The ICAS Lectures

No. 99-226-GCC

 China's Economy:
 Reform and Perspectives 

  Gregory C. Chow

ICAS Winter Symposium
Asia's Challenges Ahead
University of Pennsylvania
February 26, 1999

Institute for Corean-American Studies, Inc.

965 Clover Court, Blue Bell, PA 19422

Tel : (610) 277-9989; (610) 277-0149
Fax: (610) 277-3992

Biographic Sketch: Gregory C. Chow


Gregory C. Chow

It is now just over twenty years after China initiated its economic reform in 1978. Since then the average rate of growth of GDP has been a phenomenal 9.5 percent per year. This essay reviews the reform process, discusses the impact of the current Asian financial crisis and attempts to assess the prospects of China's economy in the future.

The Reform Process

In 1978 Chinese leaders realized the weakness of Soviet-style planning and the need for reform but did not have a blueprint. They decided to experiment, adopting what was successful. Experimentation also helped in getting party support as many party members were otherwise not willing to accept and support the changes. Deng 's slogan was 'seek truth from facts' and not from ideology. The first successful reform occurred in the agricultural sector. It was initiated locally when some commune leaders discovered that by assigning land to each farm household and allowing it to keep all the products in excess of the amount required by the procurement quota, rather than practicing collective farming, the total output of the commune could be greatly increased. The success by experimentation led the central leadership to adopt this agricultural responsibility system for the entire country. China changed in two to three years from collective farming to private farming and market reform for the agricultural sector was essentially completed.

Reform for the industrial sector was much more difficult. Large state enterprises could not easily be divided into small production units, although an attempt was made to introduce the idea of the responsibility system into the industrial sector. Secondly economic efficiency of an industrial enterprise depends not only on the incentive system inside the enterprise but also on the prices and supply conditions of inputs and prices and demand conditions of outputs which were then subject to government control. Reform of the price system was therefore required. In the early 1980's state enterprises were first given some autonomy in production, distribution and investment decisions. In the middle 1980's price control and central allotment of inputs were gradually reduced. In the initial stage of price reform, there was a two-tier price system for products supplied by the state, the lower price available to state enterprises but at limited quantity of supply, and the higher market price at which needed product can be purchased. The former amounts to a fixed subsidy to a state enterprise and does not affect it marginal decisions which are determined by the market price. Later the two set of prices gradually converged. In 1987, the contract responsibility system was introduced. Under this system an enterprise was leased to its management and a fixed tax was collected from the enterprise, allowing the enterprise to keep all the remaining profits. According to statistical studies, productivity of state enterprises was increased in the 1980s but to a lesser extent than in the more dynamic township and village enterprises. The shortcomings of the state enterprises include inadequate training and experience of the management to deal with problems facing a modern enterprise, inadequate compensation to the management (often only a third or less of the compensation in comparable township and village enterprises), excess supply and possibly low quality of existing labor force, and perhaps the governance system. I say perhaps because there are many examples of efficient and profitable state enterprises under able management which is a major factor for its performance. Further reform of the state enterprises will be discussed later.

The third area of reform is the control of the macroeconomy. Since the early 1980's China has tried to establish a macro-control mechanism to exercise monetary and fiscal policies in lieu of central planning. Banking reform started at least in 1983 when the People's Bank was officially changed to a central bank. Until today it has not actually functioned as a central bank because there are no effectively functioning commercial banks. There were four specialized banks, the Industrial and Commercial Bank, the Agricultural Bank, the People's Construction Bank and the Bank of China which were converted to commercial banks in name but are entirely owned by the government and do not yet function as commercial banks in its credit policies. In March and May 1995 respectively the People's Congress passed the Law on the People's Bank of China and the Commercial Bank Law. Both are modern in content, very similar to the laws governing the Federal Reserve System and the commercial banks in the US except that the Bank of China has less autonomy and is under the control of the State Council. In practice, however, commercial banks do not function effectively because of political interference, lack of trained personnel, the control of interest rates for loans and deposits, and insufficient incentives. Government ownership of these commercial banks has one advantage. It makes a banking crisis in China unlikely even under the present circumstances when some 20 to 25 percent of the loans are bad mainly as a result of past obligations to extent loans to state enterprises. China has a high savings rate of over 30 percent and the Chinese people keep most of their savings as bank deposits as they have a limited number of alternatives. They assume that these deposits are guaranteed by the government and are save. There is no reason for a bank run. Macroeconomic control has been exercised mainly through fixing the amounts of credits which commercial banks in different regions are allowed to extent and the quantity of currency in circulation.

The fourth area of reform is the open door policy. The volume of foreign trade has increased from just below 10 percent of GDP in 1978 to over 35 percent in 1996. Following the development experience of Taiwan and South Korea exports were promoted. Trade deficits in the 1970s and the 1980's were changed to trade surpluses in the 1990s. Control of foreign exchanges was gradually liberalized. With successive devaluation of the Chinese currency from 1.7 yuan to one US dollar in 1980 to 8.6 yuan in 1994, the exchange rate was made equal to the market rate and the Chinese currency became convertible as far as trade transactions were concerned. From 1995 to the present the exchange rate has remained approximately 8.3 yuan to a dollar.

The encouragement of foreign investment is the second component of the open door policy. Direct foreign investment increased from a meager amount of 1.8 billion US dollars in 1984 to 41.7 billion in 1996, mostly coming from Hong Kong. Although foreign investment is a small fraction of GDP it accounts for over 60 percent of China's exports. It is extremely important for China's development as it helps the transfer of technology, managerial skill and modern business practice to China as well as provides competition to state enterprises, forcing them to be more efficient.

The fifth area of reform is encouraging the development of non-state sectors of the economy. By the early 1980s the agricultural sector was almost entirely privatized. By 1996, state-owned enterprises accounted for only 28 percent to gross industrial output. Collectively owned, individually owned and other types of enterprises accounted for 39, 16 and 17 percent respectively (China Statistical Yearbook 1997, p.415). The dramatic growth of the collectively owned township and village enterprises is a fascinating story. These enterprises were built by the political and economic resources of the township and village governments to increase revenue. They are subject to market competition. They employ the managerial skill of competitively selected and highly paid managers. They utilize the high-quality labor force available in the countryside. They are examples of economically efficient enterprises which are publicly owned and are operating without a modern legal framework. The non-state sectors have grown to such an extent that even if the minor state sector grows slowly economic progress in China can continue.

The sixth area of reform is concerned with institutional infrastructure. This includes in particular the legal and educational systems. Reform of the legal system has been a slow but continuing process. Formally many aspects of a modern legal system are now in place, including laws governing business conduct and bankruptcy laws and courts to enforce them. In practice, disputes are still settled partly by political influence, personal relations and bribery, making it difficult to do business in China. The educational system has been greatly improved. Modern economics and management education has been introduced into university curricula. Special training programs have been provided to government officials in charge of banking, financial and fiscal affairs. Much remains to be done simply because of the sheer size of the Chinese population.

Impact of Asian Fincncial Crisis

While the above reforms were making progress the Asian financial crisis came unexpectedly. China had much sounder economic fundamentals than the South Eastern countries hit by the crisis. Its currency was not overvalued. For four years up to the end of 1997 the Chinese currency was freely traded at the official rate. Inflation was low in China, at 0.8 percent in 1997 and -0.3 percent in 1998. China had 140 billion of foreign reserves in 1997, a trade surplus and a continued flow of foreign investment. China did not have a large amount of short-term foreign debts and financial investments which can be suddenly withdrawn when foreign creditors or investors lose confidence. China was affected mainly because devaluation of the currencies of neighboring countries reduced the competitiveness of its exports. For the first time in over two decades total value of exports decreased in 1998, but China still maintained a trade surplus and a substantial amount of foreign investment.

The policies to deal with the Asian financial crisis consist mainly of increasing government expenditures in infrastructure building, and modifying the speed of reforms in both the industrial and financial sectors. To maintain aggregate demand when exports were reduced, the government tried to build more railways, highways, agricultural land and water conservancy facilities, municipal facilities and environmental protection facilities. Broadly defined, government investment of US $1.2 trillion was planned for the three years 1998 to 2000. As a result, the rate of growth of real GDP in 1998 was 7.8 percent as compared with 8.9 percent in the previous year. One cannot tell to what extent the rapid increase in government investment was achieved at the expense of lowering efficiency and the quality of the real output. It is somewhat surprising that a more expansionary monetary policy was not pursued in 1998 to increase aggregate demand and to finance some of the government investment as the country was experiencing a deflation in prices and a stagnant private demand.

On the reform of state enterprises, it was announced in the report of General Secretary Jiang Zemin to the 15th Congress of the Communist Party in September 1997 that "We should support, encourage and help diverse forms in our collective economy. Public ownership can and should take multiple forms." The essence is to change state enterprises to share-holding companies. This is the first time reform of state enterprises reaches the stage of what we can call privatization, even though such a word is not used. For the small and medium sized enterprises, restructuring has taken place whereby managers and workers purchased shares according to their wages. Members of a board of directors were elected by the share-holders. For example if the monthly wage of a worker is 600 yuan, he may pay 2000 yuan for his shares while a high-level manager may pay 5 to 10 thousand yuan for her shares. The shares can be traded internally but not in public. For large state enterprises, restructuring takes a variety of forms but mostly the form of a modern corporation. Shares can be purchased by outsiders. Companies which are qualified according to their financial performance can have shares traded in the Shenzhen, Shanghai, Hong Kong and even the New York stock exchanges. The State Economic and Trade Commission and its branches at provincial, city and county levels have direct responsibility for the restructuring of the state enterprises under their jurisdiction. The restructuring process is effectively administered through central directions given in Beijing at meetings involving party and government leaders from all provinces. These officials in turn transmit the directives to lower levels in all parts of China. The personnel is competent.

During such a restructuring process, workers get laid off, leading to unemployment. Besides the unemployment problem, some workers had their wages reduced, sometimes by as much as 50 percent or even more. Some did not receive their regular salaries. These problems are concentrated in provinces with a large number of state enterprises especially in the northeast. For the country as a whole, the recorded unemployment rate increased from 3.2 percent in 1996 to 4.0 percent in 1997. It was reduced to 3.2 percent in October 1998. The unemployment problem is expected to be under control for three reasons. First the government is monitoring the state of unemployment to prevent massive social unrest. This is slowing down somewhat the process of restructuring state enterprises. Second, the Chinese people are resourceful. Many laid-off workers have found work in the market, especially in the service sector. Third, the government is stimulating the economy through infrastructure building which absorbs some workers; it also helps retrain them and place them into new jobs.

On the reform of the financial system, the current crisis appears to be speeding up the enforcement of a transparent financial reporting and the supervision of financial institutions by the Peoples Bank. Several investment trusts, notably the Guangdong Investment Trust and Investment Company GITIC, which were financed by government capital were bankrupt in late 1998 and early 1999. Foreign banks and investors considered their money to be protected by the government when they put it in these trusts, which legally is not the case. The fact that some of them were allowed to go bankrupt has revised the expectations of future investors, making them more discriminating. In February 1999 the Government decided to close down five state investment trusts which were subsidiaries of the major commercial banks engaged in risky investments. Supervision of financial institutions has become more strict in China.

The open-door policy or globalization of the Chinese economy was slowed down by the Asian financial crisis. Chinese leaders must have observed that opening the Chinese financial markets to short-term foreign investment and allowing free capital flows are hazardous. They were aware of this risk when they divided the shares in the Shenzhen and Shanghai stock exchanges into A and B shares, and allowed foreign investors to buy only B shares. Fluctuations in prices of the B shares affect the fortune of foreign investors only. China was in the process of gradually making its currency convertible for capital transactions, but the crisis has caused it to impose restrictions on transactions even in the current account.

This is related to the issue of whether China should or would devalue its currency. The advantage of devaluation is to make its exports perhaps more competitive, provided that it would not lead to another round of devaluation by its neighbors. There are many more reasons not to devalue. From the purchasing power parity viewpoint China has a zero and a negative inflation rate in 1997 and 1998. It has over 145 billion dollars of reserves. The reserves are increasing because of a trade surplus and an inflow of foreign investment. The economy is growing at a rapid rate and does not require increasing exports to stimulate it in the short run. In the long run if the trade surplus and the flow of foreign investment continue, the supply of foreign exchange will exceed the demand for it, leading naturally to an appreciation of the Chinese currency. In the short-run the Chinese leaders have stated repeatedly that there will be no devaluation. Keeping this promise assures their credibility and the role of China as a stabilizing force in the current financial crisis. The advantages of maintaining the existing exchange rate appear to far outweigh the possible gain of devaluation.

In spite of the strong economic fundamentals and political rationale supporting the existing exchange rate, many people inside and outside China still expected the Yuan to devalue against the dollar. People including exporters decided to put some of their earnings in foreign currencies. By early fall, 1998, China's foreign reserves remained at about 140 billion even when there was a trade surplus of 30 billion and foreign investment of 27 billion. The free market exchange rate for the Yuan as found in banks in Hong Kong was about 8 percent lower than the official rate. The government decided to restrict the flow of currency out of China. Although it could claim that there was no change in exchange rate policy, in practice there were more forms to fill out and more delays in getting approval when one applies for foreign exchange legally. In summary China's reform process has been an experimental and gradual process. It was to be continued before the Asian financial crisis. State-enterprise reform, financial reform and the opening of the Chinese economy have all been affected by the crisis, but there is no question that as soon as conditions allow the reform process will continue, incorporating the lessons learned from the crisis.

What are the trends and prospects?


Consider the first area of reform, that of the agricultural sector. Privatization alone is recognized to be insufficient for future needs. One area requiring much attention is the introduction of modern technology to agriculture, including decentralized research to meet the need of each locality to increase productivity. A second is the improvement in infrastructure, including transportation, communication and electric power. A third is education, not only for the young but for the farming population to learn new technology, management and marketing skills. So far the government has not encouraged the development of non-state distribution systems in agriculture, and marketing of grain still relies on procurement by the state.

As far as reform of the state enterprises is concerned, it is likely to pick up speed as soon as the crisis is over. The government is very determined to proceed with the reform as it cannot continue to subsidize the loss-making enterprises which account for about half of the 100,000 state enterprises. As these state enterprises are producing less and less of China's total output and as some of them are becoming financially independent, share-holding companies they will become less of a burden to the economic growth of China.

The banking and financial sector has benefited from the experience of the crisis. More transparency in financial reporting and stricter supervision of financial institutions are taking place. Banking reform is expected to be slow. It takes time to train qualified modern bankers, to rid the banks of political influence and to make it behave as profit-making and risk-calculating enterprises. The government has not tried to restructure the banks to become share-holding companies open to private ownership as in the case of state industrial enterprises, but allowed rural cooperative funds to sell shares and extend small loans to farmers as working capital. In recent years, there have grown other commercial banks than the big four. These banks are subject to less political influence and behave slightly more like modern commercial banks, but their shares are all held by government agencies. To reduce political influence on the banks by local governments, a new rule was instituted to appoint local bank managers by the bank's headquarters and not subject to the approval of the local government; the four state commercial banks would be free from local government interference in their credit policy. Furthermore, there has been discussion to set interest rates according to the market forces of demand and supply. All these reform measures take time.

China' globalization has also been slowed down, including in particular making the Chinese currency convertible for capital account transactions. After the financial crisis developing countries are now more cautious in opening their capital markets to free short-term capital flows. China is no exception. In fact China should be given the credit for recognizing some of the pitfalls of entering a completely free global financial market without sufficient institutional preparations. There are still the same pros and cons for China to enter the WTO from the Chinese point of view. China certainly wishes to participate in the world economic community as far as trade and investment are concerned, but it is reluctant to open its domestic market for imports too rapidly for protectionist reasons. When China will enter depends on the result of bargaining.

Several other important economic problems are facing the government. One is the environment. In both the rural and urban areas the environment has deteriorated greatly. De-forestry, flood, soil erosion and polluted air are all very serious. Floods were extremely damaging in 1998. Of the ten most polluted cities in the world in 1999 nine are in China. Deterioration of the environment has resulted from years of neglect. Second is increased income inequality. Although all segments and areas of China have benefited greatly from economic growth, disparity has widened between the rich coastal provinces and many provinces in the interior. Third, while the pre-reform system provided health care, retirement compensation and employment security to members of the society, under the current market economy substitutes for these provisions have not been firmly established. Fourth, highly subsidized urban public housing is being replaced by private ownership. In each of these four areas the government has recognized the importance of the problems and devoted economic resources to solve them, but the solutions are slow for the first three. I cannot end an essay on economic reform without commenting on political reform in China. This is not the place to debate whether political reform toward democracy is necessary for economic reform. All can agree that, as economic reform leads to improvement in the living standard of the citizens and gives them more economic power and freedom they will demand more political power and freedom. In China, political reform has taken place in several forms. There is now more political power exercised by the People's Congress which once only rubber-stamped the legislation introduced. The legal system has been strengthened to the extent that citizens can and have sued the government for violating their rights. That does not mean that the courts' decisions are all free of political influence. Thirdly, there are many more public elections at the village level to select government officials. In early 1999, there was one public election at the county level and it was watched closed by the public to see whether the central government would allow it. The election did take place, but the government decided not to allow a second one, at least not in the near future. The Chinese government is introducing political reform at a speed which most Western observers consider too slow, but it is the speed at which the government is comfortable, given its background and experience and its interest in maintaining power and social stability. Some observer may speculate that unless the government introduces democratic reforms more rapidly, there will be political instability or economic reform will stop. To the latter possibility I wish to point out that even if economic reform were to slow down the existing economic institutions are sufficiently close to those of a functioning market economy that economic growth can continue at a reasonably high speed for another decade, as it has done so in the last decade. Serious political instability seems unlikely because the majority of the population appears to support the government but this is only a personal judgment subject to error. In conclusion, economic reforms in China are likely to continue in the manner and directions as described above. Because of the strong fundamentals of the Chines economy as demonstrated by its good performance during the financial crisis substantial growth will continue perhaps for another decade after the current crisis. For more than a decade I would not wish to predict.

This page last updated 3/12/99 jdb


ICAS Fellow