Institutions in Chinese Economic Transformation

It is thus possible to turn back to view the orthodox establishment’s Proposition One on China, concerning the nature and attributes of its reformed economic institutions (see beginning of section two), in different light. What it considers as market-supplanting elements of the Chinese economy are precisely the egalitarian systemic features, particularly those of SOEs. The observation is widely agreed upon: that the institutions of SOEs have significantly deviated from principles of the market economy, notably individualistic property rights. Conceptually, in the relevant literature, China’s enterprise reform has generally been portrayed as a process of the state attempting to induce entrepreneurial activities by the management. But, this process has occurred in a broader context where various stakeholders of enterprises – local governments, workers, local communities, the banks and other business partners – have been involved to form a web of checks and balances governing the operation and development of enterprises. This systemic feature is visible not only in SOEs but also in enterprises of other types of public ownership, including the renowned collectively-owned township and village enterprises (TVEs). ²¹

The crucial question, however, is: what are the developmental implications of this rigidity-infused, long-term-oriented systemic feature of Chinese public firms? It was alluded to, in the beginning of this section, that this feature has its advantage of underpinning the egalitarian pattern of income distribution and therefore mass consumption. But, has it also resulted in gross inefficiency of enterprises at the micro level – as the orthodox establishment has persistently maintained?

The assertion about China’s allegedly ailing state sector has been so popular in the media that it seems trivial to answer this question. But, in the scholarly rather than journalistic literature, the assertion has in fact been a matter of debate. The debate first centers around the assessment of productivity change of SOEs in the reform era. Because of the very different estimation results of total factor productivity growth in SOEs obtained by large number of different studies, and because an objective criterion is lacking to resolve the difference, the orthodox assertion has been far from the dominant view on the matter. Even the World Bank (1996, p.23) has to adopt a concessive tone by stating: “(China’s state sector) remains a drag on the economy during the reform era – even though its efficiency may be improving.” Hence, and in connection with the 1997-98 East Asian financial crisis, the orthodox establishment has shifted to base its assertion on the financial performance of SOEs. It is claimed that the trend of declining enterprise profitability, together with the rising ratio of non-performing loans of state banks, are symptoms of the same ill: the gross inefficiency of SOEs. It is further claimed that this must be treated as a matter of urgency, as otherwise an East Asian-type crisis is most likely to occur in China. ²²

Compared with the orthodox Proposition Two (on development) dissected in section four, this Proposition One (on institutions) does not fare better with reality. At one level, it is a gross exaggeration to assert that the nexus of SOEs, state banks and the state itself as a whole has ever been on the verge of a financial collapse. The fact that the Chinese economy performed well during and after the 1997-98 East Asian crisis flies in the face of this assertion. To the extent that the nexus has indeed accumulated financial problems, this is largely a result of the fiscal difficulty of the state rather than enterprise inefficiency. For, over the reform era, SOEs have paid all the social costs that should have been the responsibility of state finance. They have paid income taxes at much higher rates than other enterprises, while also facing serious under-capitalization from the state-owner. At another level, the observed decline of enterprise profitability reflects more a macroeconomic issue than microeconomic inefficiency. As can be seen from Figure 4, the pre-tax profit rate of SOEs has in fact been very close to the average of all enterprises: slightly higher in the 1980s and slightly lower in the 1990s, while both exhibiting a tendency of secular decline up until 1998, and of substantial rebound post-1998. Noting that China’s accounting system has tended to underestimate depreciation, and hence to overestimate the capital stock of SOEs which are in general much older than non-SOEs, it could be argued that the profit rate of SOEs is likely to have been higher than industrial average in most years of the reform era. ²³

[Figure 4]

Figure 4 also shows that, throughout the reform era, the pre-tax profit rate of large-scale enterprises has been higher than the industrial average. It can be verified that the same applies to the comparison of other performance indicators, such as output and productivity growth. Given that the vast majority of large-scale enterprises are in fact SOEs –they have formed the core of China’s state sector – it appears that the orthodox Proposition One cannot be farther from the reality. What is more reasonable, therefore, is to see how this seemingly paradoxical reality could be made sense of. What kind of advantage can be generated by the systemic feature of SOEs, which appears to have more than compensated for the (allocative) efficiency loss that is deemed unavoidable from the standpoint of orthodox economic theory?

It has been noted that the reformed Chinese enterprise system has been infused with rigidities, especially with an emphasis on maintaining a long-term relationship with major stakeholders. This is akin to the canonical East Asian, or Japanese, system, and there are well-developed theories to explain the economic advantage and disadvantage of systemic features of this kind. Succinctly, in the context of steadily growing market demand, industrial firms that are infused with rigidities and long-term orientation are especially capable of improving productivity via various kinds of dynamic efficiency, particularly through collective learning. In contrast, in the context of stagnant or contracting demand, firms of this kind have difficulty in adjustment and hence tend to be out-competed by flexible, market-conforming and short-term-oriented firms. ²⁴

The above theoretical argument appears to be reasonable for explaining the fact that, with respect to the indicator of industrial profitability, China’s SOEs out-competed non-SOEs in the demand-expanding 1980s (and again in 2004-2007) but were out-competed in the demand-stagnant 1990s (Figure 4). Conversely, such an explanation also pushes to the forefront the most prominent feature of the Chinese “model” of economic transformation especially in the first half of the reform era. This, namely, is the basically appropriate match between mass consumption at the macro level and the long-term-oriented behavior of enterprises at the micro level, and, behind this, that between the egalitarian income distribution and the systemic feature of enterprises being accountable to major stakeholders. The significance of this match is no less than the sustained rapid economic growth itself. It offers the opportunity for China to embark on a path of late development that takes a strongly socialist character. But, there are also serious constraints on such a pattern of economic transformation. The introduction of market practices might be necessary for the formation of micro-level incentives for economic development, but market reforms in the strict sense – i.e., in applying principles of individualistic property rights – are bound to disrupt the indicated match between the macro environment and the micro institutions. On the macro side, such reforms tend to reduce workers’ income and threaten their job security, thereby undermine egalitarian income distribution and mass consumption. On the micro side, such reforms tend to threaten the loyalty or long-term commitment of major stakeholders (again, workers in particular) to the firm, thus undermine the scope for productivity-improving innovative activities.

The 1995-97 nationwide downsizing drive in state industry is especially crucial in this regard. Initiated by the state leadership with an objective of transforming large and medium SOEs into modern corporations and small SOEs into shareholding cooperatives, the drive was seized upon by many local governments to simply sell off state assets while unilaterally defecting on the state’s obligation for the job security of workers (and passing the liabilities of the sold enterprises onto state banks and ultimately to the central government). The crux of the matter is that, in the context of the demand-stagnant 1990s, SOEs had difficulty in utilizing the relative efficiency attributes of their rigidity-infused, long-term-oriented institutions to generate dynamic increasing returns. They were thus ill-equipped for competing with the more market-oriented private and collective firms, as well as Western transnational corporations which began to enter China on a massive scale from the early 1990s onwards. The downsizing drive launched by local governments, in the form of mass lay-off, further worsened the situation.

Consequently, unemployment surged, consumption expansion slowed down further and investment growth also stagnated. Together with the worsening external environment caused by the East Asian crisis, all these plunged China into serious difficulties in the closing years of the century. A state of deflation persisted at the macro level. Worsening financial performance of industrial enterprises and state banks was the norm at the micro level. It was only with a significant policy reversal that economic growth was sustained in the crisis-prone period of 1998-2002. This policy reversal took the form of the state leadership shifting from the stance of pushing forward the marketization drive to forcefully implement a range of market-supplanting policies. These policies included Keynesian-type fiscal stimuli, welfare-state measures, policies to revitalize SOEs and state banks, and a cautious approach to further liberalization of the regime of external finance. ²⁵

The policy reversal in 1998-2002 did not result in the resumption of the previous pattern of economic transformation, however. What has emerged is a new pattern that exhibits strong resemblance to the canonical East Asian model of economic institutions and growth. At one level, the path of industrialization characterized by capital deepening has become firmly established, with the pace of capital deepening tending to accelerate. This is largely due to the fact that consumption expansion has continued to be sluggish, and its leading role has been taken over by investment – hence the characteristic of “producing investment goods for producing investment goods”. At another level, consistent with capital deepening and economic growth based on increasing returns is the rapid expansion of large-scale enterprises: their value-added share in Chinese industry as a whole increased from 27% in 1998 to 36% in 2002. This is somewhat ironical, as it occurred in a period when, on the world scale and particularly from the orthodox establishment, there was widespread criticism of the East Asian model of capital-deepening industrialization carried out by large-scale business conglomerates – the model dismissively termed as “crony capitalism”.

This new pattern of economic transformation is clearly different from that of the first half of the reform era. There is no trace of an appropriate match between egalitarian income distribution and a systemic feature of enterprises being accountable to major stakeholders. True that, along with capital deepening and the indicated policy reversal, there has been a a phenomenal revival of the state sector. The value-added share of SOEs in Chinese industry increased from 33% in 1998 to 35% in 2002 and further to 37% in 2004, amid the rebound of their profit rate to once again surpass the industrial average. Yet, in an institutional sense, this revival has been more than outweighed by the massive decrease in the employment share of SOEs in Chinese industry: it decreased from 38% in 1998 to 15% in 2007. And this reflects the broader trend of shrinking employment share of the public sector in the Chinese society as a whole. Of the total of urban employment, the combined share of state-owned and collectively-owned units decreased from 76% in 1995 to 41% in 2000 and further down to 24% in 2007. In the rural areas, the employment share of township and village enterprises has continued to grow (though at a substantially slower pace than that of the first half of the reform era), but these enterprises have mostly been transformed from collective ownership to private ownership. Surely, a society where the main part of labor employment is with the private sector is very remote from socialist goals.
6. Conclusions
Because of its worldwide importance and its seemingly anomalous nature, China’s economic transformation in the era of globalization has presented a formidable task for scholars to make sense of. The central message of this paper is that any attempt to taking up this task needs to start with stylized facts of the reality, rather than “first principles” or “fundamental theorems” of economic theories. For analyzing the dynamics of China’s sustained rapid economic growth, the paper takes as its starting point the observation that the process has undergone a transition from labor-intensive, consumption-led to capital-deepening, investment-led industrialization. The paper then argues that to explain the strength and limitation of this dynamics it requires a broad theoretical perspective of transformational growth – a synthesis of Marxian theory of capital accumulation, Post-Keynesian theory of demand determination, and Schumpeterian theory of innovation. It is also from this perspective that attempts are made to explain the direction of evolution of the overall process of economic transformation. The focus is on the appropriate match, or otherwise, between the growth dynamics and the concurrent institutional reforms.

Such an analytical approach, while argued in the preceding sections as being more convincing than the existing orthodox as well as critical studies, certainly has limitations. Throughout the paper, we have left untouched a dimension that is conceivably of enormous importance in China’s economic transformation: namely, politics. But, politics has been at the heart of the relevant literature. The critical scholarship’s thesis of “super-exploitation” claims that repressive politics has been the most important factor in explaining China’s experience of economic growth and reforms. The transition orthodoxy likewise claims that the contrast between China and countries of the former Soviet bloc has been in a significant measure explained by politics (see, e.g., the statement by the World Bank quoted in section two).

From the perspective of transformational growth, the inquiry into the role of politics in China’s economic transformation comes down to answering the following question: if the pattern of economic transformation in the first half of the reform era proved very successful, in terms of economic growth and social development, why was it abandoned in the early 1990s? Why did the Chinese state unfailingly pursue the policies of rapid marketization in the 1990s? An adequate answer to these questions would require analyzing such fundamental issues as the changing social formation and class relations – defined, to be rigorous, in the Marxian sense in relation to the prevailing “modes of production” – in China, as well as the changing relationship between China (“socialism in one country”) and the capitalist world. These issues are really too big to be dealt with in this paper.

Nevertheless, it might be possible to attempt a less deep-going answer to the indicated questions by looking at the “agents”, rather than “structures”, in China’s social formation. Recall that what has most fundamentally undermined the depicted pattern of economic transformation is the 1995-97 enterprise downsizing or privatization drive (together with the process of financial liberalization in 1993-95). From these developments, it could be posited that, to an extent, the Chinese state authorities have been captured by the newly emerged financial interests in the economy. By extension, it can be said that the power relations in the Chinese society has been to some extent dominated by agents of accumulating speculative capital. Yet, the fact that the Chinese state leadership turned to adopt the wide range of market-supplanting policies in the 1998-2002 period suggests that the indicated capture and dominance are far from absolute or unconstrained.

1. 
   For the analysis of major trends of world development in the Golden Age, including the outstanding performance of the newly industrializing economies and countries of the former Soviet bloc, see Gordon (1988). For an analytical overview of the worldwide developmental crisis and uneven development after the Golden Age, see Singh (1992). Weeks (2001) gives a more theoretical treatment. Lo (2001) notes the structural features of the world economy that have been highlighted in the relevant literature as possible causes of the crisis, while Lo (2007) furthers the same proposition by taking into consideration of recent trends in world development. Easterly (2001) notes the almost total ignorance of the worldwide developmental crisis in the mainstream literature.
   
2. 
   Unless otherwise indicated all statistical data in this paper are from issues of China Statistical Yearbook. The quality of China’s statistical data has invited suspicions, but, in the scholarly literature, even the foremost skeptics accept that the actual performance of long-term economic growth is not significantly different from that indicated by official data (Rawski 2002). Because China is both a developing country undergoing very rapid structural changes, and a “transition economy” experiencing the marketization and monetization of assets and economic activities, statistical accuracy is inevitably a serious problem. Nevertheless, as Naughton (2007, ch.6) notes, official data remain the most reliable data in existence. Scholars have also raised concerns on the possibility of official falsification of data, not by the central government but by local authorities of various levels (Rawski 2002). In a response to such concerns, Xu Xianchun (2001), a leading researcher with the National Bureau of Statistics, contends that the Bureau has developed an increasingly sophisticated system to verify the reliability of data reported by lower-level authorities, and has accordingly made the necessary adjustments.
   
3. 
   “China calls on EU to recognize full market economy status”, Xinhua, 4 June 2008, http://news.xinhuanet.com/english/2008-06/04/content_8308052.htm; “China hopes Japan to recognize its market economy status as early as possible”, Xinhua, 3 December 2007, http://news.xinhuanet.com/english/2007-12/03/content_7190838.htm; “China expresses bilateral trade concerns to U.S. in economic dialogue”, Xinhua, 5 December 2008, http://news.xinhuanet.com/english/2008-12/05/content_10458000.htm. For a scholarly review of the issues concerning China’s quest for the recognition of its market economy status from its main trading partners, see Green (2004).
   
4. 
   See Hart-Landsberg and Burkett (2004), Harvey (2005), and Li (2008). Arrighi (2007), with his favorable views on Chinese economic transformation not only in achieving real development domestically but also in promoting a more equal international economic order, clearly appears to be the exception rather than the norm in the circles of left-wing, critical scholars.
   
5. 
   See IMF (2000), OECD (2005), and World Bank (2002), all containing main elements of these two propositions. For Proposition One, see also Lardy (1998) and Steinfeld (2000). For Proposition Two, the pioneer work is Sachs and Woo (1994).
   
6. 
   Examples of such claims abound, see, e.g., The Economist 24^th-30^th October 1998, pp.15-16 and pp.23-28, together with the citations listed in the previous endnote.
   
7. 
   The notion of the “natural path of development” coined in the form of the stages approach to comparative advantage is most fully presented in the World Bank’s 1987 World Development Report, which is, in turn, based on the previous work by economists associated with the Washington establishment, such as Bela Balassa and Anne Krueger. The following statement by Balassa (1981, p.22) is a good summary of the essential idea of the stages approach: “the process is exemplified by Japan that shifted from unskilled-labor intensive exports to skill-intensive and to physical-capital intensive exports and is increasingly expanding its technology-intensive exports.” See Lo (1995) for a review, and critique, of this body of work.
   
8. 
   The “Kaldor-Verdoorn Laws” are of the following forms: first, economic development is often associated with the process of industrialization, in the form of an increasing share of employment of resources and production of output by industry in the economy; second, there exists a positive relationship between output and productivity growth within the industrial sector; and, third, there also exists a positive relationship between industrial growth on the one hand, and the output or productivity growth of the rest of the economy on the other hand (Kaldor 1966; McCombie and Thirlwall 1994). The interpretation of these observations by Kaldor and associates has been a matter of debate, but the stylized facts themselves have been largely a consensus in the literature (Syrquin 1994).
   
9. 
   Toner (1999, ch.6) summarizes the Kaldorian theory of economic growth. Nell (1998) is a seminal work in the broader Post-Keynesian tradition on transformational growth, while Boyer and Petit (1991) provides a schematic account of the tradition. Lo and Smyth (2004) review the even broader literature of transformational growth, which also encompasses relevant theories from the Schumpeterian and Marxian traditions. Kaldor (1957) is the classic in Post-Keynesian theories of the determination of the composition and growth of aggregate demand.
   
10. 
    The explosive growth of mass-production “new” consumer durables in China in the first half of the reform era is best indicated by the following examples: between 1978 and 1992, the annual output of color television receivers increased from merely 3800 units to more than 13 million units, that of household washing machines increased from 400 units to more than seven million units, and that of household refrigerators increased from 28,000 units to almost five million units. The same pace of growth was evident in a wide range of similar products, so much so that they collectively signified a “consumption revolution” that was felt by the entire urban population in China. Within several years in the middle of the 1980s, China emerged from almost nowhere to become the biggest manufacturer in the world of many of these products. For a detailed study of the achievements and problems of these developments, see Lo (1997).
    
11. 
    Figures cover the formal sector of Chinese industry: “township-and-above independently accounting industrial enterprises” before 1998 and “all state-owned industrial enterprises plus non-state-owned above-scale (of five million yuan in sales revenue) industrial enterprises” from 1998. Hence, figures pre- and post-1998 are not strictly comparable but are only indicative of the trend of evolution. Official statistics of the machinery sector are available from issues of China Machinery Industry Yearbook, which, however, reports the share of gross output of the machinery sector in Chinese industry mostly in various base-year constant prices. The figures reported here are reconstruction using the ex-factor price indices of all industries and of the machinery industry as deflators.
    
12. 
    Relative labor productivity is defined as the per worker value-added of the industry in question relative to the average of the manufacturing sector as a whole. Traditionally, in the literature of trade analysis, a value of 0.9 and below for this measure suggests that the industry is labor-intensive, while a value of unity or above suggests that it is a capital-intensive industry. For the period between 1980 and 1992, the value of the measure for China’s broad machinery sector averaged to around 0.91, while that for the electronics industry alone averaged to around 1.25 (Lo and Chan, 1998).
    
13. 
    Singh (1992) analyzes the slowdown in late industrialization with an emphasis on the worsened demand conditions after the Golden Age. Taylor and Rada (2003) provides a more recent analysis along the same line of arguments.
    
14. 
    Life expectancy at birth in some ways reflects the combined effect of all indicators of social development because “it summarizes the impact of health and nutrition on the human organism” (Naughton 2007, p.222). In 1980, the indicator was 66.8 years for China and 65.6 years for all middle-income economies. By 2000, the figures increased to 70.3 years and 69.1 years, respectively (World Bank data cited in Li 2008, p.34). Li (2008) provides an elaborate assessment of China’s performance in various social development indicators – particularly life expectancy at birth – and reaches the same judgment as this paper.
    
15. 
    Data from Li Shi et. al. (2000) and Renmin Ribao (People’s Daily) 9^th July 2002.
    
16. 
    Fransman (1986) provides perhaps the most thorough and incisive review of the literature on the Feldman-Mahalanobis model and related growth theories. For further elaborations in relation to theories of transformational growth, see the citations in footnote 9.
    
17. 
    Meng (2004) provides a reformulation of the relevant theories, particularly on the role of product innovations in the debates surrounding Rosa Luxemburg’s theory of capital accumulation and Ernest Mandel’s theory of the long waves in capitalist development.
    
18. 
    For the orthodox view, see World Bank (1996, ch.9), and Lardy (2002). For the view of the mainstream of the critical scholarship, see Hart-Landsberg and Burkett (2004) and Harvey (2005, ch.5). But note the different view of Arrighi (2007) and Glyn (2006), both appear to hold the thesis of “under-cutting” but not “super-exploitation”. Conceptually, even if it is true that Chinese labor has been under-cutting the world working class as a whole, this is not necessarily the result of Chinese wage being persistently depressed to levels below those of competitor countries. An equally plausible underpinning of under-cutting would be faster productivity growth of Chinese labor. The contentious issue then is not about super-exploitation as the basis of economic growth, but rather about the division of the fruits of productivity improvement.
    
19. 
    Lo and Chan (1998) analyze the implications of China’s massive expansion in the export of mechanical and electronic products since the mid-1980s, and argue that these exports have largely leapfrogged over the country’s “given” comparative advantage. Yoshitomi (1996) gives a similar assessment: “China has revealed comparative advantage vis-à-vis ASEAN countries in capital- and technology-intensive products despite a similar development stage and even lower per-capita income. China’s comparative advantage in labor-intensive and natural resource-based products is essentially in relation to advanced countries and NIEs [newly industrializing economies], not ASEAN countries. However, it is also interesting to note that over the past ten years, China has been gaining comparative advantage relative to NIEs (in a broad range of technology- and capital-intensive industries).” See Rodrik (2006) for a more recent study that arrives at the same conclusion, and the more skeptical view of Naughton (2007, ch.16).
    
20. 
    This is a main theme of what can be called the “capability theory of late development” (Amsden 1989; Wade 1990), where the argument is that late development requires the creation of sophisticated production capabilities – and technology import is needed for the creation. Scholars that apply this theory to study Chinese industrialization have concluded that what is required for successful late development is not just production capabilities as such but rather the building up of an indigenous “national system of innovation” (Lu 2000; Lazonick 2003). In line with our discussion on collective learning, a complementary “capability theory of business institutions” (Aoki 1990; Best 1990) might be needed for the study of the Chinese experience. More on this in the next section.
    
21. 
    It is a consensus in the scholarly literature that the degree of egalitarianism in income distribution was extremely high by international standards in both urban and rural China in the first half of the reform era, and that this was mainly due to the nature and role of the “socialist system” (Naughton 2007, ch.9). The perception of an exceedingly high degree of egalitarianism was also a common sense underpinning all the policy efforts to promote market reforms particularly at the enterprise level – with the 1995-97 mass privatization drive as the culmination (see below). In contrast to the general focus on its distributive function, the productive function of Chinese public firms has rarely been noticed. Lo (1999) and Smyth (1998) are among the exceptions, which analyze the productive attributes of the institutions of China’s SOEs and TVEs, respectively. Both studies observe that the reformed enterprise system – whether SOEs or TVEs – has exhibited the kind of institutional rigidities and long-term orientation that are akin to the canonical Japanese system, and argue that this system has embodied the kind of relative efficiency attributes detailed below.
    
22. 
    Representative of the orthodox view on productivity growth are the works by Woo et al. (1994a, 1994b). Representative of the dissident view are the works by Jefferson et al. (1992, 1996). Along the orthodox line, the most articulate analysis of the financial aspect of Chinese enterprise performance is Lardy (1998).
    
23. 
    Lo (1999) gives an assessment of the performance of SOEs, particularly large-scale enterprises, that is in line with the arguments presented here. Cheng and Lo (2002) contend that, even without taking into account of social burdens, the financial performance of SOEs has been at least comparable to the rest of Chinese industry while that of large-scale SOEs has been much better.
    
24. 
    Aoki (1990) provides a schematic, theoretical exposition on the relative efficiency attributes of the (both stylized) Japanese firm vis-à-vis the American firm. Lo and Smyth (2004), in a similar vein, synthesize a range of theories on technological paradigms, growth paths and economic institutions to investigate the relative efficiency attributes of different economic systems.
    
25. 
    Lau (1999) provides a detailed analysis of the 1995-97 enterprise downsizing and privatization drive. Lo (2001) and Lo (2007) analyzes the significance, short term and long term, respectively, of the policy reversal in 1998-2002.
    

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