China s Gradual Economic Reform and Opening to Trade ( ) Reform Without Losers

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1 China s Gradual Economic Reform and Opening to Trade ( ) Reform Without Losers Dual Track Economy Starting in 1978 the Chinese economic policy makers slowly phased in market prices. They used a dual price system where production quotas are set and the output is sold to the state at the (usually lower) state administered price, and any "over quota" production is sold in the market at the market price. Similarly consumers were allocated ration tickets allowing them to buy their personal quota of goods at the low state price. To the extent that they wanted to consume more than their quota, they could buy it without a ration ticket in the free market. Over time the administered prices slowly rose to the market price, ration tickets where reduced and by the middle 1990s the ration tickets were discontinued and most consumer goods were bought and sold at market prices. Still, key sectors of the economy remained under price controls. These sectors include the banking sector (interest rates fixed), air transport (fares are computed based on the kilometers of the flight), steel, coal, petroleum, gold, etc.. The positive effect of this approach is that it established market price signals from the very beginning. These price signals served their informational purpose of guiding economic behavior at the margin. A major disadvantage of the dual price system is that created large opportunities for corruption by the officials in charge of distributing the goods to be sold at the low administered prices. These officials then had vested interests to protect and may have been instrumental in slowing the reform process. Proportion of Products Sold at Different Kinds of Prices Retail Sales At State Price 97 NA At Market Price 3 NA Agricultural Sales At State Price 94.4 NA 47.8 At Market Price 5.6 NA Industrial Sales At State Price At Market Price

2 Family Responsibility System (early 80s) Local villages were allowed to experiment with the Family Responsibility System whereby the collective land was divided and allocated for use by individual families. To make the allocation fair, the land was allocated according to family size. Each family was given equal shares of good bottom land and not so good hillside land. Each family was responsible for its share of the collective's quota (sold to the planners at the low state price), and could use the rest of their resources to produce goods for the market. Peasants used the market prices to determine where to allocate their resources...pigs, chicken, fresh vegetables and so on. For villages located near large cities, this system provided large competitive free markets. And urban consumers were increasingly buying at the free markets as their ration tickets were reduced. Two obvious results are that incentives changed, and that plots of land were fragmented so that scale economies were lost. While villages were not forced to make this change, by 1983 the vast majority of villages had adopted it. Agricultural production soared during the first years of the reform. Some argue that the growth in agricultural output was due to the phenomenal increase in the application of chemical fertilizers, but this increase itself was primarily the result of the reforms. This initial boost, however, was a one shot affair and further increases in agricultural production would only come with more reforms. As long as peasant productivity remains low, peasant income will remain low and lag behind the income growth of the cities. As the US experienced in the 1930s, reducing the farming population is a difficult process.

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4 Town & Village Enterprises (80s) Before 1978 many of the village collectives did more than just grow crops. With the surplus labor and high rates of savings, and insufficient allocation of inputs (from the central plan) these collectives had often allocated resources to small village enterprises. For example, a collective may have a small fertilizer producing facility, a brick works, or a catfish pond. With the opening up of free markets, these collective facilities evolved into collectively owned businesses which were called Town and Village Enterprises (TVEs). While these TVEs were not privately owned, they were market driven and guided by market prices. They were sometimes the recipients of foreign direct investment. What we would call profit, stayed within the collective to be used for schools, parks, old age assistance, etc. It is a little known fact the real force behind the Chinese economic growth of the 1980s was the TVE. TVEs faced market prices, harder budget constraints, and were controlled more by local managers than the large state owned enterprises. Still, the TVEs have the potential for inefficient behavior when compared to private enterprise. In many cases local officials interfered with decisions to cut back employment. And since profits are not claimed by stock holders who can sell their stock, these enterprises can earn less than their opportunity costs without control by stockholders. In this way, the budget constraint facing TVEs was not as hard as for privately owned firms. Share of Industrial Output by Ownership Type State Industry (SOE) Collective (TVE) Individual and Other

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6 State Owned Enterprise (SOE) Growing Out of the Plan The state owned enterprises were the center pin of the old planning process. They tended to be huge and geographically located according to planning rather than market criteria. The typical SOE was a walled community which provided housing, health care, schooling, pensions and other social services to its workers. There weren't many reasons for a worker to leave the walls which surrounded the SOE. After 1978 the SOEs continued to operate almost unchanged. But there was also a sort of "family responsibility system" for the SOE. Once they satisfied the quota for the plan they were free to sell "out of plan" output in the free market. Here the SOE had some incentive to pay attention to market signals. Still the SOE's were certain to get bailed out if they couldn't meet their expenses by "loans" from the state owned banking system. So the SOEs continued to operate under a soft budget constraint with the expected poor incentives and low efficiency. As the reforms moved into the late 1990s, the government was showing that it was increasingly willing to let some of the most egregiously loss making SOEs close down. Workers of a closed SOE were suddenly unemployed and looking for work for the first time in their life. They also had lost any claim to a pension since the old policy was that the SOE provided the pension and the central government has not initiated much of a national pension plan. This also cut some workers off from their traditional source for medical care. Regionally the unemployment rate can be as high as 30%, especially in the Chinese rust belt. For some regions of China, economic activity was the result of planning. For example large heavy industrial plants were built in remote Gansu province. A large number of workers were sent to Gansu under the plan. Once the planning sector is reduced and these heavy industrial plants are allowed to fail, the reason for much of Gansu's industrial activity ceases. Under the market regime, located heavy industry so far from the markets isn't rational. Thus despite China's steady economic growth, there are substantial regions of the country experiencing full scaled depressions which rival those observed in Belarus or the Ukraine. The data charted below indicate the progress made at reforming state owned enterprise. While the SOE's share of industrial output has fallen since the onset of reforms, the allocation of investment funds via the stat e controlled banking sector did not begin to fall until the 1990s. In the 1990s, with both output share and investment share for SOEs falling, the fall in the % employed in state industry has been slow to fall and in absolute numbers, has actually risen during this period. The lagging productivity in a large portion of SOEs has remained a difficult problem. For the last 30 years or so, under the soft budget constraints of planning and partial reform, many SOEs have been kept afloat when, based on narrow market efficiency measures, they should have been allowed to fail.

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8 The Trade Sector during the Early Reforms ( )

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10 Special Economic Zones (Disarticulation) Starting in 1980, China opened several SEZs in southern China close to Hong Kong (and Taiwan). Producers in these zones could import materials and components free of many regulations and tariffs. The Chinese government also provided substantial subsidies for infrastructure. In 1984, China established similar arrangements in 14 other coastal cities.

11 Exchange Rate Devaluation Like most other planned socialist economies, the China s exchange rate was overvalued at the beginning of the reform. The over valued exchange rate subsidized the importation of capital goods needed for the economic plan. It also led to an excess demand for foreign currency, a rigid system of controls, limitations on who could legally hold foreign exchange, and a vibrant black market. During the 1980s, Exporters were helped by a substantial devaluation of the official exchange rate, from 1.5RMB/$ in 1981 to 8.3RMB/$ in While China did experience higher rates of inflation than the US, the IMF states that this represents a 70% devaluation in real terms.

12 : Dual exchange rate (FEC & RMB) From 1986 to the mid 1990s, China used a dual currency system. Chinese could legally hold and transact only in RMB (people s money). Foreigners and imported products could use Foreign Exchange Certificates. FEC RMB

13 Demonopolization of Trading Companies Throughout the 1980s China continued to restrict the rights to engage in trade. Still, that was an increase in the number of firms allows to conduct international firms, from 12 in 1978 to 5000 in Tariffs Tariffs actually increased during the early 1980s. This was part of a longer term strategy of first turning non tariff barriers into tariff barriers, and then, reducing the tariffs en route to ultimate membership in the WTO (finished in 12/2003). While China s tariffs were high in the early 1980s, they were not unusually high for a developing country.

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15 Corruption While the gradual reforms can be said to have ushered in markets and trade to avoid unsustainable, short term shocks, the two track system opened the door to what is usually labeled as corrupt behavior. See SCMP article noting government officials who refused to work without bribes.