast, both planned economies and traditional market economies do not build themselves under the rule of law. One of the most important distinctions that separate a bad market economy from a good one is that, in a bad market economy, there exists an unhealthy relationship between the state and the economic agents (including business enterprises) due to the absence of the rule of law.

2. The Two Economic Functions of the Rule of Law

People often associate the word "democracy" with the word "rule of law". I do not intend to dwell upon the issue of democracy here. Neither do I want to focus on the intrinsic moral values of the rule of law. What I want to focus here is on how the rule of law works in a market economy. In other words, I want to look into how the rule of law facilitates economic efficiency and development.

All economic systems are governed by certain rules of game, and the governing rule for a modern market economy is the rule of law. The rule of law has two economic functions. First, the rule of law regulates and limits discretionary interventions of the state in economic activities. Secondly, the rule of law regulates the economic behavior of individuals and enterprises to create an orderly, stable environment with fair competition, clearly defined and well protected property rights, and effectively enforced contracts. In essence, these two economic functions of the rule of law are about regulating the relationship between the state and the market through legal institutions so that economic development is both possible and sustainable.

The first economic function of the rule of law is to constrain government arbitrariness. This is where the fundamental differences between the "rule by law" and the "rule of law" come into play. The rule by law is by no means a novel idea to us Chinese. An emperor could govern his citizens by means of legal codes. In contrast, an important part of the rule of law is about how common people can constrain the government's power by legal institutions. Only the rule of law can safeguard a free economy. If the government's behavior is not constrained, then no economic freedom can be guaranteed, and in turn there will be no modern market economy.

Why is it so important to limit the government's discretionary influence on economic activities? First of all, the government naturally has greater power than individuals because the government possesses an array of coercive means, an example of which is the police force, that common people do not have. Secondly, without constraint, it is very hard for the government to refrain from discretionary interventions that are often arbitrary and harmful to economic activities. An example of such arbitrary discretionary intervention is the numerous unauthorized fees charged by local governments in China. Thirdly, as economic agents rationally anticipate such government behavior, they become reluctant to invest, chase short-term and small-scale projects, and bribe government officials. This is one major reason why some economies stagnate. It is actually a "lose-lose" situation for both the government and the economic agents, because through arbitrary interventions the government hurts itself with reduced tax revenues due to lower incentives and distorted investment. Economists regard this kind of problem as a lack of "credible commitment" from the government.

How can we establish credible commitment from the government? Credible commitment can be established by constraining government behavior through the rule of law, which will ultimately bring a "win-win" situation. The logic here is a reverse of the "trap of economic stagnation" discussed above. First, the government, constrained by law, cannot arbitrarily interfere with economic activities. For example, under the rule of law, the government cannot arbitrarily restrict economic activities, cannot impose arbitrary charges, and cannot change economic policies frequently and arbitrarily. Secondly, anticipating a stable and friendly economic environment, individuals as well as business enterprises will rationally make long term investments. Thirdly, with the economic vitality resulting from motivated economic agents, the government can actually harvest more tax revenues. This logic resembles the mechanism of increasing total taxes by cutting marginal tax-rates, but here the issue is not about tax rates; instead, it concerns a credible commitment from the government not to prey on individual initiatives.

Through the above analysis we see a paradox of power. As the power of the government enlarges, the government can act more easily upon its own will, which renders its promises less credible. If economic agents do not believe in the government's policies, they will not have incentives to work or invest. Conversely, the rule of law constrains the government's behavior, which makes the government's promises more credible, which in turn benefits the government itself. As an example, the English Glorious Revolution in the 17th century transferred the tax power from the Crown to the parliament. In the war between Britain and France, which came after the Glorious Revolution, Britain was able to finance a substantial amount of military expenses by issuing government bonds because the government had established credibility in repaying debts. In contrast, France, which still had a arbitrary Crown, was unable to do so.

The second economic function of the rule of law is for the state to enforce laws and contracts in an impartial way. This can be achieved only after the government distances itself from microeconomic decisions. Defining property rights, preserving fair competition, fighting monopoly and enforcing contracts are all essential to economic development because they are necessary for establishing credible commitments among economic agents. Without the enforcement of contracts, economic agents cannot become motivated because they will always worry about opportunistic behavior of the other parties to the transaction. But how can we establish an orderly market environment? The enforcement of contracts and preservation of competition should rest on the rule of law instead of the government's discretion. For example, the government should not be in a position to define arbitrarily what unfair competition is, or what business activities need to be regulated.

It is by no means an easy task for the government to act as a impartial arbitrator. For example, errors could occur during the enforcement of law, either unintentionally or intentionally such as when induced by vested interests. Therefore, under the rule of law, it is essential that individuals and business enterprises are empowered to challenge the government on laws, regulations and judgements and to sue the government if necessary. The Administrative Procedure Law and Administrative Redress Law that we have enacted is a promising start, but we still have a long way to go.

Another substantial barrier to the effective enforcement of law is the judicial corruption. Obviously, a corrupt judiciary, which gives rise to insecure property rights and ineffective contract enforcement, forces business enterprises to resort to the traditional way of making back-door deals instead of using legal methods when there is a dispute. This is one of the factors that suffocate economic activities. A better way to tackle the problem of judicial corruption is to create better institutions rather than relying on political campaigns.

In summary, the second economic function of the rule of law is fundamentally about how the government acts as an impartial "third-party" in economic transactions.

3. Two Current Examples

Two examples will help illustrate the relevance of the above analysis.

First, in the name of "normalizing the market," a variety of government interventions emerged in China in recent years to "strengthen rules and management" by requiring numerous permits and certificates for business activities. Except for a few requirements that were necessary, most of these measures were against the spirit of the rule of law. The economic goal of the rule of law is to minimize rent-seeking and encourage competition. In the West, one reason for some regulatory failures is that the government agencies may have been "captured" by certain industries. But at least their government's original intention was to protect consumers, except that it did not withstand certain economic temptations. But we Chinese have gone further. For one example, certain government transportation bureau, instead of representing consumer interest and encouraging competition, openly establishes price monopoly. For another example, many municipal governments restrict the influx of peasants by creating numerous permits. Our rice and oil coupons already resting in history museums, it is now the time to collect permits and certificates. Even more alarming are some government agencies that are obtaining monopoly profits in the name of national security.

Regarding these certificates and permits, I wrote in my article "A Tale of Silicon Valley," published in the January 2000 issue of the "Journal of Comparative Economic and Social Systems," that Bill Gates and Steve Jobs might not be able to receive our "engineer certificate" because they never finished college. The early Apple computer probably also could not be certified by our academic experts as a "high tech" product because it was really a toy. But Gates, Jobs and the Apple computer are the legends of our time and the symbols of creativity and economic success. Imagine what the world would look like if Gates and Jobs could not develop their ideas because they could not obtain certain "certificates!"

Nowadays, business enterprises and individuals in China are suffocated by large-scale rent-making activities of government agencies under the name of "strengthening the management of the market." If these activities continue, they will create the kind of "institutionalized corruption" found in Latin America and India, which would produce a bad market economy. We should not on the one hand try to combat corruption, but on the other hand create new opportunities for rent-making and open more doors for corruption. It is worth noting that many countries including India are loosening government control in favor of market freedom while we Chinese are moving in the opposite direction. The irony is that one of India's motivations for reform is "China's success in reforms in the past ten-plus years!"

The rule of law is probably more important than "privatization." Russia's example is very illuminating. The relationship between the Russian government and their business sector did not change much after the privatization as the government continues to harass business enterprises and suffocate business initiatives. Therefore, I disagree with the proposition that "sell all, then everything will be OK." The key, instead, is whether the government can keep a distance from businesses after privatization.

Some regulations are needed, such as regulations of the securities market. And some permits are also called for. But a fundamental characteristic of a modern market economy based on the rule of law is a real separation between the government and the business sector. As such, it is wrong to implement and strengthen "macroeconomic management" at each level of government and in each government agency. In fact, the more extensive are government regulations, the more likely there will be corruption.

My second example concerns the problem of income inequality. This is not only an issue of fairness; it is also an issue of economic efficiency. Inequality may result in social unrest and instability. There are two very different approaches to address the problem of income inequality. One approach is to strengthen government intervention by taking more away from the rich and giving more to the poor through a radically progressive income redistribution program. This approach can be very dangerous and may bring us back to the era of "eating from one big bowl." There is an alternative approach, which recognizes the fact that people are most resentful to inequalities that are the results of corruption and power abuse. Few people in the United States complain about the new multi-millionaires in Silicon Valley. But if someone is enriched through power abuse and corruption, even if it is only a hundred thousand dollars, people would be very upset. At the root of corruption and power abuse is unconstrained government power, and the solution is not to increase government intervention, but rather to decrease intervention so as to reduce rent-making and rent-seeking opportunities. Therefore, the rule of law is an important measure for combating corruption and alleviating income inequality.

4. Constructing a Market Economy on the Basis of the Rule of Law

To continue our successful reforms of the last twenty years, China now needs to embrace some new ideas. Our goal for the next ten to twenty years should be to construct a modern market economy on the basis of the rule of law. External conditions such as joining the World Trade Organization and the globalization of economy and trade have made achieving this objective even more pressing. We are also facing enormous pressures internally, examples of which include the lack of economic vitality, increasing unemployment rates, corruption, and income inequality. To address these problems, we cannot move backward; we must rely on the establishment of the rule of law.

Our economists and policy-makers need to do a great deal of technical and operational works for future reforms. But first, we need to clear up misconceptions in our mindset. To correct these misconceptions, we not only need to abandon the mindset of central planning that has been with us for several decades, we also need to throw away the feudalistic mindset that has existed for thousands of years. The traditional Chinese culture does not have the concept of a "limited government" on the basis of the rule of law. But we have seen the successful examples of other Chinese communities such as Hong Kong and Singapore, which achieved phenomenal economic growth based on the rule of law. We should have confidence in ourselves.***

(The author is Professor of Economics at the University of Maryland. This article is based on a speech given at a conference on China's economic reform in Beijing on February 26, 2000. It is translated from Chinese by Minfang YAN and Duan WU.)

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