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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