Information about Asia and the Pacific Asia y el Pacífico

Chapter 13 Inflation and Growth in China’s Transition: A Comparison with Eastern Europe and the Former Soviet Union

Manuel Guitián, and Robert Mundell
Published Date:
June 1996
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Justin Yifu Lin

For the transition from a centrally planned economy to a decentralized market economy, two different approaches have been followed in recent years. The first approach is a “big bang” or “shock therapy” approach (Lipton and Sachs, 1990). The reforms undertaken in Eastern Europe and the former Soviet Union are typical examples of this approach. The supporters of the big bang approach consider stabilization, marketization, and privatization to be the necessary components of an economic reform. Just as God created all things in seven days, the big bang approach attempts to complete all these components simultaneously or in sequence over a short time. The alternative is the “gradual,” “organic,” or “evolutional” approach (Kornai, 1990), which has characterized China’s recent reforms. It is a piecemeal, partial, incremental, sequential, and often experimental approach that does not involve large-scale privatization. Some economists regard this approach as self-defeating, while the former is deemed to be theoretically perfect and feasible (Murphy, Shleifer, and Vishny, 1992).

The advocates of the shock therapy approach expect the reform to have a “J-curve” effect on economic growth; that is, GDP is expected to decline initially, and that decline would soon be followed by a strong recovery. However, the shock therapy in Eastern Europe and the former Soviet Union resulted in an unexpectedly sharp and prolonged decline in GNP with extraordinarily high inflation rates (see Table 1).1 China’s reform started at the end of 1978. Since then, its GNP has grown continuously at a phenomenal rate, while the price level has been relatively stable, compared with the rates of growth and inflation in Eastern Europe and the former Soviet Union (see Figure 1).

Table 1.Growth and Inflation in Eastern Europe and the Former Soviet Union(Percentage change)
Real GDPRetail Price
Czech Republic31−1−14−7n.a.0211571120
Kyrgyz Republic−5−25−1685855600
Macedonia, former Yugoslav Republic of−11−15−71151,691580
Slovak Republic310−16−6−80211611025
Source: Bartholdy and Flemming (1993).


Source: Bartholdy and Flemming (1993).


Figure 1.Economic Growth and Inflation in China

Source: State Statistical Bureau (1995, pp. 4, 8, and 45).

Although the overall performance of growth and inflation in China has been remarkable, the economy has experienced several growth and inflation cycles since the onset of the reforms in 1978. It appears that higher-than-average growth in a year will inevitably lead to higher-than-average inflation one or two years later, and higher-than-average inflation in a year will in turn lead to a lower-than-average growth in the succeeding period. There seems to be a tradeoff between growth and inflation in China’s transition to a market economy.

In this paper, I attempt to analyze why the gradual approach to reform in China resulted in continuous growth with a relatively low inflation rate during the transition period, whereas the shock therapy implemented in Eastern Europe and the former Soviet Union resulted in a sharp decline in GNP with an extraordinarily high inflation rate; what has led to the growth and inflation cycles in China; and what reforms are necessary for China to achieve sustained and stable growth in the future.

Development Strategy and Major Prereform Problems

Most economic problems in China before and after the reforms can be traced to the adoption in the early 1950s of a strategy that emphasized the development of heavy industry. China’s prereform economic structure had three integrated components: (1) a distorted macroeconomic policy environment that featured artificially low interest rates, overvalued exchange rates, low nominal wage rates, and low price levels for basic goods and raw materials; (2) planned allocation for credit, foreign exchange, and other materials; and (3) a traditional micromanagement system of state enterprises and collective agriculture. These three components were endogenous to the choice of a capital-intensive strategy in a capital-scarce agrarian economy, although the specific institutional arrangements that were actually adopted in China were also shaped by socialist ideology, the Chinese Communist Party’s experience during the revolution, and the Chinese Government’s political abilities.2 The relationship between the development strategy and the economic structure is summarized in Figure 2.

Figure 2.Traditional Economic Structure in China

At the founding of the People’s Republic in 1949, the Chinese Government inherited a war-torn agrarian economy in which 89.4 percent of the population resided in rural areas, and industry accounted for only 12.6 percent of the national income. At that time, a well-developed, heavy-industry sector symbolized a country’s power and economic achievement. Like government leaders in India and many other newly independent developing countries, Chinese leaders intended to accelerate the development of heavy industries. After China’s involvement in the Korean War in 1950, with its resulting embargo and isolation from Western nations, catching up to the industrial powers became a necessity for national security. In addition, the Soviet Union’s outstanding record of nation building in the 1930s, at a time when Western market economies were experiencing the Great Depression, provided the Chinese leadership with both inspiration and experience for adopting a strategy oriented toward heavy industry. Therefore, after recovering from wartime destruction in 1953, the Chinese Government planned to pursue heavy industry as a priority sector. The goal was to build, as rapidly as possible, the country’s capacity to produce capital goods and military materials. This development strategy was shaped through a series of five-year plans.3

Heavy industry is a capital-intensive sector. The construction of a heavy-industry project has three characteristics: (1) it requires a long gestation:4 (2) most equipment for a project, at least in the initial stage, must be imported from more advanced economies; and (3) each project requires a lump-sum investment. When the Chinese Government initiated this strategy in the early 1950s, the Chinese economy had three characteristics: (1) capital was limited, and, consequently, the market interest rate was high;5 (2) foreign exchange was scarce and expensive because exportable goods were limited and primarily consisted of low-priced agricultural products; and (3) the economic surplus was small and scattered owing to the nature of a poor agrarian economy. Because these characteristics of the economy were mismatched with the three characteristics of a heavy-industry project, the spontaneous development of capital-intensive industry in the economy was impossible.6 Therefore, distorted macroeconomic policies were required for the development of heavy industry. At the beginning of the First Five-Year Plan, the Government instituted a policy of low interest rates and overvalued exchange rates to reduce the costs of both interest payments and imported equipment.7 Mean-while, to secure enough funds for industrial expansion, a policy of low input prices, including nominal wage rates for workers8 and nominal prices for raw materials, energy, and transportation, evolved alongside the adoption of this development strategy. The assumption was that the low prices would enable the enterprises to create profits large enough to repay the loans or to accumulate enough funds for reinvestment. If the enterprises were privately owned, the state could not be sure that the private entrepreneurs would reinvest the policy-created profits in the intended projects.9 Therefore, private enterprises were soon nationalized,10 and new key enterprises were owned by the state to secure its control over profits to invest in heavy-industry projects. Meanwhile, to make the policy of low nominal wages feasible, the Government had to provide urban residents with inexpensive food and other necessities, including housing, medical care, and clothing. The low interest rates, overvalued exchange rates, low nominal wage rates, and low prices for raw materials and basic goods constituted the basic macroeconomic policy environment of the heavy-industry strategy.11

These macroeconomic policies created an imbalance in the supply and demand for credit, foreign exchange, raw materials, and basic consumer goods. Because nonpriority sectors would be competing with priority sectors for low-priced resources, plans and administrative controls replaced markets as the mechanism for allocating scarce credit, foreign reserves, raw materials, and basic goods, ensuring that limited resources would be used for the targeted projects. Moreover, the state monopolized banks, foreign trade, and material distribution systems.12

In this way, competition was suppressed, and profits ceased to be the measure of an enterprise’s efficiency.13 Because of the lack of market discipline, managerial discretion was potentially a serious problem. Managers of state enterprises were deprived of the autonomy they needed to mitigate this problem.14 The production of state enterprises was dictated by mandatory plans, and an administrative allocation system furnished them with most of their material inputs. The prices of their products were determined by pricing authorities and their circulation was controlled by government agencies. The wages and salaries of workers and managers were determined not by their performance but by their education, age, position, and other criteria according to a national wage scale. Investment and working capital were mostly financed through appropriations from the state budget or through loans from the banking system according to state plans. State enterprises remitted all their profits, if any, to the state, and the state budget would also cover all losses incurred by the enterprises. In short, state enterprises were like puppets. They had no control over hiring, using profits, planning production, marketing their products, and supplies of inputs.

The development strategy and the resulting policy environment and allocation system also shaped the evolution of farming institutions in China. To secure cheap supplies of grain and other agricultural products for urban, low-price rationing, a compulsory procurement policy was imposed in the rural areas in 1953. This policy obliged peasants to sell set quantities of their produce, including grain, cotton, and edible oils, to the state at government-set prices (Perkins, 1966, chap. 4).

In addition to providing cheap food for industrialization, agriculture was also the main foreign exchange earner. In the 1950s, agricultural products alone made up over 40 percent of all exports. If processed agricultural products are also counted, agriculture contributed to more than 60 percent of China’s foreign exchange earnings up to the 1970s. Because foreign exchange was as important as capital for the Government’s heavy-industry strategy, the country’s ability to import capital goods for industrialization in the early stages of development clearly depended on the performance of agriculture.

Agricultural development, like industrial development, required resources and investment. The Government, however, was reluctant to divert scarce resources and funds from industry to agriculture. Therefore, alongside the heavy-industry strategy, the Government adopted a new agricultural development strategy that would not compete for resources with industrial expansion. The core of this strategy involved the mass mobilization of rural labor to work on labor-intensive investment projects, such as irrigation, flood control, and land reclamation, and to raise unit yields in agriculture through traditional methods and inputs, such as closer planting, more careful weeding, and the more widespread use of organic fertilizer. The Government believed that collectivization of agriculture would ensure these functions. The Government also viewed collectivization as a convenient vehicle for effecting the state’s program for procuring low-priced grain and other agricultural products (Luo, 1985). Income distribution in the collectives was based on each collective member’s contribution to agricultural production, although monitoring a member’s effort is extremely difficult in agricultural production. The remuneration system in the collectives was basically egalitarian (Lin, 1988).

The distorted macroeconomic policy environment, planned allocation system, and micromanagement institutions outlined above all made the maximum mobilization of resources for the development of heavy industry possible in a capital-scarce economy. Because most private initiative in economic activities was prohibited, the pattern of the Government’s investment was the best indicator of the bias in the official development strategy. Table 2 shows the sector shares in state capital construction investment from the First Five-Year Plan (1953–57) to the Sixth Five-Year Plan (1981–85). Although more than three-fourths of China’s population lived from agriculture, agriculture received less than 10 percent of state investment during 1953–85, while 45 percent went to heavy industry. Moreover, heavy industry received the lion’s share of the investments that fell under the heading “other,” including workers’ housing and infrastructure. As a result, the value of heavy industry in the combined total value of agriculture and industry grew from 15 percent in 1952 to about 40 percent in the 1970s (see Table 3).15

Table 2.Sector Shares in State Capital Construction Investment(In percent)
Five-Year PlanAgricultureLight


Source: State Statistical Bureau (1987a, p. 97).

These years represent an interruption of the five-year plans.

Source: State Statistical Bureau (1987a, p. 97).

These years represent an interruption of the five-year plans.

Table 3.Sector Composition(Current prices; in percent)



Judging from China’s sectoral composition, the trinity of the traditional socialist economic structure—a distorted macroeconomic policy environment, a planned allocation system, and a puppetlike micromanagement institution—met its intended goal of accelerating the development of heavy industry in China. However, China paid a high price for the achievement. The economy is very inefficient owing to low allocative efficiency because of the deviation of the industrial structure from the pattern dictated by the comparative advantages of the economy, and to low technical efficiency because of managers’ and workers’ low incentives to work.

Low Allocative Efficiency

In the current stage of China’s economic development, capital is relatively scarce and labor is relatively abundant. If prices were determined by market competition, capital would be relatively expensive and labor relatively inexpensive. Therefore, the comparative advantages of the Chinese economy lie in labor-intensive sectors. If investments had been guided by market forces, profit incentives would have induced entrepreneurs to adopt capital-saving and labor-using technologies and to allocate more resources to labor-intensive industries. The effects on the industrial structure of the strategy to develop heavy industry are illustrated in Figure 3. Let us assume that there are only two sectors in the economy, namely, labor-intensive light industry and capital-intensive heavy industry. Given the endowments, the production possibility frontier is OCD. EP represents the line of market-determined relative prices, which existed before the imposition of the heavy-industry strategy. When relative prices are not distorted, the economy will produce OY0 of light-industry products and OX0 of heavy-industry products. However, to develop heavy industry, the state monopolized the allocation system and used administrative measures to allocate resources. If we suppose that the target of the development strategy is to expand heavy industry from OX0 to OX1, then the state would need to limit the production of light industry from OY0 to OY1 in order to shift resources from light industry to heavy industry. The production possibility frontier is truncated to Y1AD. If there is no technical inefficiency, the production mix of the economy would locate on A, corresponding to a quantity of OY1 light-industry products and OX1 heavy-industry products.16

Figure 3.Development Strategy and Truncated Production Frontier

As we can see from Figure 3, the static consequence of the strategy is that the economy, based on the prices before distortion, suffers a loss of ea in absolute magnitude or ea/eO in relative measure.17 The income loss attributable to allocative inefficiency implies the reduction of surplus available for investment. If we assume that a fixed portion of the national income is used for investment, the decline in investment would further diminish gross investment. However, if we assume that the Government’s plan is to develop light and heavy industry in a fixed ratio of OX1/OY1, then each production cycle would repeatedly generate an income loss of ea/eO in relative measure. All these factors significantly dampen the growth of the whole economy. To maintain the growth rate, it is necessary to raise the accumulation rate, resulting in insufficient consumption and long-lasting, low living standards for the population.18

Low Technical Efficiency

Because profits ceased to be a measure of efficiency and the planned allocation system often failed to distribute materials on time, managers were forced to keep large reserves and had no incentive to use resources economically. Overstaffing, underutilization of capital resources, and overstocking of inventories are all characteristics of state enterprises.19 Moreover, managers had no control over workers’ wage rates and bonuses. A worker’s payment was not related to his or her effort in the enterprise or to the enterprise’s profits. The remuneration system hence dampened work incentive. Similarly, in the agricultural collectives, the farmworker’s incentive to work was low because the link between reward and effort was weak.20 Losses resulting from these technical inefficiencies mean that actual production will locate on some point inside the production possibility frontier, such as point B in Figure 3.

Because of the above two factors, the Chinese economy was very inefficient. The most important indicator of inefficiency was the extremely low rate of total factor productivity growth. A World Bank study shows that, even calculated under the most favorable assumptions, the growth rate was merely 0.5 percent between 1952 and 1981, only one-fourth of the average growth rate of 19 developing countries included in the study (World Bank, 1985a). Moreover, total factor productivity of China’s state enterprises was stagnant, or even registered negative growth, between 1957 and 1982 (World Bank, 1985b).

Growth and Inflation: An Analytical Review of China’s Economic Reforms

As Perkins (1988, p. 601) pointed out, “it is unlikely that China’s leaders had a worked-out blueprint in mind when they set out to reform the economic structure.” However, retrospectively, China’s reforms followed a logical process that is predictable from the above theoretical model. The traditional socialist economic structure is endogenous to the adoption of a strategy to promote heavy industry in a capital-scarce economy. The main weakness in this economic structure was low economic efficiency arising from structural imbalance and incentive problems. Before the late 1970s, the Government made several attempts to address the structural problems by decentralizing the allocative mechanism from the central to the local government.21 However, the administration of the allocative mechanism was not changed and the policy environment and managerial systems were not altered, and the attempts thus failed to rectify the structural imbalance and improve economic incentives. The goals of the reform in late 1978 also included rectifying the structural imbalance and improving incentives. However, what set those reforms apart from previous attempts were the micromanagement system reforms, which made farmers, managers, and workers in state enterprises partial residual claimants. This small crack in the traditional economic structure eventually widened, leading to the gradual dismantlement of the system and to a higher average growth rate, as well as to cyclical movements of growth and inflation.

Reform of the Micromanagement System

The most important change in the micromanagement system was the replacement of collective farming by a household-based system, now known as the household responsibility system. The change in farming institutions had not been intended at the beginning of the reforms. Although the Government recognized in 1978 that solving managerial problems within the collective system was the key to improving farmers’ incentives, the official position at that time was still that the collective was to remain the basic unit of agricultural production. Nevertheless, a small number of collectives, first secretly and later with the blessing of local authorities, began to try out a system of leasing a collective’s land and dividing the obligatory procurement quotas among individual households in the collective. A year later these collectives brought out yields far larger than those of other teams. The central authorities later recognized the existence of this new form of farming but required that it be restricted to poor agricultural regions, mainly to hilly or mountainous areas, and to poor collectives in which people had lost confidence in the collective system. However, this restriction was ignored in most regions. Production performance improved after a collective adopted the new system, regardless of its relative wealth or poverty. Full official recognition of the household responsibility system as a nationally acceptable farming institution was eventually given in late 1981, exactly two years after the initial price increases. By that time, 45 percent of the collectives in China had already dismantled and instituted the household responsibility system. By the end of 1983, 98 percent of agricultural collectives in China had adopted this new system. When the household responsibility system first appeared, the land lease was only one to three years. However, the short lease reduced farmers’ incentives for land-improvement investment. In 1984, the lease contract was allowed to be extended to up to 15 years. In 1993, the Government allowed the lease contract to be extended for another 30 years after the expiration of the first contract.

Unlike the spontaneous nature of farming institution reform, the Government initiated the reform of the micromanagement system of the state enterprises. These reforms have undergone four stages. The first stage (1979–83) emphasized several important experimental initiatives that were intended to enlarge enterprise autonomy and expand the role of financial incentives within the traditional economic structure. These measures included the introduction of profit retention and performance-related bonuses and permitted state enterprises to produce outside the mandatory state plan. The enterprises involved in exports were also allowed to retain part of their foreign exchange earnings to use at their own discretion. In the second stage (1984–86), the emphasis shifted to a formalization of the financial obligations of the state enterprises to the Government, and enterprises were exposed to market influences. In 1983, profit remittances to the Government were replaced by a profit tax. In 1984, the Government allowed state enterprises to sell output in excess of quotas at negotiated prices and to plan their output accordingly, thus establishing the dual-track price system. During the third stage (1987–92), the contract responsibility system, which attempted to clarify the authority and responsibilities of enterprise managers, was formalized and widely adopted. In the last stage (since 1993), the Government has attempted to introduce the modern corporate system to state enterprises. In each stage of the reform, government intervention has been reduced further, and the state enterprises have gained more autonomy.

The reform of the micromanagement system has achieved its intended goal of improving technical efficiency. Empirical estimates show that almost half of the 42.2 percent growth of output in grain and other crops during 1978–84 was driven by changes in productivity brought about by the reforms. Furthermore, almost all of the productivity growth was attributable to the changes resulting from the introduction of the household responsibility system (Fan, 1991; Lin, 1992; McMillan, Whalley, and Zhu, 1989; Wen, 1993). According to production function estimates in several studies, the increase in enterprise autonomy increased productivity in the state enterprises (Chen and others, 1988; Gordon and Li, 1991; Dollar, 1990; Jefferson, Rawski, and Zheng, 1992; Groves and others, 1994). Therefore, the reforms in the micromanagement system in both agriculture and industry have created a flow of new resources, an important feature of China’s reforms.

The increase in enterprise autonomy under a distorted macroeconomic policy environment, however, also invited managers’ and workers’ discretionary behavior. Despite an improvement in productivity, the profitability of the state enterprises declined and the Government’s subsidies increased, owing to a faster increase in wages, fringe benefits, and other unauthorized expenditures (Fan and Schaffer, 1991) and to the competition from the autonomous township and village enterprises (Jefferson and Rawski, 1994).22 However, once the enterprises tasted autonomy, it was politically too costly to revoke it. The decline in the profits of state enterprises and the competition from the township and village enterprises forced the Government to try other measures, which entailed further increasing the autonomy of state enterprises in the hope that the new measures would make the enterprises financially independent.

Reform of the Resource Allocation System

The increase in enterprise autonomy put pressure on the planned distribution system. Because the state enterprises were allowed to produce outside the mandatory plans, they needed to obtain additional inputs and to sell the extra outputs outside the planned distribution system. Under pressure from the enterprises, material supplies were progressively separated from the plan, and retail commerce was gradually deregulated. At the beginning, certain key inputs remained controlled although the number of controlled items was gradually reduced. Centralized credit rationing was also delegated to local banks at the end of 1984.

An unexpected effect of the relaxation of the resource allocation system was the rapid growth of the nonstate enterprises, especially the township and village enterprises.23 Rural industry already existed under the traditional system as a result of the Government’s decision to mechanize agriculture and develop rural processing industries to finance the mechanization in 1971. In 1978, the output of the township and village enterprises accounted for 7.2 percent of the total value of industrial output in China. Before the reforms, their growth was severely constrained by a lack of access to credit, raw materials, and markets; the reforms created two favorable conditions for their rapid expansion: (1) a new stream of surpluses brought about by the household responsibility reform provided a resource base for new investment activities; and (2) because of the relaxation of rigidity in the traditional planned allocation system, access to key raw materials and markets opened up. During 1981–91, the number of township and village enterprises, employment in these enterprises, and their total output value grew at an average annual rate of 26.6 percent, 11.2 percent, and 29.6 percent, respectively. Their annual growth rate in total output value was three times that of the state firms in the same period, and, in 1993, their output accounted for 38.1 percent of China’s total industrial output. The share of industrial output from nonstate enterprises increased from 22 percent in 1978 to 56.9 percent in 1993 (State Statistical Bureau, 1995, p. 73).

The rapid market entry of township and village enterprises and other types of nonstate enterprise had two unexpected effects on the reforms. First, nonstate enterprises were the product of markets. Because they were outside the traditional economic structure, nonstate enterprises had to obtain energy and raw materials from competitive markets, and their products could be sold only to markets. They had hard budget constraints and would not survive if their management was poor. Their employees did not have an “iron rice bowl” and could be fired. As a result, the nonstate enterprises were more productive than the state enterprises, as comparisons of the rate of growth of output and total factor productivity between the state and collective sectors in Table 4 show. The dynamism of nonstate enterprises exerted pressure on the state enterprises and triggered the state’s policy of transplanting the micromanagement system of the nonstate enterprises to the state enterprises and of granting more autonomy to the state enterprises. Reform measures for improving the micromanagement system of state enterprises—such as replacing profit remittances with a profit tax, establishing the contract responsibility system, and introducing the modern corporate system—were responses to competitive pressure from township and village enterprises and other nonstate enterprises (Jefferson and Rawski, 1994). Second, the development of nonstate enterprises significantly rectified the misallocation of resources. In most cases, nonstate enterprises had to pay market prices for their inputs, and their products were sold at market prices. Responding to price signals, nonstate enterprises adopted more labor-intensive technology and concentrated on more labor-intensive small industries than did the state enterprises.24 Therefore, the technological structure of nonstate enterprises was more consistent with the comparative advantages of China’s endowments. Their emergence mitigated the structural imbalance caused by the Government’s strategy to develop heavy industry. As a result of the improvement in resource allocation, the reforms accelerated.

Table 4.Growth Rate of Output and Total Factor Productivity
State sector
Total factor productivity2.401.803.01
Collective sector
Total factor productivity4.633.455.86

Reform of the Macroeconomic Policy Environment

In the traditional socialist economic structure, the distorted macroeconomic policy environment was linked most closely to the development strategy, and its effects on allocative and technical efficiency were indirect. The reform of these policies was thus the most sluggish. We will argue later that most economic problems that appeared during the reforms—for example, the cyclical pattern of growth and the rampant rent seeking—could be attributed to the inconsistency between the distorted policy environment and the liberalized allocation and enterprise system. As a result, the Chinese Government constantly faced a dilemma: to make the macroeconomic policy environment consistent with the liberalized micromanagement and resource allocation system or to re-centralize the micromanagement and resource allocation system to maintain the internal consistency of the traditional economic structure. Revoking enterprise autonomy would have met with resistance from the employees of state enterprises. A return to the traditional economic structure would also have meant the reappearance of economic stagnation. Therefore, no matter how reluctant the Government may have been, its only sustainable choice was to reform the policy environment and make macroeconomic policies consistent with the liberalized allocation and micromanagement system.

Changes in the policy environment started in the commodity price system. After the introduction of profit retention, the enterprises were allowed to produce outside the mandatory plan. They first used an informal barter system to obtain the needed inputs and to sell the products at premium prices. In 1984, the Government introduced the dual-track price system, which allowed state enterprises to sell their output in excess of quotas at market prices and to plan their output accordingly. The aim of the dual-track price system was to reduce the marginal price distortion in the state enterprises’ production decisions while leaving the state a measure of control over material allocation. By 1988, only 30 percent of retail sales were made at plan prices, and the state enterprises obtained 60 percent of their inputs and sold 60 percent of their outputs at market prices (Zou, 1992).

The second major change in the policy environment occurred in the foreign exchange rate policy. In 1979–80, the official exchange rate, at roughly Y 1.5 per US$1, could not cover the costs of exports because the average cost of earning one U.S. dollar was about Y 2.5. The Government therefore adopted a dual-rate system at the beginning of 1981. Commodity trade was settled at the internal rate of Y 2.8 per US$1; the official rate of Y 1.53 per US$1 continued to apply to noncommodity transactions. After 1985, the yuan was gradually devalued. Moreover, the proportion of retained foreign exchange, which was introduced in 1979, was gradually raised, and enterprises were allowed to swap their foreign exchange entitlement with other enterprises through the People’s Bank of China at rates higher than the official exchange rate. Restrictions on trading foreign exchange were further relaxed with the establishment of a “foreign exchange adjustment center” in Shenzhen in 1985, in which enterprises could trade foreign exchange at negotiated rates. By the late 1980s, such centers were established in most provinces in China, and more than 80 percent of foreign exchange earnings were swapped in such centers (Sung, 1994). The culmination of foreign exchange rate policy reform was the establishment of a managed floating system and unification of the dual rate system on January 1, 1994.

Interest rate policy was the least affected area of the traditional macroeconomic policy environment. Under the strategy to develop heavy industry, the interest rate was kept artificially low to facilitate the expansion of capital-intensive industries. After the reforms started, the Government was forced to raise loan rates and savings rates several times.25 However, the rates were maintained at levels far below the market-clearing rates throughout the reform process. In late 1993, the Government announced a plan to establish a development bank with the function of financing long-term projects at subsidized rates and to turn the existing banks into commercial banks. The completion of this reform is expected to take three to five years. Moreover, it is unclear whether after the reform the interest rate will be regulated or will be determined by markets. The mentality behind the heavy-industry strategy is deeply rooted in China’s political leaders. To accelerate the development of capital-intensive industry in a capital-scarce economy, a distorted macroeconomic policy environment—at the very least in the form of a policy to maintain a low interest rate—is essential. It is likely that administrative interventions in the financial market will linger for an extended period.

Consequences of Reform

Because the reforms of macroeconomic policies, especially those regarding the interest rate, lagged behind those in the allocation system and micromanagement institutions, there were several economic consequences.

Growth and Inflation Cycles

The policy of interest rate suppression has not yet been eliminated. Because of the below-market clearing rate, enterprises have incentives to obtain credits in excess of the supply. Before the reforms, the excess demand for credit was suppressed by restrictive central rationing, and inflation was therefore under state control. Since the initiation of reform, especially since the banking system reform in 1984, whenever the Central Government’s direct control of credit rationing has been relaxed, an investment rush has occurred. On the one hand, because the expansion in credit during an investment rush is not supported by an increase in savings, the bank must finance the credit expansion by creating additional high-powered money. On the other hand, the rush leads to an investment-led growth and a bottleneck in transportation, energy, and the supply of construction materials. Therefore, the high growth rate that is fueled by the expansion of credit and the money supply inevitably results in a high inflation rate subsequently. Because the Government is reluctant to increase the interest rate as a way to check the investment thrust and high inflation,26 it must resort to rationing credits and controlling investment projects directly. The rationing and controls favor the state sector. The pressure of inflation is reduced, but slower growth follows. As mentioned earlier, although the reforms in the micromanagement system have improved the productivity of the state sector, the deficits of the state sector increase owing to the discretionary behavior of the managers and workers in the state enterprises. Therefore, increases in the Government’s fiscal income depend more and more on the expansion of nonstate sectors. During periods of tightened state control, the growth rates of the nonstate sectors decline because their access to credit and raw materials is restricted. Such a slowdown in the growth rate becomes fiscally unacceptable, and the state is forced to liberalize administrative controls to give the nonstate sectors some room to grow. A period of faster growth follows. Nevertheless, conflicts between the distorted policy environment and the liberalized allocation and micromanagement system will arise again. The cyclical pattern of growth and inflation described above has occurred three times since 1984.

The delegation of credit approval authority to local banks in the autumn of 1984 resulted in a rapid expansion of credit and an investment spurt, which resulted in an investment-led overheating in 1984–85. As a result, the money supply increased 49.7 percent in 1984 compared with its level in 1983, causing the inflation rate to jump from less than 3 percent in the previous years to 8.8 percent in 1985 (see Figure 1). The Government implemented a retrenchment program at the end of 1985 to control investment and inflation, and the rates of growth and inflation dropped in 1986. The Government’s attempt to liberalize prices in early 1988 gave rise to expectations of high inflation. The real interest rates for savings and loans turned negative because nominal interest rates were not adjusted. A panic buying and mini bank run occurred, causing the money supply to increase by 47 percent in 1988 and the inflation rate to reach 18 percent (see Figure 1). This was the first time in the recent history of China that the inflation rate had exceeded two digits. Fearing that inflation might be out of control, the Government again introduced a retrenchment program in October 1988 to directly control credits and investment. The inflation rate dropped significantly after 1989. However, partly because of the retrenchment program and partly because of the mood after the Tiananmen Square incident, the growth rate dropped to less than 5 percent in 1989 and 1990, the lowest growth rate since the reforms were introduced.

Encouraged by Deng Xiaoping’s trip to the south in the spring of 1992, the Government reoriented its policy toward economic growth. The control on credit was relaxed and resulted in another investment spurt. The growth rate of GDP reached 13.6 percent in 1992 and 13.5 percent in 1993. The overheating of the economy had already become apparent in the spring of 1993. The Government attempted to introduce another round of retrenchment in June 1993. Nevertheless, fearing that the momentum of growth might be checked, the Government had difficulty reaching a consensus among the leadership about the desirability of a retrenchment program, and its implementation was softened. As a consequence, the growth rate still reached 11.8 percent in 1994, but the inflation rate escalated to 21.7 percent, the first time inflation had exceeded 20 percent in China since the early 1950s.

The above review shows that, as long as the interest rate is artificially fixed at a below-market clearing level, the existence of a trade-off between growth and inflation is unavoidable during the transition process. To control inflation and the expansion of the money supply, the Government needs to tightly control credit and investment. Slow growth will be the result. A relaxation of control on credit and investment will lead to fast growth. However, a rapid expansion of the money supply and high inflation will follow consequently.

A second consequence of the inconsistency between the distorted macroeconomic policy environment and the liberalized allocation system and micromanagement institutions is rampant rent seeking. After the reforms, market prices exist, legally or illegally, along with planned prices for almost every kind of input and commodity that the state controls. The difference between the market price and the planned price is an economic rent. It is estimated that, in 1988, the economic rent from the controlled commodity price, the interest rate, and the exchange rate was at least Y 200 billion, about 21.5 percent of the national income. In 1992, the economic rent from bank loans alone reached Y 220 billion (Hu, 1994,).27 The nonstate enterprises as well as the autonomous state enterprises certainly have the incentive to engage in rent-seeking activities through bribes and other measures to obtain underpriced resources from the state allocation agencies. It is reported that under competitive pressure, the state enterprises in the heavy industries, which are given priority in obtaining state-controlled resources, also need to make certain side payments to banks and other allocation agencies to secure the earmarked loans and materials or to obtain them promptly.

Because of the rent-seeking activities of other types of enterprises, state enterprises are often unable to obtain the credits and materials earmarked to them in the plans. The rent-seeking activities also cause widespread public resentment and become a source of social instability. To guarantee the survival of the state enterprises and to curb social resentment, the Government attempted to reinstitute tight controls on the allocation system during the retrenchment programs of 1986, 1988, and 1993. However, the controls were relaxed later to allow faster growth. Except for the interest rate, administrative controls on the prices of most materials and commodities have been removed.

Transition in China and Eastern Europe and the Former Soviet Union: A Comparison

The economic problems of prereform China—namely the structural imbalance and the low incentives—are common to all socialist economies because they all adopted a similar economic development strategy and because they all have a similar macroeconomic policy environment, planned allocation system, and puppetlike state enterprises. Empirical evidence shows that, as in prereform China, Eastern European and Soviet economies were all overindustrialized, with oversized state enterprises; their services sectors and light industries were underdeveloped; and employees’ incentives were low (Newbery, 1993; Brada and King, 1991; Sachs and Woo, 1994). The dramatic differences in economic performance during the transitions in China and in Eastern Europe and the former Soviet Union are attributable to the differences in their approaches to reform.

For an economy with a given stock of resources, the efficient point in the production plan is point E; however, under the strategy to develop heavy industry, the actual production point is B, as illustrated in Figure 3. The “big bang” approach to reform attempts to change a country’s whole economic structure immediately so that the existing stock of resources can be used more efficiently. Diagrammatically, the approach attempts to move production from point B to point E. Stabilization, marketization, and privatization are necessary conditions for achieving this goal because, to induce economic agents to move from B to E voluntarily, the agents should have a stable expectation about the economy, correct relative price signals, and the incentives to respond to these price signals. The prescription of stabilization, price liberalization, and privatization is internally consistent. The scheme is equivalent to replacing, in rapid succession, the whole traditional economic structure, shown in Figure 2, which is endogenous to the strategy to develop heavy industry.

If the transitional costs of reform were free, the big bang would enable an economy to jump from point B directly to point E, as the dotted line in panel A of Figure 4 shows. However, some fixed equipment in heavy industries cannot be used for production in light industries; for other equipment, modifications are required for new uses (Brada and King, 1991). Workers in heavy industry also need retraining before they can be assigned to new jobs. Moreover, the establishment of new market institutions takes time and resources (Murrell and Wang, 1993; Lin, 1989). During the initial stage of reforms, an increase in light industry would not compensate for the decline in heavy industry. Therefore, instead of moving directly from point B to point E, the economy moves first from B to F before reaching E. The resulting GNP path of growth is a J-curve, as shown in panel B of Figure 4. How large the decline in GNP would be and how long it would take before recovery would depend on how severe the initial distortion was and how quickly the necessary institutions could be established, which can only be determined empirically. The experiences of Eastern Europe and the former Soviet Union, shown in Table 1, suggest that a decline can be more than 50 percent of GNP and that it will take several years before a turning point is reached. The government is certain to encounter a legitimacy crisis when the results of reforms are so dreadful (Dewatripont and Roland, 1992). The leadership may not be able to hold a consensus on the course of further reforms, and political instability is likely to follow. Instead of a J-curve, the result of shock therapy may be a big “L-curve.” Moreover, the bankruptcy of the oversized capital-intensive, heavy-industry enterprises will cause the unemployment of hundreds of thousands of workers. For fear of a political backlash to mass unemployment, even after state enterprises are privatized, the governments in Eastern Europe and the former Soviet Union must still subsidize the inefficient enterprises by issuing new money (Shleifer, 1995). A drop in GDP and a rapid expansion of the money supply inevitably lead to viciously high inflation in countries that adopt the big bang approach.

Figure 4.Big Bang Reform

When China embarked on reform in the late 1970s, the political leadership did not question the feasibility or desirability of the traditional economic structure. Its intent was simply to improve incentives in the state enterprises and collective farms by giving agents some autonomy so that a closer link could be established between personal reward and individual effort. That is, the intent was to move from point B to point A in panel A of Figure 5. The empirical studies cited in the section on China’s development strategy and major prereform problems show that the attempt was successful and that a new stream of resources was created by the reform of the micromanagement system. The granting of partial autonomy was only a small crack in the traditional economic structure. However, the partial autonomy also implies that entrepreneurs gained partial control over the allocation of the newly created stream of resources. The suppressed sectors in the traditional economy are those that represent the comparative advantages of the economy. The unexpected results of the micromanagement reform are that, driven by profit motivation, autonomous entrepreneurs allocated the new stream of resources under their control to the more profitable suppressed sectors. Because the planned allocation system and distorted macroeconomic policy environment were preserved, the state still controlled the old stream of resources and dictated that these resources be allocated to the priority sectors. That is, the economy followed a dynamic path from point A to a point close to G, instead of to H, in panel A of Figure 5. Therefore, throughout the reform, the economy has enjoyed continuous growth, as shown in panel B of Figure 5. Moreover, as the economy grows, the proportion of resources allocated according to the planned prices diminishes. Therefore, by the time the price of a commodity was liberalized, the shock was much smaller than the gap between the market price and the plan price would have suggested.28 Nevertheless, because the reform in the policy environment lagged behind the reforms in micromanagement institutions and the resource allocation system, a cyclical growth pattern will exist until the macroeconomic policy is eventually liberalized and consistency is restored to the economic structure.

Figure 5.Gradual Reform

Concluding Remarks

The traditional economic structure of a socialist economy—the distorted macroeconomic policy environment, the planned resource allocation system, and the puppetlike micromanagement system—was a product in China of institutional innovation induced by the Government’s attempt to pursue a strategy to develop heavy industry in a capital-scarce economy. This structure made possible the accumulation of resources for building up the sectors that would receive priority under the strategy. However, economic efficiency was low owing to the unbalanced production structure and the suppression of incentives. Despite the differences in the initial conditions and the stage of development in China and in Eastern Europe and the former Soviet Union, their prereform economic structures and problems were similar because they all pursued a strategy to develop heavy industry in a capital-scarce setting.

When China embarked on reform, the leaders did not have a blueprint. The Government’s initial objective was simply to improve economic inefficiency by giving partial autonomy to micro agents so as to strengthen the incentive mechanism. However, once the integrity of the traditional economic system was broached by the introduction of enterprise autonomy, institutional changes occurred that laid the groundwork for a more efficient market system. China’s transition, therefore, has followed a path that can be explained by the theory of induced institutional innovation (Lin, 1989; North, 1990). In the process, the efficiency of the state enterprises was improved through greater autonomy and through competition from the nonstate sectors. However, the dynamism of the economy came mainly from the swift entry of new small nonstate enterprises. The old planned allocation system and distorted macroeconomic policy environment gradually became unsustainable and were discarded. During the reform process, the state, the enterprises, and the people have had time to adjust to the new market system. The reforms benefit the majority of the population as the economy continues to grow strongly. However, a cyclical growth pattern is inevitable unless the macroeconomic policy environment is further liberalized so as to establish the structural integrity of a market economy.

Using the big bang approach, Eastern Europe and the former Soviet Union have also attempted to replace an inefficient economic system with a more efficient market system. Small, privately owned firms emerged immediately after the lifting of the ban on private enterprises. However, the privatization of medium- and large-scale state enterprises was prolonged and proceeded slowly in many of the countries (Murrell and Wang, 1993; Wang, 1992), and the swift privatization in Russia did not harden the large enterprises’ budgets (Shleifer, 1995). This resulting enterprise mix is in fact similar to what emerged in China. However, China’s approach did not disrupt production in the state sectors. Therefore, China’s gradual approach to reform achieved the same positive effects of the big bang approach but avoided the collapse of production and the disruption of a hyperinflation caused by the big bang approach.

Adopting capital-intensive industries as the priority sectors at a capital-scarce stage is a common phenomenon not only in the socialist economies but also in many developing countries. All these economies had a similar economic structure and experienced similar economic problems. Therefore, the experience of China’s reforms may yield useful lessons for designing reform policies in other economies where the heavy-industry strategy or other similar development strategies have been adopted under capital-scarce conditions. Certainly, stage of development, endowment structure, political system, and cultural heritage differ from one economy to another. To be effective, a reform should take the economy’s initial conditions into consideration and exploit all favorable factors inside and outside the economy. Therefore, the specific design and sequence of reforms in an economy should be “induced” rather than “imposed.” However, the Chinese experience shows that it is possible to tap the potential provided by the suppression of incentives and imbalance in the production structure in the prereform economy as a way to achieve growth and to avoid hyperinflation during the transition.


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Note: This paper draws heavily on Justin Yifu Lin, Fang Cai, and Zhou Li (1994 and 1995).


The collapse of international trade owing to the dissolution of the Council for Mutual Economic Assistance (CMEA) has also contributed to the decline of GNP in these countries. However, shock therapy was undoubtedly a major cause of these downfalls (Brada and King, 1991; Csaki, 1994).


Perkins and Yusuf (1984, p. 4) noted that a unique feature of China’s economic development under socialism was the Government’s ability to implement village-level programs nationwide through bureaucratic and Communist Party channels. Therefore, the Government was able to impose certain institutional arrangements in the economy that were deemed important on the grounds of ideology or economic rationality and that may not be feasible in other economies (Perkins, 1966).


The five-year plans were disrupted in 1963–65, the period immediately after the agricultural crisis of 1959–62. The First to the Seventh Five-Year Plans covered, respectively, 1952–57, 1958–62, 1966–70, 1971–75, 1975–80, 1981–85, and 1986–90.


The construction of a light-industry project, such as a small textile factory, takes one or two years to complete. The construction of a large heavy-industry project, in general, takes much longer. For example, in China the average construction time for a metallurgy plant is seven years, for a chemical plant, five to six years, and for a machine-building plant, three to four years (Li and Zheng, 1989, p. 170).


Three percent a month was a normal interest rate in the informal financial markets that existed before the adoption of the development strategy. It is equivalent to 36 percent a year.


The spontaneous development of heavy industry was impossible for several reasons. First, the high interest rates made any project that required a long gestation unfeasible. For example, as indicated in footnote 4, it takes on average seven years in China to complete the construction of a metallurgy plant. The market interest rate in the early 1950s in China was about 30 percent a year (2.5 percent a month). If the fund for the project were borrowed at the market rate and repayment were made after the completion of the project, the principal and interest payment, calculated at a compound rate, for each dollar borrowed in the first year of the project would be $6.27. It is obvious that no project would be profitable enough to shoulder such a high interest burden. Second, since most equipment had to be imported from more advanced countries, the limited supply of foreign exchange again made the construction of heavy industry expensive under the market-determined exchange rate. Third, because the agricultural surplus was small and scattered, it was difficult to amass enough funds for any lump-sum project.


For example, the interest rate on bank loans was officially reduced from 30 percent a year to about 5 percent a year. For a $1 fund borrowed at the beginning of a seven-year project, the principal and interest payment at the time that the project was completed would be reduced from $6.27 to $1.41.


Although real GNP per capita tripled between 1952 and 1978, the nominal wage was kept almost constant, increasing only 10.3 percent during the same period (State Statistical Bureau, 1987a, p. 151). However, because of in kind subsidies, real wages to urban workers were not as low as nominal wages suggested. Moreover, urban wage rates may decline sharply if the restriction on the rural-urban migration is removed. We owe this point to an anonymous referee. For a more detailed discussion of the formation of low nominal-wage policy, see Cheng (1982, chap. 8) and Wu (1965, chap. 4).


Even with all the price distortions that facilitated the development of heavy industry in China, the time required for a heavy-industry project to earn back the capital investment was, on average, about four to five times longer than for a light-industry project (Li, 1983, p. 37). Therefore, a profit-maximizing private owner would have higher incentives to invest in a light-industry project.


Under the New Democracy Policy, adopted by the Communist Party in the late 1940s, private enterprises were supposed to coexist with state-owned enterprises for an extended period after the revolution. However, the enterprises were nationalized after 1952 when the Government adopted the heavy-industry strategy. The attempt to secure profits for the heavy-industry projects was the motivation for the Government’s change in position toward private enterprises.


Theoretically, the Government could use subsidies instead of distorting price signals as a way to facilitate the development of capital-intensive heavy industry in a capitalscarce economy. It can be shown that the subsidy policy is more efficient economically than the policy of price distortion. However, with the subsidy policy, heavy industry would incur a huge explicit loss and the Government would have to tax other sectors heavily to subsidize the loss. In such a situation, the Government would find it difficult to defend its position of accelerating the development of heavy industry. Moreover, the government in a developing economy may not have the ability to collect huge taxes. This may explain why governments, not only in socialist economies but in capitalist economies, use price distortions instead of subsidies to facilitate the development of priority sectors.


In the literature on China and other socialist countries, many authors presumed that the distorted policy environment and administrative controls were shaped by socialist doctrines. Although the socialist ideology might have played a role in the formation of these policies, the existence of these policies and controls also has an economic rationale. They facilitate the implementation of the heavy-industry strategy in a capital-scarce economy. This explains why nonsocialist developing economies, such as India, also had a similar policy environment and administrative controls when they adopted the same development strategy.


An enterprise is bound to be loss-making if its outputs happen to be inputs to the other sectors, for example, energy and transportation, because the prices of its outputs are suppressed. On the contrary, an enterprise is bound to be profit-making if its outputs are at the low end of the industrial chain, because the enterprise can enjoy low input prices and high output prices at the same time.


State enterprises were granted some autonomy after the reforms in the late 1970s. As expected, one of the results of this reform was a rapid increase in wages, bonuses, and fringe benefits at the expense of enterprises’ profits.


When the reforms started, the Government initially planned to increase the share of agriculture in the state’s fixed capital investment from 11 percent in 1978 to 18 percent in the following three to five years. Owing to the rapid agricultural growth brought about by the rural reforms, agriculture’s share in the state’s fixed capital investment actually declined sharply to only about 3 percent in the late 1980s and early 1990s. However, the share of total fixed capital investment in agriculture in the nation as a whole did not decline as much as the figures suggest, because part of the decline in state investment was compensated for by an increase in farmers’ investment (Feder and others, 1992). Similarly, the share of heavy industry in the state’s fixed capital investment did not decline after the reforms. However, the state’s share in total investment declined from 82 percent in 1980 to 66 percent in 1990. Investments of sectors other than the state sector are mostly on projects that are less capital intensive. Therefore, the share of heavy industry in the nation’s fixed capital investment is less than the share in state investment.


Similarly, the development of a services sector was suppressed so as to facilitate the development of heavy industry. Agriculture, except for grain and cotton, was also suppressed. Grain and cotton were treated differently because the Government also pursued a grain self-sufficiency policy, and cotton was the basic raw material for industry.


The studies by Desai and Martin (1983) and by Whitesell and Barreto (1988) estimate the misallocation of capital and labor among the sectors of the Soviet economy, which also adopted a strategy to promote the development of heavy industry. Desai and Martin find losses from misallocation in the range of 3–10 percent—possibly up to 15–17 percent of the inputs employed in industry. Whitesell and Barreto find that in the early 1980s output gains equivalent to 4–6 percent could have been achieved through a reallocation of capital and labor among the sectors of Soviet industry.


The average annual rate of accumulation was raised from 24.2 percent of national income in the First Five-Year Plan to 33.0 percent and 33.2 percent in the Fourth and Fifth Five-Year Plans, whereas the average annual growth rate of national income dropped from 8.9 percent to 5.5 percent and 6.1 percent. As a result, wages for state employees were held almost constant between 1952 and 1978. As Deng Xiaoping admitted to visiting overseas Chinese in October 1974, wages were low, the living standard was not high, and workers in China only had enough clothing and a full stomach (Cheng, 1982, p. 248).


Brada (1991) estimates that overstaffing in industry in the former Czechoslovakia was as high as 15 percent. The State Economic System Reform Commission estimated in a recent report that the total number of excess staff in China’s state enterprises was more than 30 million, about 30 percent of the total labor force in the state sectors (“Over-Staffing in the State Enterprises Is over 30 Million,” 1995). Studies by the World Bank (1985a) show that, for the production of per unit GDP, the consumption of energy, steel, and transportation in China was, respectively, 63.8–229.5 percent, 11.9–122.9 percent, and 85.6–559.6 percent greater than those of other developing countries. In the structure of total capital, working capital accounted for the largest share in China and was 4.8–25.7 percentage points higher than that of other countries. This implied that inventories of inputs and outputs were larger and that inventories were kept longer in China than in other countries.


Lin (1992) estimates that losses attributable to low incentives in the agricultural collectives amounted to as much as 20 percent of total factor productivity. For a theoretical model of the monitoring problems regarding incentives in a collective farm, see Lin (1988).


The first attempt was made in 1958–60, the second in 1961–65, and the third in 1966–76 (Wu and Zhang, 1993, pp. 65–67).


The emergence of these enterprises and their impact on the reform of state enterprises is discussed in the following subsection.


The nonstate enterprises also include private enterprises, joint-venture enterprises, overseas Chinese enterprises, and foreign enterprises. Among them, the township and village enterprises are the most important in terms of output share and number of enterprises. It is noteworthy that township and village enterprises, although different in many aspects from state enterprises, are public enterprises that are funded, owned, and supervised by the township or village governments.


For example, in 1986 an average industrial enterprise in China had 179.9 workers, and the fixed investment per worker was Y 7,510 (State Statistical Bureau, 1987b, p. 3), whereas an average township or village enterprise in the same year had 28.9 workers, and the fixed investment per worker was Y 1,709 (State Statistical Bureau, 1987a, p. 205).


To stop bank runs, the savings rates were indexed to inflation rates in October 1988. But the policy was revoked in 1991. In May 1993, the interest rate for a one-year time deposit was 9.18 percent, and for a basic investment loan of one to three years it was 10.8 percent (State Statistical Bureau, 1993, pp. 670–71). However, the market rate for a commercial loan was between 15 percent and 25 percent.


The low interest rate policy is necessary if the capital-intensive and loss-making state enterprises are to survive.


The total credit of the state banks was Y 2,161.6 billion ($248.5 billion at the swap market exchange rate). The difference between the official interest rate and the market rate was about 10 percent. The rents from bank loans alone were as high as Y 216 billion.


The official exchange rate was Y 5.7 per US$1, and the swap market rate was Y 8.7 per US$1 when the exchange rate in China was unified to the swap market rate at the beginning of 1994. However, the shock was very small because before the unification about 80 percent of the foreign exchange had already been traded in the swap markets.

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