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The Razor's Edge

China Walks A Fine Line On The Way To The Free Market

Research by Alwyn M. Young

Just 20 years ago, China was among the world's poorest countries, with 80 percent of the population living on incomes of less than $1 a day. Since China launched its economic reform program in 1978, its transition from a centrally planned to a market-based economy has fueled one of the world's highest growth rates: an average rise in Gross Domestic Product of 9.3 percent a year. Most often, a movement to market is about a devolution of power from the central government to the private sector. But one of the perils of gradual reform is the possibility that it will give rise to new economic distortions, the removal of which poses new and unexpected challenges to reformers. Chicago international economics and finance professor Alwyn Young stands on the sidelines of the Chinese free market fanfare and produces evidence that China's journey to the private sector has taken some unexpected turns.

“Instead of a movement from central planning to free market economy, you see a movement from central planning to local planning,” says Young. “Local planning can be a lot more efficient than central planning, so I'm not saying China is a disaster. But local planning certainly has its problems.”

In his 1997 study “The Razor's Edge: Distortions and Incremental Reform in the People's Republic of China,” Young uses the reform experience of the People's Republic of China to highlight a potential pitfall in the process of incremental, or gradual, reform: Incremental reform leads to the creation of “rental opportunities,” incomes that can be earned because of government-mandated distortions. Due to the slow nature of the reform process, these rental opportunities are fairly long-lasting. This allows for a prolonged battle to capture, and then protect, these rents, leading to the creation of new distortions in the economy. In this sense, the reform process can be derailed. While some distortions are eliminated, moving the economy to a free market, others are added, drawing it off on unexpected tangents.

What is Happening In China?

The so-called liberalization and transformation of the People's Republic of China over the past 20 years is perhaps best characterized as a process of devolution. Although the central government has released control over prices, outputs and enterprise budgets, these functions have been taken up, albeit in a less systematic fashion, by local governments.

Before the reforms, about 75 percent of government revenues were collected in industry. This was achieved by the central government “skewing” prices: The government made raw material prices extremely low, and final goods prices extremely high, which generated substantial surpluses and rents in manufacturing and processing industries.

In the silk processing industry, for example, farmers would sell their raw silk for a low price to a silk processing plant, usually in Shanghai. The factories would then process the silk, make huge profits, and hand those profits over to the central government.

Before the reforms, the central government mandated which products local governments were allowed to produce. At the beginning of economic reforms, around 1978, the central government relaxed some controls without removing others. In an important instance, they removed the controls mandating which jobs people could perform, while keeping the artificial price wedge between raw materials and final goods in place.

With labor restrictions removed, people were struck by the sudden power to make their own investment and labor allocation decisions. They no longer had to work on the farm or in other specified industries, but prices were still controlled by the government.

To continue the silk processing example, under the traditional system, the two provinces next to Shanghai -- Jiangsu and Zhejiang -- would produce raw silk, ship it to Shanghai where it was processed into finished silk and then sold throughout the country. Because of the price wedge, Shanghai made enormous profits on silk processing.

“As soon as you give the provinces the option of doing whatever kind of investment they like, they immediately think `Forget shipping to Shanghai, let's process the silk ourselves,'” says Young. And this is exactly what they did. Jiangsu and Zhejiang kept their raw silk for themselves, cutting off Shanghai. In the first half of 1988, silk factories in Shanghai received 40 tonnes of their planned allocation of 2,000 tonnes of raw silk. In a country that accounted for 90 percent of world exports of raw silk, Shanghai found itself in the surprising position of using valuable foreign exchange to import silk for its factories.

The “silkworm cocoon war” was reflected in other industries such as coal and cotton and was typical of the many interregional trade conflicts, in both raw materials and finished manufactured goods, which appeared in China during the 1980s and 1990s. Nobody wanted to send their raw materials to anyone else for processing -- they wanted to process everything themselves. Local governments throughout the country moved to develop manufacturing industries and restrict the outward movement of raw materials in an attempt to capture the rents implicit in centrally mandated price wedges.

As the reforms progressed, the central government relaxed price controls, eliminating the artificial price wedges, which unleashed a fierce competition between the old industrial centers and the newly hatched rural industries.

“To give another example: Originally, Shanghai was forced to sell its watches at 10 times production costs. At that price, everybody was competitive in producing watches and wanted to have his own factory,” explains Young. “Suddenly, the price controls are removed. Now, Shanghai can come into your province and undercut your watch price. Everyone now wants to protect his own turf. All these local governments internalized the distortions of the plan -- the skewed prices and high rents.”

“And this is the story of protectionism from time immemorial,” says Young. “Think of China as being the equivalent of Latin America in the 1950s: a bunch of small economies, all of them reasonably successful, but possessing these long-term structural problems because they contain industries that use political power to protect and defend themselves. How that works out in the long run is problematic.”

Protectionist trade barriers are now rife in China. Local governments have placed tariffs and even physical barriers on interregional transport routes.

“Local officials basically sit at the railway station and any good that comes in that is not a local good is charged,” says Young. In addition, stores that sell non-local goods are fined. Stores that sell only local goods are subsidized. Special permits and licenses that heavily favor the purchase of local goods are enforced. The legal system is subverted as well. The courts ignore nonlocal pleas and encourage local enterprises not to pay nonlocal bills. Judges foolish enough to rule in favor of nonlocal firms are punished.

With price controls no longer in place, these strict trade barriers have caused prices to vary widely.

“Look at China's economy in 1987 and you see four major television manufacturers,” says Young. “By 1993, there are seven major producers, and a number of minor ones, but TVs everywhere are sold at different prices. Outputs are converging, but prices are diverging. The Chinese market has opened up globally but is falling apart internally.”

Where is the Central Government?

“The central government is very aware of all of this activity,” says Young. “It rails against interprovincial trade wars, sends down task forces to mediate conflicts at provincial borders and has gone so far as to establish a separate ministry to police trade -- the Ministry of Internal Trade. The problem in China is basically this: when the central government shows up, everything goes according to their plan, but their power doesn't seem to be very sustainable. They have tremendous power for short periods of time, and then they're gone.”

“Bit by bit, the central government is yielding power to the localities. In the early 1990s, about 1,200 localities in China declared themselves `special economic zones' granting special tax incentives and reduced tax rates,” says Young. “The government said `this is ridiculous' and closed down 1,000 of them which means that they left 200 open. Two hundred localities just declared themselves tax-free zones and got away with it. The government rubber stamped them.”

Should Foreign Business Invest In China?

“First, the decision to go into `China' isn't a decision to go into `China.' You have to pick a local economy. They each have a separate market,” says Young. “You have to be prepared to come to terms with both the central government and the local government.”

Despite the sharp increase in foreign direct investment into China -- US$45 billion in 1997 -- it may be that the biggest foreign direct investors in China are the Chinese themselves.

“Chinese corporations go to Hong Kong, incorporate, and invest in themselves, because when they do that, they enjoy all kinds of changes in tax rules and accounting,” says Young. “So the point is, if your firm is considering a move into China, realize that the numbers are exaggerated. There are a lot fewer foreign investors going into China than you think. The Chinese are going into China, investing in themselves.”

Striving For a Free Market

Despite new distortions rising from incremental reforms, one truth remains unquestioned: The people of China are working harder today because they now have the incentive to do so.

“Under the old plan, the central government took every surplus; the more efficient you were, the more they took away from you, so why work hard? Now, local workers get to keep more of the benefits and they are working a lot more efficiently. That's the big plus,” says Young. “The big minus is that they are working harder in the wrong tasks. They are involved in duplicate industries in every province, which isn't efficient.”

“Most economists see Chinese rural industry as the 'natural outcome' of the entrepreneurial talents which have been freed by the movement to market, and they see the role of the local governments as 'encouraging the integration of the capital markets and free market entrepreneurial talent,'” says Young. “But I think rural industry is basically the symptom of the disease. Rural people went into industrial sectors because they were arbitraging the price distortion. So everybody became an electric fan maker or a TV maker, not because they were suited to being this type of producer, but because there was a price distortion there that favored being one.”

“So the incentives are effective in making people work harder and do things better, but I still say the presence of this rural industry phenomenon is a distortion. A lot of economists don't agree with me. But they did not agree with me years ago either, when I argued that the underlying productivity growth of the industrial countries of East Asia was no different than that of the economies of Latin America.

“An economic system characterized by government control -- even local government control -- over prices, output and investment is not typically viewed as being conducive to long-term prosperity. It remains to be seen whether the central government of China can wrest back enough power from its regions without reestablishing inefficient central control. What China needs is the moral equivalent of the interstate commerce clause of the U. S. Constitution, which restricts the power of local governments to control the interregional movement of goods and factors. This would allow the central government to bring out the most virtuous aspects of interregional local government competition, while restricting its more pernicious manifestations.”

Alwyn M. Young is Joseph Sondheimer Professor of International Economics and Finance at the University of Chicago Graduate School of Business.

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