Lessons of China’s Transition from a Planned to a Market Economy Justin Yifu Lin Peking University and Hong Kong University of Science and Technology

Introduction Socialist countries’ transition is one of the most important events in modern history China started the transition in 1979 with a gradual, dual-track approach and achieved remarkable performance from the very beginning When EEFSU started their transition in the early 1990s, most economists favored the big-bang approach and predicted the EEFSU to outperform China In the 1990s, Chinese economy continued to growth dynamically whereas the EEFSU experienced an “L- curve” in their GDP growth

Does Chinese Experience have General Implications? Chinese approach violates almost all the basic propositions for a successful transition The debates: –China’s success is attributable to its unique initial conditions –China’s success poses a challenge to the wisdom of Washington consensus The EEFSU had no other choice but a big bang approach. However, no matter what approach is adopted, the actual process will be a gradual process.

The organization of the paper Logic origin of the traditional planned system in China and EEFSU Process of China’s Transition Lessons from China’s experience Concluding remarks

Main Arguments Economic institutions of the plan economy are endogenously shaped the CAD strategy due to the needs to protect/subsidize the nonviable enterprises in the priority sectors The Shock therapy fails due to its negligence of the endogenous nature of the planned institutions The dual track approach is desirable because it liberalizes the previously suppressed sectors meanwhile continues to provide supports to the nonviable enterprises in the previously priority sectors The completion of transition to a market economy depends on giving up the CAD strategy and resolving the issues of nonviable firms

Characteristics of Heavy Industry projects –Long Gestation –Needs for Equipment Imports –Lump-sum Investment Characteristics of low-income economy –Scarce of capital –Scarce of foreign exchanges –Difficulty of mobilizing funds for large project Firms in priority sectors is not viable in an open, competitive markets

Macro-Policy Environment and Shortage Market Monopoly Macro arrangement for solving the conflicts: –Suppression of Interests –Over-value of exchange rate –Suppression of prices of raw materials and intermediate goods, and suppression of wage rates –Suppression of prices of living necessities The distortions and shortages

Shortage and Planned Allocation Mechanism To guarantee the limited resources would be allocated for the projects in the priority sectors, the market is replaced by the following institutions: –National Planning –Administrative allocation according to national plan

Lack of Competition and Corporate Governance Information asymmetry and incentive incompatibility are prevalent –Firms are nationalized in order to guarantee the investment of economic surplus on priority projects –Managerial autonomy are deprived to avoid managerial discretions

Planned Economy and Rural Institutions Monopolized Procurement and marketing of agricultural products Collectivization

The performance of Traditional System Through the above institutional arrangements, the government was able to establish a complete heavy industrial sectors The economy was inefficient due to misallocation of resources (allocative inefficiency) and incentive problems (technical inefficiency), as shown in Figure 2

China’s micro-first approach China pursued perestroika to stimulate dynamism but avoid glasnost to avoid the collapse of communist party This approach differed not only the big bang approach in EEFSU but also the IMF/World Bank’s standard macro first approach to transition

Micro-management System Reform The transition started with a spontaneous replacement of collective farming system with the Household Responsibility System The SOEs were giving partial autonomy and allowed to share profits through –Profit retention –The contract system –The modern corporate system The productivity in agriculture increased significantly. The productivity in SOEs also increased but their profitability declined.

Resource Allocation Mechanism Reform To make the increase in managerial autonomy a reality, SOEs were allowed to obtain additional inputs and to sell extra outputs outside the plan, leading to the emergence of a dual-track system An unexpected result is the entry of TVEs and other non-state enterprises –Improving resource allocation –Competitive pressure on SOEs

Macro Policy Environment Reform Dual-track prices system were introduced alongside the dual-track resource allocation system The price of a resource would be liberalized when the resource was mostly allocated by the market tract Except for the interest rate, the prices for most commodities and services have been liberalized by the mid 1990s.

The Achievements and Problems of China’s Approach (1) The dual-track approach resulted in stability and continuous growth, as illustrated in Figure 3.

The Achievements and Problems of China’s Approach (2) Due to institutional incompatibility, the economy is troubled by –Large non-performing loans –Widespread rent-seeking activities –Regional disparities The problems are related to the needs of supporting SOEs. The final completion of transition depends on the successful elimination of SOEs’ viability problem and social burdens so that the state is not obliged to subsidize/protect the SOEs

Challenges of China’s Transition to Early Consensus Early consensus: –Quick Privatization is necessary for real market competition and for Elimination of soft budget constraint –Big-bang price liberalization is necessary for preventing output fall and a dual-track system encourages arbitrage, corruption, and diversion of scarce resource from high-value to low-value uses China’s experience shows: –SOE’s soft budget constraints arise from policy burdens –Competition on a level-playing field is more important than ownership

Why Previous Attempts for Gradual Reform Failed in EEFSU SOEs were not allowed to set their prices, which prevented the improvement of resource allocation Entry of nonstate enterprises were subject to severe restriction, which prevented the competition Managers were allowed to set the workers’ wage levels, which led to the sharp decline of state revenue The wage inflation caused the worsening of shortage

Will People in EEFSU respond to Opportunities from Dual-track Reform Workers and farmers received heavy subsidies in EEFSU and thus some argued that only by ending the subsidization of the state sector was it possible to free labor from state sector to non-state sector In effect, although the opportunity costs for a worker to leaving state sector were higher than in China, the expected gains for doing so in EEFSU were also much larger.

An Analogy When a chasm is narrow, it’s all right to jump over it. When a chasm is too wide and too deep, it is desirable to fill and to narrow the chasm before making the jump

Lessons The state can take measures to improve micro incentives by granting partial autonomy and encouraging local and private institutional innovation The state can introduce a dual-track price and allocation system so that to improve the resource allocation and maintain the survival of SOEs The state can liberalize the price when the commodity is largely allocated by the market The final success of the transition to a market economy depends on the elimination of SOE’s viability problem and social burdens so that the state is not obliged to subsidize/protect SOEs