How reform worked in china the transition from plan to market (the MIT press)

Introduction: A New Perspective on Reform1 How Reform Worked in China I Dual-Track Market Liberalization 2 Reform without Losers: An Interpretation of China’s Track Approach to Transitio

How Reform Worked in China

The Transition from Plan to Market

Yingyi Qian

The MIT Press

Cambridge, Massachusetts

London, England

© 2017 Massachusetts Institute of Technology

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Names: Qian, Yingyi, 1956- author.

Title: How reform worked in China : the transition from plan to market /

Yingyi Qian.

Description: Cambridge, MA : MIT Press, [2017] | Includes bibliographical

references and index.

Identifiers: LCCN 2017007623 | ISBN 9780262534246 (pbk : alk paper)

eISBN 9780262342704

Subjects: LCSH: China Economic policy 2000- | Central planning China |

Central-local government relations China | Federal government China |

Decentralization in government China | Mixed economy China.

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For my parents

Introduction: A New Perspective on Reform

1 How Reform Worked in China

I Dual-Track Market Liberalization

2 Reform without Losers: An Interpretation of China’s Track Approach to Transition

Dual-3 Pareto-Improving Economic Reforms through Dual-TrackLiberalization

II Unconventional Ownership of Firms

4 Institutional Environment, Community Government, andCorporate Governance: Understanding China’s Township-

III Government and Reform: Federalism, Chinese Style

7 Federalism, Chinese Style: The Political Basis for EconomicSuccess in China

8 Federalism as a Commitment to Preserving Market Incentives

9 Regional Decentralization and Fiscal Incentives: Federalism,Chinese Style

IV Initial Organizational Conditions and Reform

10 Why China’s Economic Reforms Differ: The M-FormHierarchy and Entry/Expansion of the Non-State Sector

11 Incentives, Information, and Organizational Form

12 Coordinating Reforms in Transition Economies

Index

List of Tables

Table 1.1 GDP Growth Rates by Province (percent)

Table 1.2 Growth Rates of GDP and GDP Components (percent)Table 1.3 Dual-Track Market Liberalization

Table 1.4 Industrial Output Share by Ownership (percent of total)Table 1.5 The Correlations between Local Revenue and

Expenditure

Table 1.6 Currency Seigniorage and Implicit Taxation on Bank

Deposits (percent of GDP)

Table 2.1 The Dual Tracks in Grain (million tons)

Table 2.2 The Dual Tracks in Agricultural Goods (% of output

value)

Table 2.3 The Dual Tracks in Industrial Goods (million tons)

Table 2.4 The Dual Tracks in Retail Sales (% of sales)

Table 2.5 The Dual Tracks in Non-Agricultural Employment

(million employees)

Table 4.1 China: Shares of Industrial Output Value by Ownership(1978–1993)

Table 6.1 Summary Statistics of Variables

Table 6.2 Ownership and the Institutional Environment—The LogitModel

Table 6.3 Ownership and the Institutional Environment—the Logit

Model Average TVE Shares and Ex Ante Provincial Characteristics

Table 6.4 Ownership and the Community Government’s

Objectives: The Government’s Revenue

Table 6.5 Ownership and the Community Government’s

Objectives: Non-Farm Employment and Per Capita Income

Table 9.1 Summary Statistics of Major Variables (1982–92)

Table 9.2 The Discrepancy between the Ex Ante Contracts and Ex

Post Implementation

Table 9.3 Extra Remittances vs Extra Subsidies

Table 9.4 The Correlations Between Local Revenue and

Table 9.8 The Endogeneity Problem: Provincial Marginal RevenueRetention Rate Dummy

Table 10.1 China: Selected Macroeconomic Indicators 1978–1991Table 10.2 China: Annual Consumption Per Capita (kilogram)Table 10.3 China: Living Space Per Person (square-meter)

Table 10.4 China: Consumer Durable Per 100 Urban Households(sets)

Table 10.5 China: Consumer Durable Per 100 Rural Households(sets)

Table 10.6 China: Share of Gross Industrial Output Value by

Table 10.10 China: Share of Industrial Output as Percent of theNon-State Sector 1985–1990

Table 10.11 China: Composition of Rural Enterprises 1984–1990Table 10.12 China: Expansion of Individual Business (million)1981–1988

Table 10.13 China: Distribution of State-Owned Industrial

Enterprises by Administrative Levels (1985)

Table 10.14 Comparison of Size of Enterprises in China, EasternEurope, the Soviet Union and the West, 1988

List of Illustrations

Figure 0.1 The Shares of Industrial Output: State, Collective, and

Private Firms (1978–2006) Source: China Statistical Yearbook,

various years

Figure 0.2 Ownership Forms of Foreign Direct Investment (1979–

2006) Source: China Statistical Yearbook, various years.

Figure 1.1 Provincial Marginal Revenue Retention Rates (1980–92) Notes: The upper line is the average of marginal retentionrates The lower line is the share of the provinces with 100 percent

marginal retention rates Source: Jin, Qian, and Weingast (2001).

Figure 2.1 Efficient Rationed Demand and Efficient Planned

Supply

Figure 2.2 Inefficient Rationed Demand and Inefficient PlannedSupply: Planned Quantity Is Less Than the Fully Liberalized

Market Equilibrium Quantity

Figure 2.3 Inefficient Rationed Demand and Inefficient PlannedSupply: Planned Quantity Is Greater Than the Fully LiberalizedMarket Equilibrium Quantity

Figure 5.1 Timeline

Figure 9.1 Provincial Marginal Revenue Retention Rates (1980–92) Note: The upper line is the average of marginal retention ratesand the lower line is the share of the provinces with 100% marginalretention rates

Figure 11.1 A U-form Organization

Figure 11.2 An M-form Organization

Figure 12.1 A U-form Organization

Figure 12.2 An M-form Organization

I am most grateful to my coauthors of the publications included in thisbook, both for giving me the opportunity to work with them and forallowing me to include these articles in the book I thank Jiahua Che,Hehui Jin, Lawrence J Lau, Eric Maskin, Gabriella Montinola, GérardRoland, Barry R Weingast, and Chenggang Xu for their intellectualinspiration and input in our joint works, and for their valuable

comments and suggestions for other articles included in this book.During the course of research on these projects, I benefited

enormously from helpful comments and suggestions from many

distinguished colleagues and scholars, especially Philippe Aghion,Alberto Alesina, Takeshi Amemiya, Masahiko Aoki, Kenneth Arrow,Chong-En Bai, Abhijit Banerjee, Pranab Bardhan, Erik Berglof, PatrickBolton, Bill Evans, Ronald Findlay, Roger Gordon, Avner Greif, PeterHammond, Oliver Hart, Bengt Holmstrom, Athar Hussain, D GaleJohnson, Lawrence Katz, Anjini Kochar, Michael Kremer, Anne

Krueger, Carla Kruger, Paul Krugman, Jean-Jacques Laffont, NicholasLardy, David D Li, Wei Li, John Litwack, Ronald McKinnon, JohnMcMillan, Dilip Mookherjee, Jonathan Morduch, Peter Murrell,

Ramon Myers, Barry Naughton, Roger Noll, Douglass North, Jean Oi,Albert Park, Dwight Perkins, Louis Putterman, Thomas Rawski, DaniRodrik, Sherwin Rosen, Seth Sanders, Robert Schwab, Anna Seleny,Susan Shirk, William Simon, Pablo Spiller, T N Srinivasan, Jan

Svejnar, Yijiang Wang, Shang-Jin Wei, Martin Weitzman, David

Wildasin, Oliver Williamson, Frank Wolak, Jinglian Wu, Alwyn

Young, and Heng-fu Zou

My interest in China's economic reform started in 1983 when I firstmet Professor Jinglian Wu at Yale when he was a visiting scholar and Iwas a graduate student After I enrolled in the PhD program in

economics at Harvard, my academic interest in China's reform

deepened I benefited from several academic mentors during my

graduate studies at Harvard; among them, Janos Kornai gave me

insights on reform in Eastern European and the Soviet Union, DwightPerkins guided me toward learning about China from a historical

perspective, and Eric Maskin taught me how to use modern economictools such as game theory to analyze reform problems

Since 1990, when I joined the economics faculty at Stanford,

research on China's reform has become my professional pursuit

Almost all of the articles contained in this book were completed orinitiated when I was at Stanford I am most grateful to my Stanfordcolleagues Masahiko Aoki, Lawrence J Lau, Ronald McKinnon, PaulMilgrom, and Joseph Stiglitz for their consistent encouragement andsupport for my research on China Outside of Stanford, many gave meintellectual stimulation and support for my research, and I am

especially grateful to Oliver Hart, Janos Kornai, Jean-Jacques Laffont,Eric Maskin, Douglass North, Dani Rodrik, Andrei Shleifer, and OliverWilliamson They may disagree with each other, and we may havedifferent opinions, but they are never short of intellectual depth andchallenges

I have been fortunate to be a faculty member of three universities—Stanford University, the University of Maryland, and the University ofCalifornia at Berkeley—that provided excellent academic

environments as well as financial support for the research on the

chapters in this book I am also grateful to the School of Economicsand Management at Tsinghua University in Beijing, where I am

currently a faculty member and the dean

Finally, I would like to thank the dedicated team at the MIT Press,starting with John S Covell and after his retirement continuing withJane A Macdonald and Emily Taber in the acquisitions departmentand Virginia Crossman in the editorial department, for their dedicatedwork in making this book possible

Introduction: A New Perspective on Reform

1. The Success of China’s Economic Reform

Starting in 1979, China embarked on a profound economic reform thatled to a transformation of the country from a centrally planned

economy to a market economy Over the next 37 years, China

produced one of the most spectacular growth records in human

history According to the World Bank, in 2015 the nominal GDP ofChina was nearly $11 trillion, surpassing 60 percent of U.S nominalGDP In comparison, China’s nominal GDP in 1978 was only $148billion, merely 6 percent of that of the U.S If measured by PurchasingPower Parity (PPP), in 2015 China’s GDP was $19 trillion, larger thanthe $18 trillion GDP of the U.S., the world’s largest economy in the last

100 years.1 The global market took note of the rise of the Chinese

economy and in 2015 witnessed two symbolic events: the significantimpact of China’s exchange rate movements on U.S markets in

August, and the notable effects of the U.S interest rate rise on Chinesecapital flows in December For China and the world, 2015 was a year toremember

At least one economist had actually predicted such an outcome

twenty years earlier Angus Maddison (1998) predicted in the late

1990s that China would overtake the U.S in total GDP by 2015, asmeasured by PPP Written in 2000, my article “How Reform Worked

in China” (chapter 1 in this book) contains the following simple

condition under which Maddison’s prediction would make sense:

China needed to grow 4 percentage points faster than the U.S

annually from 1995 to 2015 (see chapter 1, note 1) This is exactly whathappened Although this outcome was not a surprise to Maddison, itexceeded the expectations of most economists

Of course, China’s per capita GDP is still not high In 2015, China’sper capita GDP was $7,925 on the nominal term, about 1/7 that of theU.S It was $14,239 as measured by PPP, or one quarter of that of theU.S.2 With that level of per capita GDP, China has become a solid

middle-income country for its population of over 1.3 billion At thesame time, the structure of the Chinese economy has also changed

dramatically The share of agriculture in GDP fell from 27.2 percent in

1978 to 9.0 percent in 2015, while the share of people living in citiesincreased from 18 percent to 56 percent during the same period.3

2015 also marked the slowdown of Chinese economic growth when,for the first time since 1991, China’s growth rate fell below 7 percent.The year was a turning point, not only because China reached 60

percent of U.S GDP in the nominal term and overtook the U.S as thelargest economy in the PPP term, but also because China’s economicgrowth was entering a new era In the coming decades, China facesnew challenges, partly due to the nature of its new middle-incomestatus: China is a lot richer than it was before It is also partly due tothe costs China has paid to achieve such rapid growth, including

negative effects on the environment, an increase in inequality,

wasteful investment, excess capacity, high leverages, unfunded socialmandates, and its financial risks On top of that, its demography hasshifted and its population is getting older In 2014, the share of thepopulation aged 60 or older stood at 15.53 percent, while the

population aged 65 or older was 10.06 percent The share of the

population aged 15–59 (i.e., those in the labor force) has been

declining in absolute number since 2012

The Chinese call this situation the “New Normal.” The challengesChina faces in the next 35 years are unprecedented The Decision ofthe Third Plenum of the 18th Congress of the Chinese CommunistParty listed over 300 reform items necessary to improve the economy,including fiscal, monetary, social security, health care, and

environmental items, as well as State-Owned Enterprises (SOEs), just

to name a few The ambitious goal of these reforms is to develop Chinainto a “moderately prosperous economy” by 2021, the centennial

anniversary of the founding of the Chinese Communist Party, andfurther into a “moderately developed country” by 2049, the centennial

of the founding of the People’s Republic of China

Looking backward, it is now a historical fact that China has

successfully grown from a poor, agricultural, closed, and centrallyplanned economy to a middle-income, industrial, open, and large

emerging market economy Looking forward, it is still an open

question as to whether China’s growth can be sustained (necessarily at

a lower rate) as it continues to advance from a middle-income

economy to a high-income economy The next 35 years will answerthat question.4

2. Two Perspectives on China’s Economic Reform

Economists try to understand economic growth through a “growthaccounting” approach, which estimates the direct sources contributing

to growth—capital accumulation, labor expansion (through

reallocation from agriculture to industry and services), human capital(through educational attainment), technological progress, and so on.Because of the common factors that contribute to growth over timeand across countries, growth accounting helps economists understandthe common and direct reasons for the economic growth of all

countries during all time periods The approach is particularly usefulfor understanding how the “residual,” the so-called total factor

productivity, contributes to growth Productivity is considered

anything other than the resources already measured as inputs, and itssources include technological progress and institutional changes.5

In addition to growth accounting, economists also want to

understand the role of reform in economic development, and, in

particular, the institutional changes behind the scenes and the

mechanisms bringing about these changes Economists all agree thatChina’s fast growth in the past 37 years has critically depended onmarket-oriented reform, but there is less agreement on the main

factors of reform that have contributed to the success of China’s

economy

To begin with, all unreformed economies have good growth potentialbecause of the slack created by enormous economic distortions, andthese economies operate deep inside the production possibility

frontier Additionally, less developed economies can take advantage ofthe technological achievements of more advanced countries Closedeconomies can also benefit from opening by accessing foreign markets,talent pools, and technologies But all these conditions for growth werepresent in China before 1979 and in other poor countries, as well Itwas the reforms that made the difference

Economists have tried to understand and interpret China’s economicreform ever since it began Most of the interpretations fall into one of

two schools of thought—the first, I call the “School of Universal

Principles,” and the second, the “School of Chinese Characteristics.”Those adhering to the School of Universal Principles believe that thesuccess of China’s economic reform is due to the universal reasonsunderlying all economic success around the globe These are: lettingthe government get out of way; letting the market work; providingprivate incentives; and opening up to the global market Therefore,market liberalization, private incentives, and opening up, plus a stablemacroeconomic environment, explain the success of China’s reform.All of them are well-summarized in the Washington Consensus Thekey to China’s success for these economists is its adoption of free

market policies Therefore, China’s story offers nothing new to ourunderstanding of reform, other than proof of the fundamental

principles of the market

Adherents to the School of Chinese Characteristics believe just theopposite—that the success of China’s economic reform disproves

standard economic theory Thus, China’s reform is successful preciselybecause it did not follow the Washington Consensus: China did notprivatize all enterprises at once, nor did it liberalize the market

overnight China’s government played a crucial role in the economythrough ownership, control, and regulation, as well as industrial

policies, and these economists believe that China’s success is because

of, not in spite of, the strong governmental role in the reform Theyhold that these Chinese characteristics explain China’s success, not theconventional universal principles On a deeper level, the School ofChinese Characteristics also provides an alternative principle: the

mistrust of market, private ownership, and globalization

Both schools contain elements of truth, but both are only partiallyright

The School of Universal Principles correctly emphasizes that it isultimately the market that provides the driving force for growth Thisargument is most relevant when one compares pre- and post-reformChina The institutions of the Party and the state are common to bothbut there are critical differences in the liberalization of the market, theexpansion of private ownership, and the opening up of the economy.Further, over time China has seen more and more of these “universallyworking” elements One cannot rule out the possibility that, over the

long run, China is developing a market economy more or less in thesame way that advanced countries have, despite various short-termanomalies.

The additional advantage of the School of Universal Principles is itsnormative implications It offers a clear goal for transition to a marketeconomy and a target for eventual convergence It also provides a

benchmark for measuring the “distance” between transition

economies and the “best practices” seen in advanced countries TheSchool of Universal Principles provides the reformers in China andalso in other countries with much needed economic principles as well

as arguments against non-reformers

However, the School of Universal Principles is incomplete both inexplaining China’s reform and in providing guidance for reform As apositive theory, it cannot adequately explain the details of China’s

reform path It tends to ignore the complexity and sophistication ofthe reform and does not explain its underlying mechanisms As a

normative theory, it is often too abstract and generic to be useful inpractice The general principles usually have linear implications fromplan to market: the more market, the better; the less government, thebetter; and the faster the reform, the better Such universal principlesare useful benchmarks in theory, yet they are usually not

implementable in practice They generally cannot be operational

guides for reform in a realistic context

The School of Chinese Characteristics correctly highlights some

salient features of Chinese reform that are apparently special to Chinaand inconsistent with the best practices advocated by the School ofUniversal Principles These Chinese characteristics include: the strongrole of government in the form of state ownership, mixed ownershipinvolving government, dual-track liberalization, industrial policies,gradualism, capital control, and so on Of course, not all of these

elements are unique to China Twenty years ago, a similar debate onthe “East Asia miracle” involved some of these elements in the

contexts of the East Asian economies of such countries as Japan,

South Korea, and Singapore But China’s case involves an even greaterrole of government In addition, because China’s population is threetimes larger than all high-performing East Asian economies combined,the Chinese characteristics argument seems even more compelling as a

positive theory.

The School of Chinese Characteristics also has strong normativeimplications, at two different levels At the tactical level, it provides areform guide that is not usually the one recommended by expert

economists trained in the West or by international organizations such

as the World Bank and the International Monetary Fund It refuses tofollow common recommendations on the grounds that these

“universally applicable” reform measures do not fit into China’s

reality At the more general level, it points to the eventual deviationfrom the best practices of the advanced market economies in the longrun, and redefines the market economy with a stronger role of

government At either level, both non-reformers and reformers makeuse of this type of argument Non-reformers are against the goal ofmarket-oriented reform entirely Reformers are either against a

particular method of implementing the reform or they have some

doubts that the best practices seen in advanced countries are truly thebest solutions

However, despite its correct observations regarding Chinese reform,the School of Chinese Characteristics can be both superficial and

misleading From a positive perspective, it does not delve deep enough

to see what role these Chinese characteristics really play It is not clearhow Chinese characteristics served as necessary stepping-stones in thereform, nor is it clear how they became essential elements of the

reform As a result, this school does not rule out the possibility thatwithout certain characteristics China could actually do better, perhapsnot in terms of a faster growth, but in terms of lower costs

Furthermore, when the analysis of China’s success depends too much

on unique features of Chinese characteristics, then China’s case

becomes too special and the arguments lose generality

From a normative perspective, the School of Chinese Characteristicscan be misleading because it can be used as an excuse to delay market-oriented reform or to reject such reform altogether This is seen clearly

in China, especially after the 2008 global financial crisis The worldeconomy, and specifically the developed economies of the U.S., theEuropean Union, and Japan, suffered greatly during the crisis and tothis date still have not recovered fully This gives ammunition to

adherents to the School of Chinese Characteristics to reject the

“universal principles,” not so much on the grounds that China is doingparticularly well, but on the grounds that the advanced countries arenot Non-reformers use the ideas from the School of Chinese

Characteristics to further their goals of advocating alternative ways topermanently and fundamentally deviate from market-oriented reform.This is worrisome because it goes beyond the debate of different

reform methods and rejects market-oriented reform altogether

3. The Third Perspective on China’s Economic Reform

Those in the School of Universal Principles believe their principlesshould be universally applied, regardless of location, time, and specificcountry conditions Those in the School of Chinese Characteristics areproud of what China has achieved and reject the universal principlesaltogether based on limited observations However, because we aredealing with complicated institutional changes on such a large scalewithout the analytical and experimental tools of the natural sciences,

we especially need modesty and humility

In this book, I propose a new, third perspective through which tounderstand China’s economic reform This perspective takes certainelements from each school of thought, but it is not simply a middleroad between the two Fundamentally, this perspective is less aboutwhy reform worked and more about how reform worked If the former

is science, the latter is applied science and engineering As in

engineering, the possibility for implementation is the key

This perspective uses the universal principles as a starting point andbenchmark for comparison It also takes elements from the School ofChinese Characteristics, but goes deeper to figure out the mechanismsunderneath the surface It is less about the goal of reform than thereform process itself

To understand any reform, it is essential to focus on how to get

things done From a practitioner’s point of view, it is more useful tofind a feasible reform path than the best way This may be, and usually

is, the “second-best” way or even the “third-best” way because

implementation and execution are key This is the engineering of

at this point converged more or less to the standard form of the

market economy and will continue to do so Third, the Chinese

approach to reform worked because it was a constrained optimization.Fourth, understanding the initial historical conditions and

contemporary constraints and how reform designs respond to suchconditions and constraints is the key to understanding how reform hasworked in China Both of the former two observations are consistentwith the thought in the School of Universal Principles, but are only thestarting point The latter two observations share some views with theSchool of Chinese Characteristics, but the analyses are different

All countries have different initial historical conditions and face

different contemporary constraints The good news is that preexistingdistortions can often provide enormous potential for improvementand growth One important initial condition in China was its strongParty and state On the outside, the strength of the Party and statecould be considered disadvantageous for market-oriented reform.How to provide private incentives and overcome vested interest toliberate the market is not at all obvious at the inception of the reform.This book looks at the details of this particular context

The universal principles and Chinese characteristics can be

interpreted in terms of function and form, respectively In terms offunction, the principles are simple, standard, and universal The

reform works by getting the incentives right, making the market work,and opening up to the outside world On the other hand, the specificforms or mechanisms of the reform can be complicated and it may usenon-standard methods to perform a given function, as it needs to

respond to initial conditions and contemporary constraints

Best-practice institutions (for example, private property protected bythe rule of law), which are derived from the universal principles in thecontext of advanced economies, serve these economies well today,although this has not necessarily been true throughout the history ofthese countries The best practices do not need to take a unique form,nor should they necessarily be the reform choice for other economies.However, best-practice institutions are still very useful as a

benchmark and also as an eventual goal to which to aspire

From the perspective of best practices, reform often adopts the form

of “flawed” institutions But not all flawed institutions are the same In

fact, most of them are so flawed that they do not work What we need

instead are appropriate and adequate institutions For

appropriateness, they have to be suitable to local conditions and

satisfy all constraints, including political ones For adequateness, theyhave to be sufficiently effective to unleash the standard forces of themarket and incentives—that is, to relax the binding constraints for themarket and incentives to work When both conditions are satisfied, theinstitutions are not only feasible but also good enough to facilitateeconomic growth They are effective in the short run, and will alsoevolve further and be replaced by other institutions in the long run.6The following two examples concerning ownership of firms

demonstrate the dynamic evolution of appropriate and adequate forms

of institutional change in China

The first example shows the dynamics of ownership in domestic

firms Figure 0.1 illustrates the shares of industrial output from owned or controlled firms, collective firms (i.e., firms with local

state-government control), and others (mostly private firms) over time Thedynamic is interesting, especially in terms of the rise and fall of

collective firms, which include Township-Village Enterprises (TVEs).TVEs are an example of a “flawed” ownership form, but they were

known to work during the first two decades of China’s reform First,they satisfied the appropriateness condition: they had the advantage atthe time of political and economic discrimination against private

ownership Second, they satisfied the adequateness condition: theyprovided an immediate entry into high-profit-margin businesses wheninefficient state-owned firms failed to deliver As the economy

developed, however, the relative advantage of collective firms declinedand their share in the economy fell

Figure 0.1 The Shares of Industrial Output: State, Collective, andPrivate Firms (1978–2006).

Source: China Statistical Yearbook, various years.

The second example demonstrates the dynamics of ownership inforeign direct investment Figure 0.2 shows the shares of wholly

foreign-owned firms, equity joint venture firms, and contractual jointventure firms over time The relationships in figure 0.2 are also

interesting, especially the rise and fall of the equity joint venture firms

In these firms, foreigners have control but the government has a stake

in ownership First, they satisfied the appropriateness condition:

foreign firms needed help from the local government, and the

government’s incentive came from its stake in ownership Second, theysatisfied the adequateness condition: foreign control provided bettermanagement But, as the market condition improved, the relative

advantage of equity joint venture firms declined, so their share in theeconomy also fell

Figure 0.2 Ownership Forms of Foreign Direct Investment (1979–2006).

Source: China Statistical Yearbook, various years.

Therefore, in the third perspective, prescribing a standard menu ofbest-practice institutions (as is often done by the School of UniversalPrinciples) is easy and attractive, but may not work well in a specificcountry at a specific time Alternatively, devising institutions that areboth appropriate and adequate to local conditions is challenging andoften requires innovation Recognizing that institutions matter is onlythe beginning; the deeper and more relevant issue is to understandhow reform in institutions works

This approach can be used to reconcile the apparent tension aboutChina’s economy in what Loren Brandt and Thomas Rawski (2008)describe as “a remarkable combination of high-speed growth and

deeply flawed institutions.” Indeed, China’s institutions are flawed,and sometimes deeply flawed, as compared with the best-practice

institutions prescribed by the universal principles But these imperfectinstitutions reflect not only the country’s level of economic

development but also its contexts of transition and reform They canachieve the goals of improving efficiency and generating growth whenthe economy has a lot of slack due to preexisting distortions This bookanswers the question of what mechanisms in which imperfect

institutions can work to support good economic performance

The third perspective pursued in this book parallels Dani Rodrik’s

approach to economic reform as shown in his 2007 book One

Economics, Many Recipes “One economics” means there are

universal principles that apply to all countries However, because eachcountry has specific local contexts, the reform recipe is often differentfrom country to country Whereas Rodrik studies many different

countries, I focus only on China—the most dynamic and important, yetdifficult-to-understand case

4. Chapters in the Book

The twelve chapters of this book consist of a collection of my articles,many of which were jointly written with my collaborators

The first chapter carries the same title as the main title of the book.Written 15 years ago, it examines how reform worked in China

through the lens of “transitional institutions.” The transitional

institutions are those institutions that respond to local conditions toincrease economic efficiency while satisfying constraints They areusually not fully efficient and are therefore “second-best institutions.”However, they are “incentive compatible” for stakeholders, and

especially for the government, because the government finds

implementing them to be in its interest At the same time, these

institutions are good enough to reduce distortions and provide

adequate efficiency improvement

The rest of the book is organized in four parts, the first three dealingwith three types of institutions underlying the economy: markets,

firms, and government, respectively The last part explicitly addresses

an important initial condition: the organization of government Thechapters in each part feature concrete examples to demonstrate thecentral theme of the book, the necessity of the third perspective tounderstand how China’s reform worked, with detailed theoretical andempirical analysis

Part I concerns market liberalization with Chinese characteristics—the dual-track approach Chapter 2 provides a partial equilibrium

analysis of dual-track market liberalization and chapter 3 provides ageneral equilibrium analysis Dual-track market liberalization is thesimplest case in which transition from plan to market can be

implemented in such a way that it is not only efficiency improving(and sometimes achieves full efficiency) but also, at the same time,Pareto improving—that is, nobody is worse off It is also unorthodoxfrom the perspective of the universal principles, which would advocatefor freeing all the prices at once The feature of everybody being betteroff is desirable in reform, and dual-track market liberalization can beimplemented in practice, provided the state enforces the planned track

—the initial condition that China satisfied with its strong state

institutional feature in a transition economy—the lack of security ofproperty rights In this context, it compares three types of firm

ownership: state-owned, privately owned, and community governmentowned It derives conditions under which each is more productivethan the other two This model not only explains township-village

enterprises (an example of community government owned firms) inthe first two decades of the reform, but also sheds light on enterpriseswith mixed ownership involving government (including public-privatepartnership) in the last two decades Chapter 6 is an empirical studythat tests some of the implications of the theoretical model developed

in chapter 5 using data from rural China The evidence supports themodel’s predictions

Part III discusses the decentralization of government and its

implications for economic reform Fiscal federalism is a topic in publicfinance that usually focuses on the efficiency of providing public goodsthrough competition among localities when people vote by foot to

match their preferences China is not a federal state de jure but during

the reform it implemented a decentralized fiscal system to providelocal governments with fiscal incentives to develop their local

economies Chapter 7 includes observations about China’s regionaldecentralization during the reform and links it with local economicdevelopment In this context, it proposes to use the framework of

“federalism, Chinese style” to study the relationship between localgovernment and economic development Chapter 8 explores the ideathat federalism or, more precisely, government decentralization is auseful reform to expand market incentives This approach to market-oriented reform is unusual because the standard approach is to getgovernment out of the way It acknowledges Chinese characteristicsbut evokes the universal principle of the necessity of incentives

Chapter 9 is an empirical study to test the hypotheses developed in the

previous two chapters Local government’s fiscal incentives, as

measured by the marginal revenue retention rate, were greatly

strengthened in the early stage of reforms, which in turn provided theincentives for local governments to support more productive firmssuch as non-state enterprises, including private firms and local

government firms, rather than central government firms

Part IV concerns a specific form of initial conditions—regional-basedorganization of central planning in China as opposed to functional- orindustrial-based organization of central planning in the Soviet Union.Alternative ways to organize central planning have significant

implications for economic transition to the market and run parallel tothe alternative ways of organizing corporations in a market economy.Chapter 10 represents the first paper to draw attention to the

distinction between alternative organizations of central planning and

to connect them to the pioneering work of Alfred Chandler (1966) andOliver Williamson (1975), which compared M-form (multi-divisionalform) and U-form (unitary form) corporate organization It also

further studies the implications of government organization on

market-oriented reform Chapter 11 focuses on the incentive issues inM-form and U-form organizations by examining the theoretical

implications for the use of local information in the economy It thenutilizes data from China to test the validity of the model Chapter 12studies the coordination issue in M-form and U-form organizations,where the distinctive feature of the former is the relatively low cost forcoordinating local experiments when each region is self-contained.Indeed, reform through experimentation was a distinct feature

throughout Chinese reform, but it was rarely seen in the former SovietUnion or Eastern Europe This chapter provides a reason for this

difference: the initial condition of central planning organization

The four parts together demonstrate the central theme of the book:that examining how reform worked in China requires detailed analysisbased on universal principles and taking into account the specific

initial conditions and contemporary constraints in order to explainobserved Chinese characteristics The process of analysis

demonstrates the benefits and costs of the reform and reveals the

second-best nature of the institutional change Therefore, by analyzingthe underlying mechanisms of how reform worked, we better

understand the process and outcome of reform.

The general lessons from this book are that for a reform to be

successful, it is important to use the universal principles, even if theyalone are not enough, and that it is equally important to find specificways to implement the reform by fully incorporating the initial

historical conditions as well as contemporary constraints With largeslack in the economy, appropriate and adequate institutions in theform of second-best institutions can go a long way toward successfuleconomic reform—China’s experiences have shown that it can be done.But the lesson from the study of China also shows that simply copyingthe “China model,” if there is one, is not useful Nevertheless, the

perspective of reform provided by this book’s analysis on China’s case

is valuable precisely because it emphasizes that for reform to succeed,

it is not enough to understand why reform works; we must also

understand how reform works

When Lawrence Summers speculated in 1992 that the revolutionarychange in China might be the most significant event of the late

twentieth century, many people did not take his statement seriously.But he was right If China’s economic reform is the most significantevent of the late twentieth century, then the rise of the Chinese

economy to the world stage may be the most significant event of theearly twenty-first century

3. Data are all from China Statistical Yearbook 2016, unless noted.

4 The larger question is about political transition Even with a large,

open, middle-income economy deeply integrated with the rest of

the world, China has a political system that is much the same today

as it was 37 years ago The interaction between economic

development and political modernization is a very important topic

but it is beyond the scope of this book

5 See Dwight Perkins and Thomas Rawski (2008) for a growth

accounting study of China between 1952 and 2005

6 These ideas were first presented in my Lian Huang Memorial

Lecture “China’s Economic Transformation in Perspective,”

delivered at the Stanford Institute of Economic Policy Research on

February 27, 2008

Brandt, Loren, and Thomas Rawski 2008 China’s Great Economic

Transformation In China’s Great Economic Transformation, edited

by Loren Brandt and Thomas Rawski, pp 1–26 Cambridge, UK:Cambridge University Press

Chandler, Alfred, Jr 1966 Strategy and Structure New York:

Doubleday & Company, Inc

China Statistical Yearbook 2016 2016 National Bureau of Statistics

of China, Beijing: China Statistics Press

Maddison, Angus 1998 Chinese Economic Performance in an

International Perspective Paris: OECD.

Perkins, Dwight, and Thomas Rawski 2008 Forecasting China’s

Economic Growth to 2025 In China’s Great Economic

Transformation, edited by Loren Brandt and Thomas Rawski, pp.

829–886 Cambridge, UK: Cambridge University Press

Rodrik, Dani 2007 One Economics, Many Recipes: Globalization,

Institutions, and Economic Growth Princeton, NJ: Princeton

1 How Reform Worked in China

1. A Puzzling Reform That Worked

In the last twenty-two years of the 20th century, China has

transformed itself from a poor, centrally planned economy to a middle-income, emerging market economy With total gross domesticproduct (GDP) growing at an average annual rate of about 9 percent,China’s per capita GDP more than quadrupled during this period Thebenefits of growth were also shared by the people on a broad basis: thenumber of people living in absolute poverty was substantially reducedfrom over 250 million to about 50 million, a decline from a third to atwenty-fifth of its population; and life expectancy has increased from

lower-64 in the 1970s to over 70 in the late 1990s Both the formal statisticsand casual tourist impressions tell the same story: China’s growth isreal Two decades ago, few economists would have bet on the outcome

in China today At the time, coming out of the disastrous decade of theCultural Revolution, China was poor, overpopulated, short of humancapital and natural resources, and constrained by the ideology hostiletoward markets and opposed to radical reform Growth of this kindunder such initial conditions is a surprise

China’s phenomenal growth is not just another successful growthstory because China is not a “typical” country, although in cross-

country regressions China can only represent one data point, the same

as Singapore or Ireland or Botswana China is the largest transitionand developing economy As an economy in transition from plan tomarket, China has a population three times greater than all other

transition economies combined, including the 15 former Soviet

Republics In 2000, its $1 trillion economy was already bigger than allother transition economies combined As a developing economy,

China has a population almost three times that of all eight

high-performing East Asian economies of Japan, South Korea, Taiwan,Hong Kong, Singapore, Malaysia, Thailand, and Indonesia It has

managed to match the growth record of these economies during theirheyday, but with a much larger population The cumulative effects ofthe two decades’ growth are significant when comparing China with itstwo largest neighbors: in total GDP terms, in 1988 China was less than

half of Russia, but ten years later Russia was less than half of China.

On per capita basis, two decades ago China and India were about

equal, but now China is about twice as rich as India

China’s growth is unlikely to end any time soon In the first half of

2001, China’s economy ignored the global slowdown and continued togrow at an annual rate of about 8 percent Defying the perception thatChina has reached a plateau of growth, more and more economists arestarting to believe that the best part of China’s growth has not comeyet With entry into the World Trade Organization (WTO), they

suspect that China’s economy is on the verge of the next boom

According to Maddison’s (1998) calculation, China might overtakethe United States in total GDP in terms of “purchasing power parity”

by 2015.1 If Maddison is right, China would be the only economy,

excluding the European Union, capable of surpassing the U.S

economy (in purchasing power parity) within the next two decades.And this would make China the largest economy in the world,

regaining the historical position that it lost in the middle of the

nineteenth century No wonder Lawrence Summers speculated in theearly 1990s: “It may be that when the history of the late 20th century

is written in a hundred years the most significant event will be therevolutionary change in China” (Summers 1992)

On the ground of economic growth and improving living standards,there is no question that China’s reform has worked But this reform ispuzzling In the early 1990s, the economics profession and

policymakers reached a striking degree of unanimity on the recipe fortransition from plan to market Simply put, it calls for stabilization,liberalization, and privatization, following political democratization.Although many economists may not consider this recipe sufficient, fewwould question its necessity Theoretically, it is difficult to imaginehow a reform would work without these essential ingredients

Empirically, the fresh memory of the frustrated reform experience inHungary, Poland, and the former Soviet Union prior to 1990 suggeststhat a reform will fail if it does not follow these recommendations.The Chinese path of reform and its associated rapid growth is

puzzling because it seems to defy this conventional wisdom AlthoughChina has adopted many of the policies advocated by economists—such as being open to trade and foreign investment and sensitive to

macroeconomic stability—violations of the standard prescriptions arestriking For the most part of the past two decades, China’s reformsucceeded without complete liberalization, without privatization, andwithout democratization One might have reasoned that coexistence ofthe planning mechanism with partial liberalization would only causemore distortion and become a source of disruption, not growth.

Without privatization and secure private property rights, how couldthere be genuine market incentives? Without democracy, economicreform lacks a political basis and commitment to a market and thus isvulnerable The actual performance of the Chinese reform provides astriking contrast to these expectations Why has China grown so fast,ask Blanchard and Fischer (1993), when conditions thought to be

necessary for growth were absent?

It is not surprising that China’s reform has been viewed as an

anomaly and thus has been unappreciated by mainstream economists

For example, From Plan to Market: World Development Report 1996

on transition economies (World Bank 1996) gave China short shriftbecause it couldn’t figure out where to put China on the various

measurement parameters China simply does not fit into the generaldescription of the report

Those who do not find China’s reform puzzling often misunderstand

it Two types of misperceptions of China’s economic success are

common The first is to regard foreign direct investment (FDI) andexports as the driving force for China’s success In this connection theroles of overseas Chinese and of Hong Kong and Taiwan are oftenemphasized The simplicity of the argument adds to its power, and thetacit message—it is the foreigners and foreign markets that made

China grow—finds an appreciative audience outside China However,the argument loses its plausibility as soon as one considers a parallelexperience in Germany If Hong Kong or Taiwan could play such apowerful role on mainland China, West Germany should have beeneven more effective in East Germany, given that West Germany ismuch larger and stronger than Taiwan and Hong Kong combined, andEast Germany is much smaller than mainland China

The role of FDI in China is vastly overstated in the press In the

1980s, FDI in China was tiny FDI only started to increase

substantially in 1993, and at its peak it accounted for about 10 percent

of total investment On per capita basis, China’s FDI was not high byinternational standards It is true that China’s exports expanded veryquickly, but that cannot be the main story The direct contribution offoreign trade and investment to large countries cannot be

quantitatively as important as to those small countries

Like FDI, China’s exports were very concentrated in coastal

provinces However, contrary to a popular perception, China’s growthwas not just a phenomenon of coastal provinces—it is across the

board, both coastal and inland Inland provinces are growing fast,though coastal provinces are growing faster Anyone who has traveled

to inland cities such as Xi’an or Guiyang cannot fail to notice theirvibrant local economies Indeed, if each of China’s provinces is

counted as a distinct economy, about 20 of the top 30 growth regions

in the world in the past two decades would be provinces in China—many of which did not receive much foreign investment and did notdepend on exports Table 1.1 shows GDP growth by province in Chinaand refutes the perception that growth in China is only coastal

Table 1.1 GDP Growth Rates by Province (percent)

Source: China Statistical Yearbook.

If focusing on FDI and foreign trade tends to downplay the entirereform process and of the role of indigenous institutions, then a

simple-minded view on trade and foreign investment creates obstacles