Information about Asia and the Pacific Asia y el Pacífico

II Overview of Reforms

Gyorgy Szapary, Steven Dunaway, David Burton, and Mario Bléjer
Published Date:
March 1991
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Information about Asia and the Pacific Asia y el Pacífico
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In late 1978 China announced a program to reshape its economy. Over the subsequent ten years, economic reform involved the relaxation of direct planning controls, the decentralization of economic decision making, increased reliance on market forces in setting prices and output, the development of nonstate-owned economic entities, and an opening of China’s economy to the outside world. In the agricultural sector, where reform began, responsibility for production was transferred from collectives to households, and a system of purchases through contracts was introduced to replace the mandatory procurement of key agricultural products. In the industrial sector, state enterprises were given greater financial responsibility and granted increased freedom in determining their operations, while cooperative and individually owned enterprises have grown to occupy an important place in the Chinese economy. Price reforms reduced some of the distortions in the price structure and allowed a large number of prices to be determined by market forces. Also, external sector reforms raised incentives for exporters and allowed increased access to foreign resources through direct investment and foreign borrowing.

This chapter provides a more detailed look at the economic reforms implemented in China since 1978 and makes an assessment of their effects. But first, to provide background for this discussion, the structure of the economy prior to the reforms is briefly reviewed.

China’s Economy in Pre-Reform Period and Legacy of Central Planning1

The early years of the pre-reform period witnessed the establishment of the primacy of the state over the economy and centralization of economic control at the national level. Succeeding years were marked by a vacillation between control over the economy by the central government and control by local governments, reflecting a variety of economic as well as political considerations. However, through two complete cycles of centralization/ decentralization of economic control, the basic problems inherent in the economic system were not resolved. Centralized authority, along the lines of Soviet-type central planning, produced economic inefficiencies and a bureaucratism that China’s leaders found objectionable. Decentralization, which involved the transfer of control from central to local government but not greater reliance on market forces, tended to leave economic activity poorly administered and uncoordinated across regions, resulting in major economic disorders.

At the time of the founding of the People’s Republic of China in 1949, the economy was in disarray as a consequence of three decades of political instability and warfare. Production in the industrial and agricultural sectors was substantially below their peak levels of the early 1930s, and the transportation system was in ruins. Furthermore, the financing of war expenditures by printing money had produced hyperinflation. By 1952, however, the economy had been stabilized, primarily through restrictive monetary and fiscal policies, and the transportation system and industrial production had been substantially restored.

During the subsequent two and a half decades of the pre-reform period, China’s output growth averaged about 4 percent a year, as industrial output rose quite rapidly but agricultural production grew on average by only about 2 percent a year. This economic growth was achieved largely by increasing the amounts of labor and capital employed; there was little growth in total factor productivity.2 The average growth rate over this period masked some dramatic swings in output growth primarily associated with the cycles in centralization/decentralization of economic control. Particularly sharp breaks in the pattern of growth and development were experienced over the two periods of decentralized control (the Great Leap Forward and the Cultural Revolution). During these periods, growth was initially stimulated by decentralization, but eventually the economic situation degenerated, resulting in slow economic growth or even declining output, as the policies introduced provided disincentives to production (especially in agriculture) and because of the lack of an effective means of dealing with the economy at a national level.

Although the problems confronting the Chinese economy in the late 1970s were related in part to the dramatic shifts in economic policies that had previously taken place, they were in many respects similar to the problems encountered by other centrally planned economies and included irrational pricing stemming from controls, over-staffing and inefficiency in industry, an emphasis on product quantity and not quality, and isolation from foreign competition. These failings were exacerbated by biases against individual incentives, markets, and labor specialization. In industry, there was effectively no link between individual productivity and remuneration.3 The labor market was virtually nonexistent as a result of rigid restrictions on the geographical mobility of labor, the assignment of jobs to labor market entrants, and the system of lifetime employment under which enterprises provided housing, pensions, medical care, and other forms of welfare benefits. Other markets, most notably financial markets, were also almost entirely absent.

Objectives of and Approach to Economic Reform

By 1978, China’s leaders had reached the conclusion that more extensive use of productive factors was not the best means of achieving substantial gains in output on a sustained basis. To foster rapid growth and development, the economy needed to be restructured so as to enhance the productivity and the efficient use of resources. To achieve this objective, it was decided that market-oriented reforms would be adopted. A blueprint for the structure of the economic system on which the reform process should converge was not established, however.4 Instead, the Chinese authorities adopted a cautious and pragmatic approach. Those aspects of reform that were the easiest to put in place were implemented first. Success in these areas helped to build support for the reform process. The authorities have been relatively quick to change programs in order to solve problems as they have occurred. Moreover, to avoid wide-scale difficulties given the complexity of the task of restructuring China’s economy, reform has proceeded in an incremental fashion. Experiments with different types of reforms have been implemented on a small scale, and only implemented on a wider basis if they proved to be successful.

The basic outlines for economic reforms have been laid out by the Standing Committee of the Politburo of the Communist Party. While more specific measures have generally been developed by the State Council, local government authorities have usually been given considerable latitude in their implementation. As a result, the pace and degree of reform have varied greatly across regions of the country. The authorities in some areas have seized the initiative and pushed ahead with reforms, while others have done only the minimum required to fulfill the central government’s directives.

Experimentation with reform started in rural areas, particularly in the agricultural sector, and reforms subsequently progressed farthest in these areas. Reform began with agriculture because there was a pressing need to expand food production. Also, the task was relatively straightforward since rural households had considerable experience with managing production in response to market signals within the system of individual farm plots and rural free markets. This experience was subsequently applied to manufacturing when increased opportunities were provided to rural enterprises.

Economic reform in urban areas, which began on an experimental basis in 1979 but which was not undertaken on a large scale until 1984, was more complex because of the greater diversity of the urban economy and its development under direct government control. It involved a broad range of difficult issues with important political and social implications, including questions related to enterprise ownership and management, the role to be played by markets in setting prices, and wage and employment practices. Over time, the authorities recognized more clearly the essential elements of urban reform, including the need for enterprises to be provided with incentives to adopt profit-maximizing behavior. Accordingly, they endeavored to increase the responsibility of enterprises for their financial performance (i.e., to harden their budget constraints) and to grant them greater autonomy in making personnel, management, and production decisions. It was also recognized that in order to provide enterprises with proper signals on which to base their decisions, price reform was needed to allow prices to reflect more accurately supply and demand conditions. At the same time, reform of the foreign exchange and trade systems was required to provide incentives to exporters, increase competition, and to allow greater access to foreign resources through direct investment and borrowing abroad.

Decentralization of decision making also called for reform at the macroeconomic level, since the ability of the Government to control the economy directly was to be reduced. The progress that has been made in developing alternative indirect methods of macroeconomic control, particularly in the areas of monetary and fiscal policy, is considered in Chapter III.

Agricultural Reform

Prior to 1979, agricultural production was organized according to communes that consisted of brigades and teams.5 Detailed production planning decisions were made by higher level authorities and often did not take into account local conditions. Remuneration for workers was based on the total income of the commune and was not closely linked to individual productivity. However, farmers generally were allowed to have private plots of land and to market their production from them at rural trade fairs, although restrictions were frequently imposed on private production and trade.

The inefficiency of the agricultural sector prior to the reforms was reflected in slow growth of production. To improve agricultural performance, the Government initiated reforms in the rural areas in 1979.6 The size of private farm plots was increased, diversification of production was encouraged, and rural free markets for agricultural products were allowed to grow. Experiments were conducted with various methods of giving individuals greater autonomy, and by 1984 the household responsibility system had emerged as the dominant arrangement. Under this system, the right to use collectively owned land was contracted to farm households for a fixed period.7 The house-hold was responsible for meeting a share of the production team’s mandatory state procurement quotas, taxes on agricultural output, and contributions to collective services. After meeting these obligations, the household was allowed to dispose of its output either by selling to the state at negotiated prices or in the rural free markets. Although households were given greater discretion with regard to crops raised, they were still heavily influenced in making these decisions by the Government’s production plans.

The household responsibility system, together with increases in the relative prices of agricultural products, unleashed substantial productivity gains and resulted in a diversification of agricultural production.8 However, these achievements were costly to the Government budget, with consumer subsidies for food items increasing significantly as the increases in state procurement prices were not fully passed on to consumers. Mandatory procurement was replaced in 1985 with a voluntary contract system under which individual farmers may choose to sign contracts to provide specified amounts of certain crops, including grains and cotton, at prices set by the state.9 The quantities of major crops contracted for were generally lower than the amounts procured under the previous system, but subsidies for agricultural products continued to rise as state-fixed prices for consumers failed to keep pace with increases in procurement costs.

The growth rate of agricultural output averaged nearly 8 percent a year during 1979–84, compared with growth of less than 2 percent a year in 1958–78.10 However, it declined to about 3 percent a year during 1985–88, and the production of grain remained below its 1984 peak. Some slowdown was probably inevitable as the rapid growth rates achieved in the preceding period were partly the result of once-and-for-all productivity gains resulting from the dismantling of the commune system. But the weaker growth performance also reflected a substantially smaller improvement in the relative prices of agricultural products than in 1979–84. In particular, grain prices were raised more slowly than prices for other agricultural products in order to contain the growth in subsidies.11

A number of other factors also contributed to the slow-down in agricultural growth. Attractive opportunities became available for farmers to invest in nonagricultural activities during the 1980s, especially in the rapidly growing rural industries. Farmers have also invested a substantial portion of their increased incomes in housing rather than in improvements to the land, reflecting concerns regarding the permanence of reforms in view of the past instability of ownership arrangements for productive assets; private housing is the only significant rural asset for which the ownership rights have not been altered in the past. A low level of investment by farmers and the state has resulted in some deterioration in rural infrastructure, especially irrigation facilities. Inadequate transport, processing, and storage facilities and inefficient marketing systems also have been important constraints on agricultural growth. To improve the situation, the Government since 1987 has taken steps to increase state agricultural investment, particularly in irrigation. In addition, the transfer of land use rights was legalized in 1988 with a view to encouraging private on-farm investment.

Enterprise Reform

Rural Enterprise Reforms

Since 1979, restrictions on nonagricultural activities in the rural areas have been relaxed, and enterprises in these areas have been allowed to sell their products at market prices. As a result, a large number of individually or collectively owned enterprises were established or expanded in townships and villages.12 These township and village enterprises (TVEs) absorbed significant amounts of the surplus labor that emerged as agricultural efficiency increased following the implementation of the household responsibility system. Competition in input and output markets is generally tougher for the TVEs than for state enterprises and their budget constraints are harder, reflecting their less easy access to subsidies and credit. Consequently, they have proved to be more flexible and more responsive to changes in market conditions than their counterparts in the state sector. Productivity has been hampered, however, by dated technology and uneconomic scales of production that reflect the community orientation of TVEs. Nevertheless, the TVEs have made an important contribution to China’s development by providing competition for state enterprises and creating an environment for the development of entrepreneurial expertise. By 1987, the output of TVEs had risen to account for nearly one fourth of the gross value of industrial output, and the TVEs employed roughly 88 million workers (17 percent of the labor force).

State Enterprise Reforms

State enterprises before reform were centrally controlled via the plan, leaving enterprise managers little or no room for initiative with respect to production, pricing, marketing, and investment. Enterprises transferred all their surplus funds to the state, while losses were covered by budget subsidies. Investment funds and some working balances were provided to the enterprises through the government budget in the form of grants; the banking system supplied additional working capital. Wages were paid according to a centrally approved wage scale, and age was a major determinant of wage differences among workers. Under this system, enterprises were not held responsible for their financial results; instead, their main responsibility was to fulfill quantitative output targets established by the plan. Enterprise managers therefore had little incentive to improve efficiency and productivity.

The focus of enterprise reforms has been on increasing incentives by enhancing the enterprises’ decision-making authority and by providing them with greater financial resources, while making them more responsible for their own profits and losses.13 Following some experimentation, the Government in 1983 initiated a changeover on a national scale from profit transfers to income taxation, and by 1986 profits of almost all enterprises were subject to taxation rather than being fully remitted to the Government. Since 1986, the Government has attempted to reduce the interference of government authorities in the day-to-day operations of the enterprises through the introduction of a contract system for medium- and large-scale enterprises, leasing arrangements for smaller enterprises, and to a very limited extent the establishment of joint stock companies. About 90 percent of medium- and large-scale state enterprises had signed management contracts by 1988.14 These contracts generally specify targets for the expected performance of the enterprises, quotas for output to be sold at state-fixed prices, and obligations to the Government, generally in the form of taxes. Leasing arrangements have generally been used for small enterprises in the service sector. The lessee is entitled to all income left over after payment of taxes and the leasing fee.

A new national bankruptcy law was enacted in 1986 and came into effect in June 1988. It contains provisions allowing state enterprises to go bankrupt in cases where such firms suffer serious losses and cannot repay debt because of poor management. While enterprises or their creditors can apply for bankruptcy proceedings, the consent of the governmental department supervising the enterprise is required. Thus far, however, the authorities have been reluctant to allow the provisions of the bankruptcy law to be fully implemented partly because of concern for the implications for unemployment. Consequently, no major state-owned enterprises have been declared bankrupt, although some forced mergers have been reported.

In line with the increase in autonomy granted to enterprises, the scope of mandatory planning was significantly reduced. The proportion of fixed investment by state enterprises financed through the state budget declined sharply, falling from 60 percent in 1978 to about 14 percent in 1988, as enterprises were allowed to retain a portion of their earnings. At the same time, the number of products that are allocated through the output plan declined from about 250 items in the early 1980s to approximately 20 items in 1988. In addition, a smaller portion of the production of these items is under direct central control, although this development has been partly offset by greater control of local authorities over allocation. But despite the reduced scope of planning controls, the bulk of production of important intermediate products, including steel, coal, petroleum, and electricity remains under central and local government control.

While reforms contributed to a pickup in the growth of output by the state enterprises, their share in total industrial production fell from 81 percent in 1978 to 60 percent in 1987, reflecting the greater dynamism of nonstate enterprises and the substantial problems that continue to restrict the efficiency of state enterprises.15 The limited duration of management contracts (typically three to five years) creates incentives for management to focus on short-term rather than long-term profit maximization. Marginal tax rates also vary substantially across enterprises and costs differ because of unequal access to raw materials at state-fixed prices. These factors together with price controls and variable access to cheap credit and budgetary subsidies have distorted production and investment decisions. In addition, even under the contract management system, government interference in the management of enterprises, including over the quantity and composition of production and employment decisions, remains significant.

Reforms in Retail Trade and Services16

Until 1978, retail trade was mostly managed by the Government, with state enterprises accounting for over 90 percent of total retail sales. Since then, liberalization of the service sector has resulted in a substantial increase in the number of shops and restaurants and in the provision of personal services. During 1984—85, the management of about three fourths of small state enterprises in the commercial sector was contracted or leased to collectives or private individuals. Consequently, the share of retail sales conducted by collective enterprises and individuals increased from about 9 percent in 1978 to 53 percent in 1987. Also, as discussed above, the procurement and marketing procedures for agricultural commodities were liberalized significantly, and an increasing proportion of industrial commodities was marketed outside the central plan. However, measures introduced in 1988, as part of the efforts to fight inflation, reestablished state controls over the distribution of a number of commodities and raw materials.

Although commercial reform measures contributed to rapid growth of retail sales (averaging about 11 percent per year in real terms during 1979–87), China’s distribution system remains inefficient. In particular, inter-regional flows of goods are still subject to restrictions, reflecting local governments’ control over the distribution of goods that remain subject to mandatory planning.

Reform of the Price System

Prior to 1979, most prices were controlled by the state and changed only infrequently. As a result, domestic prices reflected neither relative scarcities nor prices on international markets. Price reform measures implemented since 1979 have involved both administrative price adjustments and price liberalization. The former began with a large increase in state agricultural procurement prices in 1979, followed by increases in consumer prices of nonstaple foods. Subsequently, a number of further price adjustments were made for grains, textiles, petroleum products, transport services, and major non-staple foods, such as eggs, pork, and vegetables.17

Price liberalization began with the introduction of the two-tier price system. This system was first introduced in the rural areas where farmers sold their output up to a quota amount to the state at fixed prices and then were allowed to sell above-quota output to the state at negotiated prices or on the free market. Selected state enterprises were also permitted to sell a portion of their output of certain products at negotiated prices on an experimental basis. Nevertheless, until 1984 the retail prices of most important consumer goods and industrial raw materials and the procurement prices of major agricultural commodities continued to be set by the state.

Following the expansion of the decision-making power of state enterprises in 1984, the two-tier price system was extended to cover a wide range of products.18 At the same time, the prices of other products were allowed to be freely determined or were negotiable within state-established guidelines. Enforcement of price guidelines generally has been left to the local authorities and the flexibility in pricing of goods subject to guidelines varies across regions. In general, however, “guided” prices have tended to move closely in line with market prices. The share of goods subject to mandatory planning and state fixed prices was reduced from two thirds of total retail sales in 1978 to about one third in 1988. Similar proportions of 1988 retail sales took place at market prices and “guided” prices. The remaining controls, however, have been reflected in production bottlenecks in such areas as energy and transportation.

The current two-tier price system has contributed to an increase in the efficiency of producers because it provides better signals for the guidance of production decisions at the margin. Under the two-tier system, however, enterprises have the incentive to negotiate for high levels of inputs at fixed prices and low quotas for output to be sold at state-fixed prices. Also, to the extent that these administered variables have been adjusted as production has increased, the ability of the two-tier system to provide appropriate incentives at the margin has been weakened. In addition, differences in output quotas and supplies of inputs at fixed prices across enterprises result in variations in profitability that can affect the ability to invest. The two-tier price system also provides substantial opportunities for arbitrage, and there has been growing concern about the corruption that it has spawned.19

Following the surge in inflation during 1987–88 (see Chapter III), there was some retrenchment in the area of price reform as the authorities focused on bringing inflation under control. While raising procurement prices of certain agricultural products, retail prices of several non-staple food items, and energy prices, the authorities in late 1988 and 1989 moved to tighten administrative controls on prices, although the extent of the tightening varied among provinces. State-fixed prices were to be more rigidly enforced, slower increases also were mandated for a number of items subjected to guided prices, and steps were to be taken to see that guidelines for these prices were more strictly observed. At the same time, the authorities indicated that further significant price reforms would be delayed.

Reform of the Wage System and the Labor Market20

Wage Reforms

The pre-reform labor compensation system provided no direct link between individual productivity and compensation. With the introduction of the household responsibility system, a link between work effort and rewards was re-established in the rural sector, first in agriculture and then in rural industry and commerce. In urban areas, bonuses were reintroduced in 1978 to improve work incentives. They were paid out of retained profits and were subject to ceilings equivalent to 2½ to 3 months salary. Enterprises also were encouraged to link workers’ pay to their performance.

In 1984, a system under which wages and bonuses are linked to certain performance indicators of enterprises, such as the value of sales or profits, was introduced on an experimental basis, and by 1988 it had been extended to about 30 percent of employees in state enterprises. Typically, a 1 percent increase in tax and profit payments warrants an increase of between 0.3 percent and 0.7 percent in the wage bill, with the exact ratio set by the Government. Within the total payroll norm, enterprises are permitted discretion over the internal distribution of wages and bonuses. Enterprises operating under the new system are subject to a progressive wage regulatory tax on the excess of the wage bill over the specified norm. In 1985, the Government implemented a comprehensive wage restructuring in government departments and institutions to establish closer links between wage rates and job responsibilities, and in 1987 the wages of certain professionals were increased.

By and large, wage reform in urban areas has proceeded slowly. Most enterprises still distribute bonuses to workers on a relatively egalitarian basis. Also, despite the tax on wages and bonuses in excess of the prescribed limits, such payments have increased significantly in recent years, particularly in 1988. Enterprises have sought to compensate workers for increases in the cost of living, and local authorities have not strictly implemented penalty taxation. Furthermore, remuneration had increasingly been provided in kind to escape the penalty. The ability of enterprises to grant excessive wage increases and bonuses also has been facilitated by their relatively easy access to credit and subsidies—the soft budget constraint.

Labor Market Reforms

Labor market rigidities in China were the result of the system of job assignments and lifetime employment, enterprise-based welfare programs (including housing and pensions), and restrictions on geographical labor mobility. In order to increase the flexibility that enterprises have in managing their labor force, a contract labor system was introduced in 1986 under which all new workers in state enterprises, with a few exceptions, have been hired on a contractual basis for a period of usually three to five years. Contract workers are usually paid higher wages than life-time employees and are entitled to unemployment insurance, while generally receiving the same rights as other workers and the same fringe benefits. In 1987, contract workers accounted for 8 percent of the total workers in state enterprises. Enterprises have also been given greater freedom in selecting employees and, in principle, they have been allowed greater latitude in dismissing or re-assigning unsatisfactory workers.

Welfare programs in the urban areas have been largely provided by enterprises, a system that not only limits inter-enterprise labor mobility because of nontransferability of benefits between enterprises, but also tends to place unequal burdens on older enterprises with large pension bills. Since 1986, pension pools covering a number of enterprises have been established on an experimental basis. Unemployment insurance schemes have also been established in various regions to protect contract workers and workers of enterprises that might be closed under the implementation of the bankruptcy law. In addition, experiments in housing reform, including private ownership, have been initiated with a view to enhancing labor mobility.

Restrictions on geographical labor mobility were eased through a system of temporary residence permits which allow rural residents to provide services in urban areas, although in 1989 these restrictions were tightened in response to growing unemployment in urban areas. Temporary residence permits have also been used in some industries in urban areas that face labor shortages. Restrictions on geographical mobility were also lifted for some university graduates.

Despite the reforms introduced over the past ten years, the current system still allows individuals little choice of employment and geographical mobility remains limited. Also, since enterprises are not granted sufficient power to dismiss labor, underemployment is a serious problem in the state enterprise sector.21

Reform of External Policies22

External sector reform has facilitated the modernization of China’s economy and in the process has had a substantial impact on its structure. With the liberalization of the external sector, exports have diversified and grown rapidly, almost doubling in relation to GNP to about 11 percent of GNP during the period 1980–88.

Trade System

Prior to 1978, China’s foreign trade was handled exclusively by 12 state-owned foreign trade corporations (FTCs) organized along product lines, each having a monopoly in its area. Levels of exports and imports each year were established and controlled in the context of a central planning system for trade, administered by the Ministry of Foreign Trade (MFT).23 Once the trade plan was determined, the FTCs implemented it under the direction of the MFT (and later MOFERT), purchasing goods for export and selling imported goods at their domestic prices. Financial losses incurred were covered by budgetary grants; profits were, fully remitted to the state. By conducting trade through the FTCs, the tradable goods sector of the domestic economy was effectively insulated from the rest of the world, and the trade plan provided a direct means of centrally controlling China’s balance of payments.

In 1978, the leadership decided that China could not modernize itself rapidly unless it expanded its economic relations with the rest of the world. Through exposure to competition from foreign firms, the efficiency of China’s tradable goods sector could be improved and greater access to advanced technologies would be provided. In reforming foreign trade, the Government followed a strategy similar to that used domestically: control over trade was decentralized, and entities engaged in foreign trade were given greater discretion and made responsible for their financial performance.

As part of the reforms, the structure of the plan was changed substantially and the influence of local governments and enterprises in determining it was increased. The plan was revised to consist of two parts: the command plan and the guidance plan. The command plan establishes mandatory levels for the volume of exports and imports of key commodities, whereas the guidance plan assigns targets for the value of exports and imports of certain products to local governments and FTCs that have considerable flexibility in determining how to achieve the targets.24 Over the years, the number of products subject to command and guidance planning has been reduced significantly.

As the role of the trade plan has decreased, direct control over exports and imports has been exercised increasingly through a licensing system. The number of items subject to licensing has varied over time depending on developments in China’s balance of payments and, more recently—particularly with regard to export licensing—depending on whether there are adequate domestic supplies.25 Export and import duties also have played a greater role in influencing the quantity and commodity composition of trade flows.

Competition in the trade sector was increased through the abolition of the monopoly powers of the central FTCs and by allowing provincial authorities to establish their own trading corporations. Also, steps were taken in 1984 to make FTCs responsible for their financial performance and to begin to pay taxes instead of remitting their profits to the state. At the same time, the “agency system” was established under which an FTC, on behalf of a domestic entity, conducts trade transactions for which a fee is charged. In 1988, most local branches of national FTCs were made independent entities responsible for their financial results, the operation of the agency system was extended, and a number of domestic enterprises were authorized to engage directly in foreign trade. These developments increased the extent to which changes in international prices were passed through to domestic prices of imported goods and to exporters.26 More recently, the authorities, concerned about a number of cases where contracts with foreign traders were broken, have begun to screen FTCs with a view to dissolving or merging unqualified corporations.

Foreign Investment

In a sharp break with previous policies, China began in 1978 actively to pursue foreign capital both through opening the economy to direct investment and by borrowing abroad.

Direct investment was viewed as a way to avoid incurring an unduly heavy foreign debt burden and as an effective means of transferring technology to China. Initially, it was envisaged that foreign investment would be restricted to particular organizational structures (primarily joint ventures), certain types of activities, and particular areas of the country. In line with this approach, special economic zones (SEZs) were established in 1980 as the principal areas for direct investment (see Osborne (1986)). These were patterned after the export processing zones that had been established in other Asian countries and offered preferential tax and tariff rates and tax holidays. In 1984, it was decided to promote foreign investment on a wider geographic basis and 14 coastal cities and Hainan Island were permitted to offer tax incentives for such investment similar to those offered by the SEZs. Over time, the authorities also have become less concerned about the ownership structure of foreign investment enterprises and have allowed wholly foreign-owned firms to be established.

Although China had considerable success in attracting foreign investment, there were increasing complaints from foreign investors that the business environment in China was not favorable. Draft regulations on direct investment issued by the State Council in October 1986 were designed to increase the attractiveness of direct investment. They provided for reductions in taxes, and the costs of certain inputs, including labor27 and promised improved access for important inputs under state control, such as energy and transportation. Also, approval and licensing procedures for foreign investment enterprises were streamlined. Another important measure was the establishment of limited foreign currency markets that relieved the requirement for individual foreign investment enterprises to balance their foreign exchange receipts and expenditures (see below).

External Debt

The authorities have a generally cautious approach to foreign borrowing, but external debt nevertheless rose sharply, particularly during 1985–88. The increase reflected in part a proliferation of entities at the local level with the authority to borrow abroad. Concern about the increase in foreign debt led to the establishment in 1987 of a debt registration and monitoring system under which all entities have to register their debt with the State Administration of Exchange Control (SAEC). Further steps were taken in early 1989 to strengthen control over external borrowing. According to the new regulations, all commercial borrowing requires the approval of the People’s Bank of China (PBC) and commercial borrowing is to be channeled through one of only ten authorized domestic entities.28

Exchange System

During the early stages of the reform process, the authorities experimented with various types of arrangements for sharing foreign exchange with the objective of strengthening incentives for exports. Under the system that has evolved, exporters exchange their foreign currency earnings at the official exchange rate and are given retention quotas with the SAEC equivalent to a portion of such earnings. These retention quotas can be traded in foreign exchange adjustment centers at a market-determined exchange rate. Typically, domestic enterprises are allowed to retain 25 percent of their foreign exchange earnings up to a target amount for such earnings established for each enterprise in negotiations with the Government. In turn, a portion, usually one half, of the foreign exchange retained by the enterprises has to be shared with local governments. Enterprises generally are allowed to retain a major share of foreign exchange earnings beyond the target level. Moreover, in early 1988, retention quotas for domestic enterprises in several industrial sectors and some regions were raised, with quotas for enterprises affected varying positively with the degree of processing of the goods exported and reaching as high as 100 percent.

Superimposed on the system of retention quotas for enterprises is the trade responsibility system introduced in 1988. This regulates the sharing of foreign exchange between the central and local governments. Under this system, all the provinces and municipalities and major cities (i.e., all administrative entities with separate planning) signed three-year contracts with MOFERT. The contracts specify annual export targets for the three-year period, the rates for the sharing of foreign exchange with the center, and the export subsidies, if any, to be provided over the life of the contract.

The official administered exchange rate has been adjusted periodically since 1978 in light of balance of payments developments and movements in costs and exchange rates in China’s major trading partners. The official rate, however, has coexisted at times with other exchange rates that have been used for certain types of transactions. For example, during 1981–84 a separate rate was used for the internal settlement of trade transactions.29 More recently, there has again been a dual exchange rate system with the establishment of the first foreign exchange adjustment centers (FEAC) in late 1986. At these centers, foreign exchange, and later foreign exchange retention quotas, are traded at rates determined by the eligible participants. Initially, market participation was limited to foreign investment enterprises, but was subsequently expanded and by 1988 all domestic entities with foreign exchange retention quotas had been granted permission to trade in the centers. The increasing access to the FEACs provided to domestic enterprises and the widening of the spread between the exchange rate in the adjustment centers and the administered exchange rate served to mitigate the effects on the competitiveness of China’s exporters stemming from the pickup in inflation during 1988.30

Banking and Financial Market Reform31

Banking System

Within the framework of central planning in place prior to 1979, the banking system in China served the limited purposes of providing the credit needed by enterprises to implement the plan for physical output and providing and monitoring cash in circulation in the economy. As decision making was decentralized under the reforms, a greater range of financial services was needed and monetary policy was required to play an increasingly important role in macroeconomic management (see Chapter III). These considerations provided the impetus for the reform of the financial system.

During most of the pre-reform period, the PBC, was the predominant domestic banking institution, basically serving as a “monobank.” With the start of the reforms, separate banks operating in specific sectors of the economy (referred to as the specialized banks) were reestablished.32 In 1984, the PBC was transformed into a separate central bank, and its commercial operations were transferred to the newly established Industrial and Commercial Bank of China. At the same time, the financing of the operations of enterprises began to be shifted from direct grants from the state budget to loans extended by the specialized banks.

Since 1986, two universal banks have been allowed to compete with the specialized banks33 in all areas of activity and a number of new banks at the provincial level have been established. Greater competition and efficiency in the banking system also resulted from measures that reduced restrictions on the activities of the specialized banks and increased the banks’ responsibility for their financial results. In practice, however, the operations of each specialized bank remains concentrated in its particular sector.

While their decision-making authority has increased, the ability of the specialized banks to direct their activities remains severely circumscribed. Most of their lending has continued to be dictated by the Government through the credit plan. Moreover, even nonplan lending has been heavily influenced by governmental pressures, particularly at the local level, to direct funding to particular enterprises. In addition, pressures at the local level have constrained inter-regional transfers of funds between branches of individual specialized banks and have impeded the development of money markets on a national scale. Hence, although a sizable interbank market has emerged, most transactions were between banks or branches within the same province.

Nonbank Financial Institutions

Nonbank financial institutions have become increasingly important over the course of the reform period. International trade and investment companies have accounted for a substantial portion of the bonds issued by Chinese entities abroad since 1982.34 Trust and investment companies (TICs), whose activities include renminbi loans, direct investments, and trust business (primarily directed lending between enterprises using a TIC as an intermediary), expanded rapidly in the late 1980s. Other types of nonbank financial institutions that have been established include leasing companies, securities companies, insurance companies, and financial companies formed by enterprise groups to handle financial services within an enterprise group. The growth of these institutions has reflected not only the higher level of house-hold savings and retained funds of enterprises, but also the desire of depositing enterprises to find an alternative to the low interest rates offered by banks.

Foreign banks play only a limited role in China’s financial system and are not permitted to engage in domestic currency transactions.

Securities Markets

The establishment of securities markets is an integral element in the development of a more efficient financial sector. The issuance of securities in China began in 1981 with the forced sale of treasury bonds to local governments and enterprises. Sales of treasury bonds were extended to individuals in 1982, again on an involuntary basis, although their yields made them attractive alternatives to savings deposits.35 In 1987, the Government began to issue bonds the proceeds of which were earmarked for capital expenditures in priority sectors. Thus far, government bonds have been placed entirely on a nonmarket basis, and although secondary markets for some issues of treasury bonds have been allowed since 1988, the volume of transactions has been limited.36

The range of financial assets issued by nongovernment entities has broadened since 1985, although the total value of outstanding securities remains small in comparison with bank lending. The new instruments include bonds issued by enterprises for which secondary markets have emerged. High yields on these bonds resulted in a substantial flow of funds from savings deposits. With the objective of limiting the growth in enterprise bonds, a requirement that state enterprises obtain prior approval for issuance from the PBC has been imposed.

There has been some experimentation with the issuance of shares as part of the reforms. They were first issued by private companies in 1982 and subsequently by state enterprises beginning in 1985. They typically provide for payment of interest and a dividend depending on the profitability of the enterprises, but they are of finite duration with maturities of one to five years and do not give the purchaser a right to participate in the management of the company. Shares have generally been sold to workers of the issuing enterprise and have been used at times as a means of evading restrictions on wage and bonus payments. In order to control the issuance of shares, rules were established by the State Council under which state enterprises were no longer permitted to issue shares to the general public; cooperatives could continue to do so but under stricter conditions. Thus far, only a small volume of shares has been issued.

Overall, therefore, securities markets are only in the very early stages of development and have yet to have a significant impact on the allocation of financial resources.


For more detailed accounts of economic developments in China during the period 1949–78, see Cheng (1982), Chow (1985), Harding (1987), and Riskin (1987).


Under the so-called iron rice bowl, state enterprises provided life-time employment, and differences in wages were small, primarily reflecting seniority.


For additional discussion of the motivations and objectives of economic reform in China, see, for example, Harding (1987), Perkins (1988), Perry and Wong (1985), and Riskin (1987).


Detailed descriptions of the agricultural sector during the pre-reform period can be found in Cheng (1982), Chow (1985), Lardy (1983), Perkins and Yusuf (1984), and Riskin (1987).


For additional information on agricultural reform, see Harding (1987), Lardy (1986), Perkins (1988), Riskin (1987), and Wiens (1987).


Initially, the contract period was five years. It was extended to 15 years for annual crops and to 50 years for tree crops in 1984, and land use rights were made legally transferable in 1988.


The analysis of China’s agricultural sector in McMillan, Whalley, and Zhu (1989) suggests that roughly three quarters of the increase in agricultural total factor productivity in the period 1978–84 was attributable to the introduction of the responsibility system, while the remainder reflected the influence of the relative increase in agricultural prices.


In practice, farmers to some extent are still compelled to sign procurement contracts with the Government. The degree of compulsion in the current system varies widely from province to province.


The growth of agricultural output in 1979–84 may be biased upward somewhat because prior to 1984 the rapidly expanding output of township and village industrial enterprises was included in the statistics.


As an inducement to farmers to sign procurement contracts for grain, the Government provided farmers with scarce agricultural inputs, such as fertilizers and diesel oil, at heavily subsidized prices.


The contracts are between enterprise management and the level of government responsible for the enterprise. The central government is responsible for many of the largest state enterprises, but most state enterprises are responsible to governments at the provincial, municipal, and county levels.


Nonstate enterprise include township, village, individual, and foreign-owned enterprises.


In some provinces, these nonstaple food prices have been decontrolled.


For additional discussion of the problems with the two-tier price system, see Diao (1987).


For additional information on reforms in this area, see Harding (1987), Riskin (1987), World Bank (1985), and World Bank (1989c).


It is estimated that as many as 20 million people (14½ percent of the urban work force) may be underemployed in the urban areas.


For additional information on reform in this area and the structure of the trading system, see World Bank (1987).


The Ministry of Foreign Trade was the predecessor to the present Ministry of Foreign Economic Relations and Trade (MOFERT).


In some provinces, it appears that guidance plans have been converted into command plans.


At the end of 1988, exports of 165 products required licenses, while 53 types of imports were subject to licensing. Exports of 10 items were prohibited.


See Wolf (1990) for an analysis of the passthrough of exchange rate changes to domestic prices in centrally planned and partially reformed economies.


Labor generally is supplied to foreign investment enterprises by a central or local government-owned labor services company. A set fee per worker is charged to cover basic wages, benefits (e.g., pensions and housing), and overhead of the labor services company. The reduction in labor costs in October 1986 reflected reduced charges for benefits and overhead; basic wages were not affected.


Borrowing from the international financial institutions is handled by the Ministry of Finance and the PBC, while borrowing from foreign official agencies is largely handled by MOFERT.


Since this internal settlement rate was more depreciated than the official exchange rate, it served to promote exports and restrain imports. Over time, however, the gap between the two rates narrowed as adjustments were made to the official rate, and the internal settlement rate was abolished in late 1984. Prior to 1981, internal settlement took place at exchange rates that varied by commodity.


At year end 1988, the average exchange rate at adjustment centers was almost ¥ 7 per dollar compared with the official rate of ¥ 3.72 per dollar. Subsequently, the official rate was depreciated twice (in December 1989 and November 1990) and in late 1990 it stood at ¥ 5.2 per U.S. dollar, compared with an average rate in the adjustment centers of about ¥ 5.7 per U.S. dollar.


References on financial system reform in China include Grub and Sudweeks (1988), Szapary (1989), and World Bank (1988a).


The Agricultural Bank of China (ABC) was set up to handle the agricultural sector, the People’s Construction Bank of China (PCBC) handled construction, the Industrial and Commercial Bank of China (ICBC) covered industry, and the Bank of China (BOC) dealt with foreign transactions. A network of 60,000 rural credit cooperatives (under the supervision of the ABC) provides small-scale rural banking services, and over 1,200 urban cooperatives (under ICBC supervision) service small individually or collectively owned enterprises.


The Bank of Communications and the China International Trust and Investment Company (CITIC) Bank.


The CITIC is the largest such company.


Interest on these bonds is, however, payable only on maturity.


Government bonds are purchased by enterprises and local governments according to a system of quotas.

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