Nafziger Economic Development (4th ed)

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concern for profits was driven by efforts to increase worker benefits, which affected managerial security (Lichtenstein 1991:73; Perkins 1991:160–166).

Enterprise managers had little control over paying or hiring labor and little in firing unproductive workers. Furthermore, the variety and amount of supplies available to a firm did not bear much relationship to output targets. Firms had little scope to search the market for the cheapest combination of input costs. Factor prices were highly distorted.

In reality, during the early period of reform, firms had a soft budget constraint. Although management and worker bonuses were nominally linked to profits and other targets, virtually no enterprise lost bonuses for not meeting targets, since firms were able to negotiate during the output year to reduce quotas. Enterprises took excessive risks because of this soft constraint. Moreover, enterprise managers bargained for profit targets, which sometimes were changed retroactively. Furthermore, governmental authorities failed to shift from a centrally directed finance system to a tax-based system; Beijing gave tax breaks to the more troubled and powerful enterprises (Prime 1991:167–185; Leung 1994:A13).

Also firms received inducements for production yet might not be able to respond because managers lacked meaningful discretionary authority. Planning was difficult, as firm norms were excessive and changed too frequently. The norms encouraged output of high-value commodities that used a high proportion of materials and delinked production from marketing.

Industrial reform was supposed to permit bankruptcy, but in practice the state still subsidized losses. Although banking reform required investment financed by bank loans on an economic basis rather than state budgetary grants, half the new capital construction in the 1980s was financed by state grants. Communist Party and local government leaders interfered with the People’s Bank of China, forcing it to renegotiate loans on more favorable terms, especially to the politically influential. A typical procedure was to use the profits of successful firms to infuse with life the failing firms, which received a substantial share of the budget in the 1980s. Inflationary pressures were high during the late 1980s, because of politicized lending and price monitoring and widespread wage pressures. These pressures were in response to a fear of worker unrest and agitation from being squeezed by increasing food prices and from an increased craving for consumer goods such as televisions, radios, tape recorders, bicycles, refrigerators, washing machines, furniture, jewelry, and Westernstyle homes (Lichtenstein 1991:13–14, 48, 69; Naughton 1991:135–159; Prybyla 1991:209–225; Beijing Review, March 28, 1994, p. 4; Leung 1994:A11).

Chinese industry in the first 10 years of the reform still suffered from the classic Soviet planning approach – using the preceding year’s achievement as the minimum target for the current year, known by the Chinese as “whipping the fast ox.” Near the end of the year, enterprises overfulfilling quotas deliberately slowed down operations in order not to increase targets too much for the subsequent year. From 1979 to 1980, Beijing instituted profit retention and rewards for fulfilling profits and other performance indicators in several pilot firms. But the experiment was suspended, as the growth of profits and other performance indicators slowed down to keep future

targets down, and local governments objected to the high administrative costs and reduced control associated with enterprise profit retention.

Moreover, most enterprises did not receive their quotas until after the beginning of the planning year. Because of dependence on administrative decisions and the cooperation of other firms in receiving inputs, enterprises kept excessive levels of inventory.

As the state set few variety, grade, or style targets, the enterprise had little incentive to produce the variety of goods demanded by the market. Price incentives also were lacking for quality improvement.

Later improvement in reform outcomes. However, by the late 1980s and 1990s, some changes spurred more managers to adopt reforms and improve market response. The experience of partial reform, especially during the wrenching industrial recession of 1980–81, increased the promarket sentiments of many planners and enterprise managers, who saw how smaller and private enterprises took advantage of opportunities offered by the market (Jefferson and Rawski 1999a:84). At the same time, the emergence of a buyers’ market, from increases in the supply of light industry and consumer goods, increased incentives to improve industrial performance and quality (Tidrick 1987:201).

A key management reform, gradually implemented in the 1980s, was to expand the right of the firm to an increasing share of residual profits. Despite remnants of planning, intrusive regulation, and administrative approval processes, by the 1990s, as bureaucratic constraints lessened, profit, not plan fulfillment, became the SOE’s prime motivator (Jefferson, Ping, and Zhao 1999:52–53; Jefferson and Rawski 1999a:67; Jefferson, Rawski, and Yuxin 1999:96–97). The government reduced the number of industrial products subject to compulsory planning from 131 in 1980 to 14 in 1988, while also reducing fixed prices on foodstuffs and inputs (Lichtenstein 1991:47), thus improving microeconomic allocation efficiency. The slowdown in revenue growth during the 1980s hardened budget constraints, tilting officials and bankers toward “sending enterprises to market” (Jefferson and Rawski 1999a:80). Furthermore, a growing number of SOEs have reorganized themselves into joint stock companies, intensifying competitive pressures on those remaining in the state sector (Jefferson and Rawski 1999b:38).

The increasing right to sell products outside the plan was a major stimulus to innovation in production and marketing. SOEs, responding to competitive pressures, increased productivity enhancements, R&D, new product development, and innovation. Evidence of increased competition was that industrial concentration ratios, the proportion of an industry’s (e.g., beer, cement, machine tools, steel) output produced by the three largest firms in the industry, was lower in China than in either Japan or the United States (Jefferson, Rawski, and Yuxin 1999:95; Jefferson and Rawski 1999a:67; Jefferson and Rawski 1999b:35–36).

Contract responsibility enables most firms to retain all or a progressively increasing share of above-quota profits. In the 1990s and early years of the 21st century, directors and managers increased their decision-making authority, less constrained by state

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interference. The association of increased profits and retained earnings with wages and bonuses served as an incentive for the firm to increase productivity. The result of increased labor incentives, labor market reforms and greater enterprise autonomy was an explosive increase in labor productivity from 1978 to 1996, especially in the 1990s (Jefferson, Ping, and Zhao 1999:48–63; Jefferson, Rawski, and Yuxin 1999:95; Jefferson, Singh, Hu, and Benzhou 1999:171–172).

SOE reform in the early years of the 21st century. Problems remain. Profit retention rates, and thus incentives, for SOEs vary substantially. SOEs’ total factor productivity is only half that of the private and TVE sectors. Although prices are increasingly determined by enterprise discretion, where there is state price control, managers widely engage in rent seeking activities (Jefferson 1999:168; Jefferson, Ping, and Zhao 1999:52–53; 60–61; Jefferson, Singh, Junling, and Shouqing 1999:137, 143– 145).

Many of China’s SOEs, similar to those in Russia, serve the function of “company town,” thus being burdened with social service, pension, unemployment insurance, health, education, and other welfare expenses (Jefferson and Rawski 1999b:32– 33).17 Moreover, like Russia, Chinese banks have “built up a mountain of nonperforming loans (NPLs) by lavishing cash on value-destroying state firms while starving deserving private borrowers” (Economist 2004:S18).

The World Bank views the lack of property rights as the problem in state-owned enterprises and TVEs (Jefferson, Mai, and Zhao 1999:107–125). Public enterprises gradually devolved ownership and control to provincial and local governments, a move contributing to the “development of a property rights market” (Jefferson and Rawski 1999b:29–30). A clear assignment of property rights “improve[s] the incentive to monitor and curtail rent-seeking behavior.” Is this possible without a change in ownership rights? According to the Bank, empirical studies indicate that a reassignment of property rights results in measurable gains in efficiency (Jefferson, Mai, and Zhao 1999:111).

However, can China change ownership rights without experiencing the colossal waste from “insider privatization” and the creation of a class of billionaire oligarchs that Russia underwent? Grzegorz Kolodko (2000:98, 158), Poland’s Finance Minister, 1994–97, thinks that Poland, Czech Republic, and Russia privatized too quickly, and that transitional countries should rather emphasize speed in commercialization and improvement of the corporate governance of public enterprises.

Other economists express optimism that over the years, private enterprises, which have bought shares of SOEs, and collective enterprises have grown faster than SOEs, and will eventually dominate the loss-ridden public enterprises. Indeed, the share of industrial output by state-owned enterprises fell from 80 percent in 1978 to

17The fact that a majority of SOEs lose money threatens the survival of the schools dependent on these enterprises, for which the government has not been willing to provide specific educational funds. Roughly 5 percent of primary and secondary students attend schools run by unprofitable SOEs (Zhang and Liu 1995). In the early 1990s, 93 percent of employees of industrial SOEs were provided with housing (Jefferson and Rawski 1999b:39).

55 percent in 1990 to 43 percent in 1994 to 28 percent in 1996 (Jefferson and Rawski 1994:47–70; Economist 1995b:33–34; Jefferson and Rawski 1999b:27; Jefferson, Rawski, and Yuxin 1999:90). Still, in 2004, SOEs accounted for 35 percent of urban employment and received half of bank loans. The largest producers of coal, steel, power equipment, and other key goods are SOEs. Virtually all of heavy industry and much of technology were in the hands of SOEs. Moreover, a majority of SOEs, an increase in a 20-year period, were losing money in 2004 (Jefferson and Rawski 1999b:37; Economist 2004c:S14).

Still the support for reform is so pervasive in China that its rulers are not likely to reverse the industrial and other domestic reforms significantly. But China faces many problems related to the reforms, including excessive credit to SOEs, the collapse of the “iron rice bowl” for workers in firms, the increased migration of the rural poor to the cities, and potentially rising worker and peasant disaffection.

Peter Nolan points out that, despite protection, subsidized loans, access to foreign technology through joint ventures, and privileged access to the stock market, China lacks truly competitive global firms. Thus, for Nolan, from a global perspective, China’s “industrial policy of the past two decades must be judged a failure” (Economist 2004c:S15).

POVERTY AND INEQUALITY

Mao Zedong’s rhetoric emphasized egalitarianism and building up the “weakest link.” In practice, its income inequality was in a range comparable to many other Asian countries, such as Bangladesh and Sri Lanka. Although China’s rural and urban inequalities were low, Mao’s urban bias policies widened rural–urban inequality so that it was higher than India’s (World Bank 1983a:Vol. 1, 84–94).

Deng Xiaoping’s slogan “To get rich is glorious” was a repudiation of Mao’s emphasis (Lichtenstein 1991:136). John Knight and Lina Song (2001:118) find that urban inequality rose from 1988 to 1995, primarily in areas where economic reform increased income and widened inequality in coastal regions and in the nonstate sector. During the same period, rural inequality increased largely because of “the increased importance of wage income and individual business income in total rural income” (ibid., p. 117). Overall income inequality has increased substantially during the years of reform so that “China in the 1980s and 1990s became one of the more unequal countries in the region and among developing countries generally” (Riskin, Renwei, and Shi 2001:3). The Gini coefficient of household income per capita rose from 38 to 45 percent from 1988 to 1995 (Knight and Song 2001:84).

However, because of rapid growth, the rural population in poverty fell from 33 percent in 1978 to 11 percent in 1984, while urban poverty declined from 1.9 percent in 1981 to 0.3 percent in 1984. From 1984 to the early 1990s, poverty reduction stopped in rural China and drastically slowed in urban China, despite rapid growth (World Bank 1992a; Khan and Riskin 2001:52–54). Wu and Perlott (2004) show that income inequality continually increased from 1985 to 2001. Inequality increased within both rural and urban areas, and also rose from shifts of population from rural

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to urban areas, but the largest contributor to the high national inequality (Gini = 0.415 in 2001) was the widening rural–urban gap.

For Zhao Renwei, there are important policy implications for reversing the increase in income inequality and end of significant poverty reduction in the late 1980s and 1990s. First, China needs to pay more attention to rural economic development. Second, the country needs a social security policy to reduce poverty and inequality from unemployment, sickness, and old age. Third, the country needs to increase investment in human capital, especially basic education. Fourth, China should use personal income taxes to redistribute income (Renwei 2001:25–43). At present, only a small percentage of urban workers pay income tax. Incomes need to be more transparent and the central state needs to improve its tax-collecting capacity (Gustafsson and Shi 2001:48). Fifth, government needs to reduce subsidies and benefits for high-income groups in urban areas. Finally, Renwei (2001:40–42) wants greater labor mobility, especially for rural people to migrate to jobs in urban areas.

BANKING REFORM

China had no capital markets before the 1978 reforms; firms, primarily public enterprises, financed investment from retained profits, interest-free budgetary grants, and loans from state-owned banks. China had a monobank system typical of centrally planned economies (Lardy 1998:60–139; Goldstein 1998:31). China’s banks, “as appendages of government, . . . are massive, bureaucratic and imbedded with an intensely political culture,” in which bank managers are rewarded on party loyalty (Economist 2004c:S18). SOEs and their reporting are of poor quality. Years of politically motivated lending increased bank bad debts to 145 percent of GDP, so that nonperforming loans were 30 percent of deposits. With China’s economic reform and subsequent opening to the international economy, the banking system grew in complexity, with the central Bank of China, national and regional commercial banks, an agricultural bank, construction bank, investment bank, housing savings banks, consumer banks, banks specializing in foreign exchange, and nonbank financial institutions, such as urban credit cooperatives, trust and investment companies, finance companies for enterprise groups, financial leasing companies, securities companies, and credit rating companies (Lardy 1998:60–76). Still, Nicholas Lardy, senior fellow at Washington’s Institute of International Economics, thinks it is too early for bailing out banks, as they will soon return to an unsustainable debt position unless they can prove “that they can operate on a commercial basis” (Economist 2004c:S18). As China moves to international convertibility of its currency, the yuan, interest rates will need to be competitive to avoid substantial pressure on the balance of payments and yuan from depositors buying higher-yielding foreign assets (Lardy 1998:77–139).

INCREASING INTERNATIONAL TRADE AND EXCHANGE

During the 1960s and early 1970s, the Chinese stressed self-sufficiency. In 1960, amid an ideological dispute, the Soviets canceled contracts and pulled out materials, spare parts, and blueprints from aid projects and joint ventures in China, leaving

bridges and buildings half built. In 1977, after Mao’s death, the Chinese leadership, recognizing how costly technological self-reliance had been, opened the door toward the world market. To change, China would now not only stress basic studies and the development and application of science and technology but also learn foreign technology through sending students to foreign academic institutions, absorb foreign production techniques suitable to China’s conditions, and raise the skills of Chinese workers, technicians, and managers (Beijing Review 1982:20–21). In 2001, China joined the World Trade Organization (WTO), which applies to countries where market prices are the rule.

In 1979–80, China first created special economic zones (SEZs), export processing zones, for foreigners to set up enterprises, hire labor, and import duty-free goods for processing and reexporting. Many foreign investors in SEZs, and later in other cities or development zones with comparable status, enjoyed preferential tax rates, reduced tariffs, flexible labor and wage policies, more modern infrastructure, and less bureaucracy than elsewhere in China.

In 2001, of the $209.4 billion foreign direct investment (FDI) that flowed to LDCs, the largest share, $46.8 billion, flowed to China (also $23.8 billion to Hong Kong, China) (UNCTAD 2003:7). Moreover, in 2002, surveys by the World Bank’s Multilateral Investment Guarantee Agency and A. T. Kearney found that China had overtaken the United States as the top ranking country in FDI confidence (World Bank 2003e:102). Foreign investors included overseas Chinese, especially from Hong Kong. Although a part of China since 1997, Hong Kong receives the same preferences as foreign investment. Because of special inducements for foreigners, sometimes domestic Chinese, who wanted to start a new industrial venture disguised the enterprise by creating a front for Hong Kong (“foreign”) investors. Although China does not recognize a separate government in Taiwan, its citizens are heavy investors, especially in electronics, taking advantage of language affinity and cheap labor, usually by entering circuitously through Hong Kong or Macao. The Asia Times (Keliher and Meer 2003) estimates that Taiwanese firms in China are responsible for 40 percent of China’s exports. Most Hong Kong and Chinese overseas investors were legitimate investors, comprising the lion’s share of foreign capital in China. Indeed, the overseas Chinese in China were more experienced and enterprising than overseas Indians18 or overseas members of other Asian nations. China also benefited from the fact that Western and Japanese investors feared being excluded from what comprises about 12 percent of world GNI PPP (World Bank 2004b:252–253) and will eventually be the largest market in the world.

Eighty-five percent of FDI flows in 1998 were to relatively prosperous coastal areas, with the largest amount in Guangdong Province, near Hong Kong (OECD 2001:7). FDI flows account for about 15 percent of China’s total capital formation, one of the highest ratios among LDCs. In 1995, FDI controlled 47 percent of China’s

18FDI inflows to India in 2001 were $3.4 billion, ranking behind not only China but also Mexico, Brazil, South Africa, Poland, Czech Republic, and Thailand among LDCs (UNCTAD 2003:7). Moreover, the surveys reported by the World Bank (2003a:102) indicated that whereas China ranked 1st in FDI confidence, the next ranking LDC was Mexico in 9th place, and India ranked only 15th.

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manufacturing exports and 53 percent of investment in electronics. FDI firms are much more profitable than domestic firms, especially SOEs (Huang 2001:147–155). Moreover, FDI enterprises, and, to a lesser extent, domestic private firms and TVEs, have been increasing export shares relative to SOEs, as the major determinants of export success are firm decision-making autonomy and exposure to freer domestic market (Perkins 1998:242, 260).

To what extent is China facing some of the hazards that modern sectors or enclaves within a dual economy encountered during colonialism and the postcolonial period of the 1960s and 1970s: a lack of linkages to other enterprises within the domestic economy (Crane 1991:841–857; Endean 1991:741–769). For Jefferson and Rawski (1999b:40), this is not likely. Indeed, foreign firms, especially “joint ventures have strongly influenced the process of industrial reform by bringing . . . access to offshore pools of funds and intimate knowledge of advanced technology, market intelligence, and management systems, into partnership with Chinese enterprises. [These innovations have] begun to ripple through China’s business community through supplier networks, competitive pressures, and the rotation of Chinese personnel to and from foreign-linked enterprises.”

A scenario similar to the end of Japan’s miracle (Chapter 3) could contribute to decelerating growth in China. China, like Japan, not only faces massive bad debts owed to banks but also may have exhausted gains from internal and external economies of scale, learning by doing, and gains from the “advantages of backwardness,”19 adopting technology cheaply from more advanced economies. An unknown includes the ability of China to respond to inequality, worker and peasant discontent, and demands for national and ethnic self-determination.

Lessons for LDCs from the Russian, Polish, and Chinese Transitions to the Market

Many third-world countries of Africa, Asia, and Latin America can learn from Russia’s, Poland’s, and China’s efforts at liberalization and adjustment. Russia’s state socialism, more developed and deep-seated than Poland’s and China’s, required more substantial institutional change for successful transition to the market. As Alec Nove (1983:168), a student of socialist economies, put it, “To change everything at once is impossible, but partial change creates contradictions and inconsistencies.”

Russia’s legacies of consumer-goods neglect, gigantimania and industrial concentration, resistance to technological innovation, shoddy quality, quota disincentives, and information concealment were more institutionalized than Poland’s. For example, Poland had less industrial concentration, had made some progress in the 1980s toward privatization, and provided more competition to state-owned monopolies after reform than Russia. Other difficulties Russia encountered in its reform were

19Compared to Russia, China suffered fewer distortions in the stock of fixed capital, because, being at a much earlier stage of development, it had little capital and did not require much in agriculture (Popov 2001:32). Later, China may have less flexibility in modifying economic strategies.

lack of incentives, false signals from prices, nonprice capital allocation, monopoly pricing after price decontrol, a soft budget constraint for enterprises, a torn “safety net” for workers and the elderly, opposition to or capture of liberalization benefits by vested bureaucratic interests, neglect of institutional and legal changes essential to expedite a market economy, and severed trade links. Poland moved toward demonopolization before or concurrently with price control, began organizing a capital and labor market, had less politicized lending to inefficient or failing firms, and provided more support to the economic welfare of the poor than Russia. Although both countries encountered opposition from the bureaucracy, resistance in Poland was less substantial, perhaps because the material levels of living of wage earners did not decline as substantially as in Russia.

Peter Nolan (1995) has two explanations for the success of China’s economic growth and reforms compared to Russia’s: (1) China’s pursuit of economic reforms while avoiding political liberalization (similar to other East Asian fast-growing economies) and (2) China’s step-by-step approach to economic reform, rejecting “shock therapy,” especially as practiced by the IMF and World Bank. Nolan shows how Russia’s efforts at glasnost (openness) and democratization destroyed the old state apparatus while failing to construct an effective successor state, thus engendering an economic collapse.

John Ross (1994:19–28) provides several rules for liberalization policy, based on the experiences of China, Russia, and Eastern Europe. First, decontrol prices, marketize, and privatize where you have competitive sectors, such as China’s agricultural sector. Second, maintain controlled prices where you have monopolistic and oligopolistic sectors, as in China’s industrial sector. Russia made the mistake of decontrolling prices, marketizing, and privatizing industrial products, thus increasing these prices for consumers and the competitive sectors. Russia’s industrial firms reduced output and raised prices to maximize profits. Third, only decontrol industrial prices when you can provide international competition, as in the case of Poland’s industry, or when government can break up existing enterprises or provide enough domestic competition so that firms will not restrict output. In Russia’s case, the instability of the rouble hampered export expansion so that foreign exchange was not adequate to import from foreigners who might have competed with domestic enterprise. Fourth, unlike Russia (and to a lesser extent China) in the early 1990s, use monetary and fiscal policies to set an interest rate to ration credit and to dampen inflation. Fifth, as in Poland in 1989, liberalize foreign exchange rates by ceasing to interfere in the market. However, you may need to restrict imports as their pent-up demand could create a balance-of-payments problem. Sixth, provide a safety net for the poor and unemployed to reduce the resistance of the population opposed to reform. In the early 1990s, Poland and China had limited success, and Russia virtually no success, in achieving the sixth rule.

In agriculture, China decollectivized much more successfully than Russia, which stifled private initiative and marketization. In industry, China encountered many of the same stubborn interests opposing liberalization as Russia did. Although China has suffered from its share of corruption, it has resisted the asset stripping and favorable

8.What can LDCs do to improve the performance of their private sector?

9.What is privatization? How successful have attempts at privatization in LDCs been? What are some of the pitfalls of privatization?

10.Assess the efficacy of MNC–SOE joint ventures in LDCs.

11.Should LDCs put more emphasis on privatization or socialization, or should they continue the status quo?

12.What were the main reasons for the collapse of state socialism in the Soviet Union?

13.Barthlomiej Kaminski indicates that state socialism is nonreformable. Evaluate this contention.

14.Evaluate the effectiveness of the “shock therapy”/“big bang” approach and the alternative approach.

15.Jeffrey Sachs contends: “I blame Russia’s problems on communist ineptitude and corruption, the utter degradation of the old administrative structure, and the thoughtless reaction of the West to the growing financial plight of the republics.” Discuss and evaluate this view.

16.The economist Thomas E. Weisskopf states: “The outlook for revitalization of Russia’s economy is bleak. Only an alternative to shock therapy can assure that the Russian economy will be successfully restructured and revitalized. . . . It would . . . require a much larger role for government in shaping the social and economic environment than radical free marketeers are willing to contemplate. Such an alternative approach would be more likely to obtain democratic support than shock therapy and therefore the Russian government would be more likely to implement it successfully.” Discuss and evaluate this view.

17.Discuss China’s urban reform, agricultural reform, and other reforms after 1978– 79, including some of the problems associated with the reforms and the impact that the reforms had on economic performance.

18.Do you agree with economists who argue that Chinese economic strategies are characterized by continuity and evolution, not abrupt change, especially when compared to those in Russia and other former communist countries undertaking reforms in the 1990s?

19.Discuss the problems China has had with the reform of its SOEs.

20.What lessons can LDCs learn from Russia’s collapse of state socialism and economic reform?

21.What lessons can LDCs learn from China’s transition from socialism to a market economy?

GUIDE TO READINGS

Bruno and Easterly (1998) examine inflation and its effect on adjustment. Stiglitz (2002b), Mosley, Harrigan, and Toye (1991:Vol. 1), FAO (1991:115–149), and Cramer and Weeks (2002:43–61) criticize IMF adjustment policies. Vera (2000) partly blames the IMF and World Bank’s conditionality strictness for Latin America’s staggering debt and stagnation during the 1980s and 1990s. Aguilar (1997)