PETER NOLAN

The China Puzzle: ''TouchingStones to Cross the River''

Why did China perform so well in the first decade and a half of reform,despite the fact that its economic institutions and policies were gravelyinadequate in relation to mainstream Western economic theory and policy?

China's approach toward post-Stalinist reform con-trasts markedly with that of most other former cen-trally planned economies. Eastern Europe and Russiahave tried to move rapidly towards a market econ-omy ("one cut of the knife"), whereas, after Mao'sdeath in 1976, China adopted an incremental reformpath ("touching stones to cross the river"). Manyobservers considered China's program to be poorlydesigned. It seemed to have led to an unsatisfactory"halfway house" that was neither capitalism norsocialism—an institutional framework which perpet-uated bureaucratic interference in the economy andwas expected, therefore, to have produced poorresults. Moreover, the Tiananmen massacre in 1989was connected closely with the tensions of economicreform. It was widely felt that this signaled the endof reform, and that China would lapse into low-growth authoritarianism.

But China confounded the consensus of criticalopinion. Even after the Tiananmen massacre, neitherreform nor economic growth was halted. In mostimportant respects, the "halfway house" economyhas performed extremely well since the death of MaoZedong in 1976. At each stage of the reform, criticsargued that the reforms had run out of steam and thatshort-term gains had been won through "easy" insti-tutional change which would damage long-term per-formance. After a decade and a half of sustained

growth, these arguments have worn thin. And now,this growth presents a puzzle for mainstream eco-nomic theory and policy.

The consensus view

While there was a minority who dissented, rarely hasthere been such agreement about a fundamental issueof economic policy. Several broad areas of agree-ment about basic propositions among economistsadvising the former communist countries in the earlypost-communist phase can be identified:

• Market socialism cannot work. Janos Kornaiwrote: " . . . the basic idea of market socialism simplyfizzled out. Yugoslavia, Hungary, China, the SovietUnion, and Poland bear witness to its fiasco. Thetime has come to look this fact in the face and aban-don the principle of market socialism." (See TheRoad to a Free Economy in For Further Reading.)

• Institutional reform cannot be sttccessful unlessthere is tnacroeconomic stability.

• Enterprises will not respond in desirable ways tomarket signals unless private property rights areestablished.

• Enterprises' attempts to make profits will notproduce socially desirable outcomes unless pricesare determined by market forces.

• Economic progress will be greatly inhibited

PETER NOLAN is a Fellow. Director of Studies in Economics, Jesus College, Cambridge, England and Lecturer in Economics andPolitics at Cambridge University.

January-February 1994/Challenge 25

unless there is full integration into the world econ-omy. In The Economy of the USSR: Summary andRecommendations, the World Bank urged, "Itis. . . essential to move as rapidly as possible to atransparent and decentralized trade and exchange ratesystem, in order to hasten the integration. . . into theworld economy."

• The pace of the transition from central planningneeds to be rapid. In the opinion of Anders Aslund,"Common sense suggests that if you are sliding intoa chasm, you should jump quickly to the otherside... and not tread cautiously. There is no theorysupporting a gradual switch of system." (See"Gorbachev, Perestroika, and Economic Crisis" inFor Further Reading.)

• Democratic political instittitions are a necessarycondition of success with economic reform.

The Chinese approach

Market socialism was the overarching philosophy ofthe Chinese economic system in the 1980s, thoughthe term "socialist market economy" was not enunci-ated formally as the guiding principle of economicorganization until as recently as 1992. The overallframework strongly resembled that of the NEP (NewEconomic Policy) in the Soviet Union in the mid-1920s and in China itself in the early 1950s. The oldStalinist system of direct administrative planning wasrejected decisively in favor of one in which marketsand their related incentives were viewed as necessaryto effective functioning of the economy. In the1980s, public enterprises were given greatlyincreased independence in production, marketing,and the disposal of their income. However, keyCommunist Party documents .spoke unremittingly ofthe economy as one in which public ownership, plan-ning, and "socialist" values were central to socio-economic life. Throughout the reform period, therehas been a continual reference to the need to com-bine the virtues of markets and planning—in strikingcontrast to the economic ideology of post-communistcountries in Eastern Europe and Russia. There, theeconomic functions of the state were looked uponwith hostility from the moment the CommunistParties were overthrown.

For a large number of observers of the Chineseeconomy, this "market socialist" mixture of marketand plan under a system in which the Communist

Party remained in power made it impossible to imag-ine that the economy could perform well. China inthe 1980s, like post-1968 Hungary, was regarded as anegative example for the reforming EasternEuropean countries and for the former USSR aftertheir anti-communist revolutions.

Jan S. Prybyla has written: "The sad chronicle ofChina's post-Mao attempt to introduce a modern eco-nomic system contains a useful lesson which others,notably the East Europeans, are taking to heart. Thelesson is that to address the economic problem in amodern way in the context of a low-calibre, ineffi-cient, slothful, wasteful, cronified socialist system,one must go all the way to the market system, do itquickly, and not stop anywhere on the way. To gopart of the way slowly, 'crossing the river whilegroping for the stones' as the Dengists put it. is toend up the creek to nowhere."

Property rights

Instead of moving rapidly toward a system in whichprivate property is the dominant form of ownership,China was committed to experimentalism and gradu-alism in ownership reform in the 1980s. Transparent,legally protected, individual property rights were theexception, not the rule in all important areas of theeconomy. Public ownership (with confused propertyrights) was the norm.

In agriculture, the "decollectivization" of farmlandwas not followed by the establishment of privateproperty rights in land. The Chinese CommunistPany (CCP) did not wish to allow the emergence of alandlord class; therefore, land could not be boughtand sold. Rather, the village community remained theowner of its farmlands and controlled their opera-tions. It endeavored to ensure that farm householdshad equal access to farmland, and obtained part ofthe Ricardian rents from the land to use for commu-nity purposes. The relative equality in local access tofarmland was a major reason for the fact that the Ginicoefficient of rural household income distributionremained so low. The rural reforms ofthe late 1970sand the early 1980s left property rights in landunclear. A commentator wrote in the CambridgeJournal of Economics: "Every member of a villagecommunity has a share in the property rights to theland of his/her community but the share is notembodied in any tangible form, such as a title deed

26 Challenge/January-February 1994

Table 1 Share of Industrial Output(gross value) Produced in Enterprises

with Different Types of Ownership*

1981 1985

78.321.0neg0.6

70.427.7

0.41.5

54.535.7

5.44.3

StateCollectiveIndividualOther

• Data lor 1981 and 1985 are both at 1980 prices: data tor 1990 are at cur-rent prices.Source: State Statistical Bureau, 1986 and 1991.

or stock, so it seems that no one is a real owner ofland." Moreover, even the way land was operatedcontinued to be heavily influenced by stale instruc-tions. The state's compulsory deliveries for somekey products {notably grain) remained in force, sothat providing grain for self consumption and com-pulsory delivery preempted around 70 percent offarmland.

In industry, although the reforms allowed individ-uals to set up businesses, state policies strongly pre-ferred the publicly owned sectors (for example, theallocation of credit, power supplies, public transport,and foreign exchange). Public ownership of indus-trial assets took both the "all people" (state) and the"collective" (often the local community) form. Still,at the end of the reform decade, around 55 percent ofindustrial output came from the "all people"-ownedsector and 36 percent from the collectively ownedsector (see Table 1). The genuinely privately ownedsector occupied only a tiny fraction of total output.

The reforms decentralized control over financialcapital. A rapidly growing share of industrial enter-prises' finance came from the enterprises' retainedprofits, from banks, and from other sources—inter-enterprise investment, and investment by groups ofenterprises in joint projects. Furthermore, much ofthe control which formerly had been in the hands ofcentral or provincial authorities was decentralizedand given to local authorities, often with ill-definedrights to claim a share of enterprise profits.

In its 1990 report on the Chinese economy, theWorld Bank lamented the confused position inrespect to property rights in the state-owned sector:"[T]he ownership of Chinese 'state-owned' enter-prises is becoming increasingly ill-defined. Ten yearsago, all industrial assets in the state-run economywere clearly controlled, and effectively 'owned' byvarious levels of govemments, which exercised both

ultimate management power and fmal claim on resid-ual income. Today, managerial authority and claimson income are split between government and theenterprise itself, as well as, to a lesser extent, thebanking system. The uncertainty attending on theownership system is putting serious obstacles in theway of improved performance." Bankruptcy in thestate sector was virtually unknown. The "soft budgetconstraint" was dominant, with a rapidly increasingshare of finance coming from a highly politicizedbanking system.

The rural collective sector was the fastest-growingpart of the Chinese industrial economy in the 1980s.The vast bulk of assets in this sector was owned bythe local community, with the community's assetmanagement board arranging, on the community'sbehalf, the key aspects of the use of the propertyunder their control. The World Bank's study of thissector concluded: "[This is] an environment in whichownership and property rights with respect to indus-trial assets are not clear and pure private ownershipis rare except in the smallest concerns... Thus, themost powerful reward for small-scale entrepreneursin other countries—the ability to reap largegains from the 'capitalization' of entrepreneurialsuccess in their firms—is absent or at least sharplycircumscribed."

Price reform

By 1984, the Chinese govemment had become con-vinced of the necessity of comprehensive pricereform. However, its approach was to give social sta-bility a high priority. "Social tolerance" {shehuichengshouxirig) was a key criterion by which reformwas to be judged. The government decided to onlygradually reform the structure of relative prices andto do so in a controlled, planned fashion. The CentralCommittee reported: "There is much confusion inour present system of pricing. . . . This irrationalprice system has to be reformed... otherwise it willbe impossible to assess correctly the performance ofenterprises. . . . As the reform of the price systemaffects every household and the national economy asa whole, we must be extremely prudent, formulate awell-conceived, feasible programme based on thegrowth of production and capability of the state'sfinances and on the premise that the people's realincome will gradually be increased, and then carry it

January-February 1994/Challenge 27

Table 2 Proportion of Products Sold atDifferent Types of Prices

trolled by a wide variety of quantitative controls (seeOne Step Ahead in China in For Further Reading).

1978 1986 1990

Share of total retail sales sold at :state-controlled pricesstate-guided pricesmarket-regulated prices

Share of total sales of agriculturalproducts sold by farmers at:

state-controlled pricesstate-guided pricesmarket-regulated prices

Share of ex-factory means ofproduction for industrial use sold at

state-controlled pricesstate-guided pricesmarket-regulated prices

Source: Li, 1992 and Tian, 1990.

9703

94.40

5.6

10000

n.a.n.a.n.a.

37n.a.n.a.

642313

29.717.253.1

25.222.652.2

44.418.836.8

out in a planned and systematic way."Virtually all prices were directly controlled by the

state in the late 1970s. By the mid-1980s, there hadbeen a large growth in the role of free markets, buteven by 1990, it was still the case that no more thanaround one-half of the value of marketed goods wassold at free market prices (see Table 2). Not muchmore than one-third of industrial means of produc-tion was sold at free market prices. Moreover, formuch of the second half of the 1980s, a large part ofmarketed output was sold under the "dual track" sys-tem with different prices for the same product in par-allel markets (state-controlled/state-guided and free).

The international economy

The value of the yuan was slowly brought closer toits free market rate. But even at the end of the 1980s,it had not become a freely convertible currency.Innumerable bureaucratic restrictions pertained atdifferent points to access to foreign currency in the1980s.

Unlike the oligarchs of the Maoist period, theleadership ofthe 1980s was convinced ofthe neces-sity of integration into the world economy. But, inthe same fashion as Taiwan and South Korea in ear-lier years, China pursued an explicitly mercantilistpath. Exports were "promoted" through a wide vari-ety of subsidies, and they frequently sustained lossesat world market prices. Imports were tightly con-

There were important changes in China's politicalsystem in the post-Mao period. The most significantof these was the attempt, spearheaded by DengXiaoping to create a professional bureaucracy. Theintention was to dismiss the old guard of party offi-cials in the government administration into retire-ment because they did not possess high technicalqualifications. This effort parallels those ofBismarckian Germany and Meiji Japan in the late19th century, or Taiwan and South Korea in the1950s. In these countries, a key point of the modern-ization drive was the creation of a professional gov-ernment administration that was responsible to anunelected executive authority rather than to anelected parliament. And much progress was made inthe 1980s.

Notwithstanding these changes, China in the1980s remained a one-party state, with the CCPfirmly in control of political life. The challenge to itsauthority in Tiananmen Square was repressed bru-tally. Many analysts felt that the CCP could not leadthe centrally planned economy more than a part ofthe way towards a market economy, since furthermovement would threaten its power fundamentally.It was felt widely that the CCP could not, of itself,make the transition to secular national rule. It had thedouble burden of highly centralized traditions ofLeninism plus millennia of centralized rule in China.The conjecture was that the CCP had to be removedfrom its monopoly of political power if the move to amarket economy was to be put into effect.

In the euphoria of the post-communist world, itwas very hard to believe that such a brutal,undemocratic regime as China's could perform welleconomically.

The results of reform

In almost all key aspects of institutional arrange-ments and policy, China's post-reform economy inthe 1980s takes on the appearance of an intervention-ist halfway bouse that most economists would pre-dict would perform very badly. Throughout thedecade, private property rights existed in only a

28 Challenge/January-February 1994

Table 3 Changes in the Characteristics ofChinese Economic Growth:

Average Annual Growth Rate(% per annum, at constant prices)

1957-75Net matenal product

of which:agricultureindustryconstructiontransportcommerce

Net material product per personGross material product of industry:

heavylight

Source: State Statistical Bureau. 1991.

5.3

1.79.84.65.32.33.3

11.28.3

10.313.9

minor part of the economy; the government contin-ued to intervene heavily in price-setting; the econ-omy remained substantially isolated from the impactof world prices; the Communist Party continued torule in a sometimes brutal and always authoritarianfashion, and intervened at all levels of the economicprocess. Indeed, some observers believed that "mar-ket socialism" was too eharitable a description of thissystem and that "market Stalinism" was a moreappropriate one.

In fact, in the first decade or so of reform. China'seconomic performance was much better than underMaoist policies. The rate of growth of net nationaloutput accelerated sharply (see Table 3). China's sys-tem of authoritarian political control enabled her tocontrol population growth, despite the bulge in thereproducing-age cohorts in the 1980s. In per capitaterms, the annual growth rate of net national outputmore than doubled. A striking shift occurred in thepattern of growth—away from that which is charac-teristic of a Stalinist economy. The overall industrialgrowth rate {already very rapid under Maoism)changed little. However, there were importantchanges in the efficiency in resource use. There wasa sharp reversal of the long-run decline in productiv-ity in state-run industry which China had experi-enced in the Maoist years, and China's state-ownedenterprises began to behave in a cost-minimizingfashion. Moreover, the typical Stalinist relationshipbetween the growth rates of heavy and light industrywas reversed, with explosive growth of light indus-try. The agricultural growth rate accelerated beyondthat achieved during the Maoist period, and with

much more economy in resource use. The growthrate of commerce and transport increased sharply, ascompared to the Maoist years, reflecting the rapidrise in the market economy.

China outperformed almost all developing coun-tries in terms of output growth and export perfor-mance (see Table 4). Moreover, it remained relatively

Table 4 Comparative Economic Performanceof the Chinese Economy in the 1980s

China India

Low MiddleIncome Income

Countries'Countries

Av. annual growthrate,1980/89 (%):

GDPAgricultureindustryServices

9.76.3

12.69.3

Av. annual real growthrate of exports,1980/89 (%) 11.5

5.32.96.96.5

5.8

3.42.53.14.4

2.92.63.02.8

0.8 5.5

Av. annual growthrate of population,1980/89 (%)

Av. annual rate ofinflation, 1980/89 {%)

Debt service as %of exports of goodsand services :

19801989

1.4

1 5.8

4.69.8

Index of average per capitafood consumption, 1987/89:(1979/81=100) 128

Daily calories per capita:19651988

Crude death rate(no./IOOO):

19651989

Infant mortalityrate (no./1000);

19811989

Life expectancy atbirth (years):

19811989

19312632

107

7130

6770

2.1

7.7

9.126.4

113

21032104

2011

12195

5259

2.7

14.9

11.427.4

103

19602182

2113

12494

5055

2.1

73.0

26.123.1

101

24822834

13

a

8151

6066

' excluding India and ChinaSource: World Bank,1983 and 1991.

January-February 1994/Challenge 29

unburdened by foreign debt, and achieved fastgrowth with relatively low inflation.

It cannot be argued that growth in the 1980s wasachieved at the expense of popular consumption. The1980s saw a revolution in all aspects of real incomes(see Table 5). A remarkable improvement occurred inthe Chinese population's diet, with considerableimprovements in the quality of produce. A vast newfashion industry sprung up in the textile sector. Asignificant increase occurred in consumer durableconsumption (mainly met from domestic produc-tion), with huge new industries springing up wherethere formerly had been virtually nothing. Housingspace per person more than doubled over the courseof a decade. Large improvements took place in theavailability of professional health care. A massivetransformation occurred in the number and variety ofservices available. The reported improvement in thealready exceptional figures for life expectancy andmortality rates suggests that the growth in livingstandards affected most social strata, even if therewas greater inequality in consumption than under theextreme egalitarianism of Maoism.

China's economic performance in the 1980s wasmuch better than that in the most relevant comparatorcountries (such as India) and was vastly better thananyone in the late 1970s could have anticipated.Were Eastern Europe and Russia to achieve remotelycomparable advances in the 1990s, their reformswould be regarded as immensely successful.

Disturbing possibilities

The Chinese system of political economy in the1980s and early 1990s was "market socialist" in anymeaningful sense of the word. Yet this was one of themost dynamic in terms both of output and incomegrowth the modern world has seen. This presentseconomists with a puzzle: Why did China perform sowell in the first decade and a half of reform, despitethe fact that its economic institutions and policieswere gravely inadequate in relation to mainstreamWestern economic theory and policy? There are anumber of possibilities, of different orders of diffi-culty for mainstream Western economics to digest.

The "easy" answer for economists reflecting onthe shambles of post-Stalinism in Eastern Europe andthe former USSR is that China entered its reformprogram with important advantages, compared to

Table 5 Changes in the Standardof Living in China

(1978-90)

Index of real per capita consumption

Consumption per capita of:grain (kgs.)edible oil (kgs.)pork (kgs.)fresh eggs (kgs.)sugar (kgs.)cloth (meters)

Ownership of consumerdurabies(no./iOO people):

sewing machineswatchesbicyclesradiosTVs

Retail outlets, cateringand service trades:

no of outlets/10,000 peopleno. of workers/10,000 people

Doctors (no./10.000 people)Hospital beds (no,/10,000 people)

Housing space per capita (sq. meters):citiesvillages

Source: State Statistical Bureau, 1990.

1978

100

1961.67.72.03.48.0

3.58.57.87.80.3

1363

10.819.4

3.68.1

1990

208

2395.7

16.66.34.9

10.6

12.351.634.222.016.2

104255

15.423.0

7.117,8

Eastern Europe and Russia. These include China'slow level of international debt, the special role ofHong Kong and Taiwan, and the fact that Chinaenjoys a strong capitalist tradition stretching back atleast a thousand years. It may be argued also that it iseasier to reform a low-income, predominantly ruralcentrally planned economy.

A more disturbing possibility is that China's incre-mentalist approach to economic reform may havebeen correct, and the attempt in most of EasternEurope and in the former USSR to move rapidlytowards a market economy may have been a seriousmistake. The correct economic advice to the formerStalinist economies may have been to stress that theirstructural transformation would require a lengthyperiod of extensive state intervention to cope withprobable large areas of market failure. The enthusi-asm of post-communist "capitalist triumphalism"among advisers to Eastern Europe and the formerUSSR may have caused a major mistake in assessingnot only the required speed of the transition but also

30 Challenge/January-February 1994

the desirable economic functions of the state over anextended period. The huge tasks of structural trans-formation in an atmosphere of great uncertainty inthe reforming centrally planned economies is pre-cisely a situation in which it is likely, in principle,tbat market failure will be especially large—with pri-vate agents tending more than under other circum-stances to look toward the short term and speculationrather than toward longer-term investment. Thus thegap between private and social benefits may be espe-cially wide. The early stage of development econom-ics in the 1940s and 1950s, and indeed, the practicalexperience of the newly industrializing countries ofEast Asia, may have been more relevant to the enor-mous tasks of transition that these economies nowface than were the mainstream economics of the1970 and 1980s, which stressed the shortcomings ofthe state as a vehicle for achieving socially desirablegoals.

An even more disturbing possibility for main-stream economics is that a main part of the reason forthe contrast may lie in the realm of politics. A suc-cessful reform strategy may require a comprehensiveperspective of political economy. A more successfultransition away from a communist economy may be

easier to achieve with a strong state that is able to taxeffectively, maintain national unity, ensure politicalstability, and place the overall national interest abovetbat of powerful vested interest groups. A self-reforming Communist Party may be the least badvehicle available to accomplish this. The causes forChina's success may lie, above all, in the set of his-torical factors that allowed the Communist Party tosurvive in China (as distinguished from EasternEurope and the USSR, where it was overthrown),and to preside over the introduction of an increas-ingly competitive economy.

The most disturbing thought of all is that China'sexplosive growth (and, increasingly, a wider growthprocess in former Stalinist Southeast Asia) since the1970s may reflect a huge inherent catch-up possibil-ity. This potentiality may have been latent in all theformer Stalinist economies, because of the vastunderperformance in relation to their huge physicaland human capital inheritance. The reform of theStalinist economies may be seen by history to havebeen a knife-edge situation in which correct choicesin political economy could produce explosive growthand incorrect ones could send the system spinningbackwards at high speed for an extended period.

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