Journal of Economic Literature 2011, 49:4, 1076–1151 http:www.aeaweb.org/articles.php?doi=10.1257/jel.49.4.1076

The Fundamental Institutions of China’s Reforms and Development

Chenggang Xu*

China’s economic reforms have resulted in spectacular growth and poverty reduction. However, China’s institutions look ill-suited to achieve such a result, and they indeed suffer from serious shortcomings. To solve the “China puzzle,” this paper analyzes China’s institution—a regionally decentralized authoritarian system. The central government has control over personnel, whereas subnational governments run the bulk of the economy; and they initiate, negotiate, implement, divert, and resist reforms, policies, rules, and laws. China’s reform trajectories have been shaped by regional decentralization. Spectacular performance on the one hand and grave problems on the other hand are all determined by this governance structure. ( JEL O17, O18, O43, P21, P25, P26)

1. Introduction Even more impressively, the contribution of TFP to the growth has increased from 11 hinese economic reforms, which have percent before 1978 to more than 40 percent Cbeen in flux for three decades, have more afterwards (Dwight H. Perkins and Thomas than doubled China’s economic growth, from G. Rawski 2008). This process has trans- an average of 4.4 percent annually before formed the world’s largest developing coun- 1978 to an average of 9.5 percent after 1978. try from a centrally planned economy into a

* University of Hong Kong and WCU–SNU. The first draft of this paper was written at Hong Kong University Lau, Eric Maskin, James Mirrlees, Katharina Pistor, Gerard of Science and Technology (HKUST) when I was visiting Roland, Yumin Sheng, Joseph Stiglitz, Zhigang Tao, Daniel there. The hospitality and generous support of HKUST are Treisman, Shaoguang Wang, Christine Wong, Jinglian Wu, greatly appreciated. Comments from participants in confer- Dali Yang, and Lian Zhou. Special thanks go to Roger ences and seminars at the China Europe International Busi- Gordon for his guidance and insightful comments on dif- ness School, University of Chicago, the Chinese University ferent versions of the paper. The usual disclaimer applies. of Hong Kong, City University of Hong Kong, IEA Round Linfeng Chen, Xiaoya Dou, Xinyu Fan, William Organek, Tables (Beijing), IPD (Columbia/Manchester), Macau, and Jin Wang served as excellent research assistants. Peking, Seoul National University, Singapore, Tsinghua and Financial support from the World Economy and Finance UNU–WIDER are greatly appreciated. I am grateful for Research Program of the Economic and Social Research helpful discussions and comments from three anonymous Council, the World Class University program through the referees, Masahiko Aoki, Pranab Bardhan, Lauren Brandt, Korea Science and Engineering Foundation funded by the Hongbin Cai, Chun Chang, Jiahua Che, Ronald Coase, Ministry of Education, Science, and Technology (grant Athar Hussain, Garry Jefferson, Yasheng Huang, Janos R32-2008-000-20055-0), HKUST, and the University of ­Kornai, James Kung, Hongbin Li, Justin Yifu Lin, Lawrence Hong Kong are sincerely acknowledged.

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mixed market economy, while simultaneously Daron Acemoglu and Simon Johnson 2005; reducing poverty at a scale unparalleled in Rodrik 2006). Yet, the Chinese government world history (World Bank 2002). During the is deeply involved in business, and there is reform period, the Chinese per capita GDP no clear separation between government increased by almost eight-fold, and China has and business. Using commonly applied stan- transformed from one of the poorest countries dards, China is, in general, below average in the world into a major economic power.1 on most measurements of the application Today’s China is the world’s largest producer of the rule of law or for governance qual- and largest consumer of many conventional ity (Franklin Allen, Jun Qian, and Meijun industrial staples and high-tech products, Qian 2005) and is among the most corrupt such as steel, cars, television sets, personal countries in the world.3 Moreover, through- computers, cell phones, and internet usage. out most of the three-decade reform pro- (National Statistical Bureau 2006b) and has cess, there was no constitutional protection the world’s largest foreign reserves. The cur- of private property rights until recently (the rent size of the Chinese economy, in terms of 2004 constitutional amendment). To sum- GDP, is larger than the sum of eighty-three marize, China’s weak institutions are ill countries in Eastern Europe, the CIS, and all suited to achieve economic development. of Africa (the author’s calculation based on Thus, the Chinese reforms pose great chal- Maddison 2003). This makes a research on lenges to standard economic theories. Can China more imperative for understanding the economic theory explain China’s reforms? world economy. Is the Chinese reform a miracle? This paper However, in sharp contrast to this spectac- will tackle these challenges through a unified ular performance, it has been reported that, conceptual framework that synthesizes exist- from the viewpoint of standard wisdom, such ing literature. as the Washington Consensus or the recent Recently, a growing amount of literature empirical literature of cross-country studies, on institutions and reforms demonstrate a Chinese institutions in government, corporate general consensus among economists and governance, law, and finance look notoriously policymakers that a set of institutions must weak. Moreover, Chinese reform policies are be in place to make markets function well. often unconventional and sometimes even Therefore, a market-oriented reform should look diametrically opposed to “standard” focus mainly on institution building to protect policy suggestions (Martin L. Weitzman and property rights. Nevertheless, a vital chal- Chenggang Xu 1994; Dani Rodrik 2006).2 lenge faced by all transition economies and According to conventional wisdom, the developing economies is how to build these government should protect private prop- requisite institutions and how to carry out the erty rights, enforce contracts, and separate reforms. A simplistic, yet fairly popular view itself from business (Douglas C. North 1981; is that markets will form as long as private

high levels of trade protection, lack of privatization, exten- 1 At the outset of the reform, China’s per capita GDP sive industrial policies, and lax fiscal and financial policies was about the same as that of Zambia, which was lower through the 1990s, these two economies hardly looked like than half of the Asian average or lower than two-thirds of exemplars of the Washington Consensus. Indeed, had they the African average, and its size was about one half of the been dismal failures instead of the successes they turned Soviet Union (Angus Maddison 2003). Moreover, it had out to be, they would have arguably presented stronger almost no trade with other countries. evidence in support of Washington Consensus policies.” 2 In comparing Chinese and Indian reforms with 3 China has a “Corruption Perception Index” level of Washington Consensus policies, Rodrik (2006) said: 5, which is similar to Indonesia, Iraq, Myanmar, Nigeria, “. . . their policies remained highly unconventional. With Sudan, and Somalia (Jacob Svensson 2005).

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property is well protected through proper Based on a large body of literature, I institutions. However, lessons drawn from argue that China’s fundamental institution numerous historical and contemporary cases that deeply affects executives’ incentives show that markets and economic develop- and behaviors, which in turn impact soci- ment do not develop spontaneously, owner- ety, is what I call the regionally decentral- ship protection is not created independent of ized authoritarian (RDA) regime (section market development, and private ownership 2). The RDA regime is characterized as a alone is insufficient for the market economy combination of political centralization and to function (Ronald H. Coase 1992; Adam economic regional decentralization. On the Smith 1763, 1776). Without government one hand, the national government’s con- functioning beyond the protection of prop- trol is substantial in that the Chinese politi- erty rights, markets often do not develop; cal and personnel governance structure has even worse, disorder can destroy markets as been highly centralized. Subnational govern- easily as dictators. Yet, failures of market-ori- ment officials are appointed from above, and ented reforms launched by governments are the appointment and promotion of subna- ubiquitous. This is a fundamental dilemma tional government officials serve as powerful faced by any institution-building reform and instruments for the national government to echoes Coase’s famous question: what is induce regional officials to follow the cen- the boundary of the firm? (Coase 1937). As tral government’s policies. This feature fun- I argue in this paper, the lessons of China’s damentally distinguishes the Chinese RDA reforms suggest that an answer to this funda- regime from federalism, where governors or mental question is ultimately determined by mayors are elected and they are supposed to the trade-offs between costs and benefits of represent and be accountable to their con- different forms of the government. The tra- stituents. On the other hand, the governance jectory of China’s reforms, reform strategies, of the national economy is delegated to sub- outcomes, achievements, and problems are national governments. Regional economies mainly determined by China’s political and (provinces, municipalities, and counties) economic institutions. are relatively self-contained, and subna- Following the theoretical literature of tional governments have overall responsibil- institutional analysis (Coase 1992; Joseph E. ity for initiating and coordinating reforms, Stiglitz 2002; Leonid Hurwicz 2007), in this providing public services, and making and paper the word “institution” refers to those enforcing laws within their jurisdictions. basic and stable mechanisms that govern the This feature qualitatively differentiates the incentives of agents and coordinate activi- Chinese economy from a typical centrally ties in major political and economic games. planned economy. Thus, “institutional foundations” in this China’s RDA regime evolved before and paper refer to those basic and stable mecha- during the post-Mao reforms, and some of nisms that determine the incentives of the its important features can be traced back to most important players in China’s reform much earlier in China’s history. There are two and development.4 critical historical factors that make China’s

2006). A popular definition of institution is given by North 4 These mechanisms are endogenous in that they are (1990, p. 3) that “institutions are the rules of the game in created through the strategic interactions of agents. Thus, a society­ or, more formally, are the humanly devised con- institution may also be regarded as the equilibrium of the straints that shape human interaction.” However, this defi- game in the economic and political world (Avner Greif nition is too abstract to be operational.

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RDA regime somewhat unique. First, China to encourage them to try out reforms and is the only country in the world that has more promote economic growth. Thus, regional than two thousand years of imperial his- competition has been a major component tory, which had a unique governance struc- of China’s three decades of reform (section ture, and today’s RDA regime inherits some 3). When a region has a higher growth rate important elements from this governance than others, the head of the region will enjoy structure. Second, the Cultural Revolution greater power and will be more likely to be is unique in the history of world communist promoted. One of the most important initia- movements. The ensuing destruction of the tives taken by many subnational governments communist institutions and society has led was the development of nonstate firms, to disillusion with the communist ideology, a including FDI and indigenous firms (e.g., change of the legitimacy base of the Chinese the township–village enterprises), which has Communist Party, and weakened resistance been the most important engine of China’s to reforms, and has shaped the basic charac- economic growth since the mid-1980s. teristics of the RDA regime, paving the road Chinese subnational governments not only for the post-Mao reforms. compete against quantifiable targets, such In the RDA regime, subnational gov- as GDP growth rate, but, they also often ernments have influence or even direct compete in initiating or testing new reform control rights over a substantial amount policies, i.e., regional reform experiments of resources, such as land, firms, financial (section 4). They have been given consid- resources, energy, raw materials, and oth- erable responsibility for regional coordina- ers.5 Subnational governments are major tion, and such decentralized coordination players in the bulk of the Chinese economy. has facilitated regional reform experiments; Under the supervision of the central govern- since subnational governments are closer to ment, they initiate, negotiate, implement, experimenting sites, they are much better divert, and resist reforms, policies, rules, informed about local information than the and laws. They drive, influence, or hamper central government and can therefore coor- regional/national economic development, dinate more effectively. Regionally based macroeconomic conditions, environmental coordination makes economywide coordi- conservation or degradation, social stabil- nation failures less likely when there are ity, etc. China’s reform trajectories have external shocks. This also makes it easier to been shaped by centrally controlled regional experiment with institutional changes locally decentralization. Spectacular performance without causing disruption to the rest of the on the one hand and grave problems on the economy. Most importantly, by incorporat- other hand are all created or closely associ- ing regional experiments as an essential part ated with this governance structure. of the central decision-making process, the At the early stages of the reforms, the political risks of advancing reforms are sub- central government delegated more autono- stantially reduced, and political opposition to mous power and provided stronger incen- reforms is significantly weakened (sections 2 tives to subnational governments in order and 4). Indeed, almost all successful reforms in the past three decades were introduced 5 “In effect, it is the sub-national levels of Government through local experiments (section 5). that implement China’s national development agenda. Nevertheless, the intrinsic deficiencies Nearly 70 percent of total public expenditure in China takes of an authoritarian regime, such as the lack place at the sub-national level (i.e., provincial, prefecture, county, and township), of which more than 55 percent takes of an independent judiciary, rent-seeking place at sub-provincial levels” (World Bank 2002). behavior, and a failure to respond to citizens’

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preferences, are important parts of the char- economic development. Nevertheless, the acteristics of China’s RDA regime, with- overall performance of China’s reforms and out exception (section 6). Although some of development appears not only magnificent these problems might be mitigated when but unparalleled in world history in its gigan- subnational governments face fierce regional tic scale and prolonged rapid growth. This competition, regional competition may lead incredible contrast between “poor” institu- to other problems, such as regional protec- tions and China’s spectacular performance tion. Moreover, many problems inherent in challenges our general understanding of the the RDA regime may be worsened when the mechanics of institutions and our under- effectiveness of regional competition is weak- standing of “institutional quality.” ened, e.g., when subnational governments First, there appear to be conceptual mis- face multiple tasks, they strategically chose understandings about what exactly consti- to ignore some tasks in the competition. Also, tutes an institution in the literature. The regional competition may lead to “races to the so-called institution is sometimes improperly bottom” for some tasks, which can be much defined or misinterpreted in certain popular worse than simply being ignored. China’s empirical or policy studies. One of the most future depends on how those problems are widespread approaches is to label a set of nar- resolved and, given that they are deficient rowly defined measurements as the perfect outcomes of the RDA regime, an ultimate “institution” based on some observed fea- solution lies in a fundamental transformation tures of developed market economies, e.g., of the institution itself. the United States. Then, all other countries’ Although determined by its distinctive his- practices are measured against this standard tory, China’s RDA regime is itself unique, to see the imperfections of those countries’ there are still some general lessons that can institutions. Although the empirical findings be drawn from China’s reforms and develop- that follow from that approach could be useful ment for other developing countries. These in a narrow scope, serious problems may arise are discussed in the concluding section. when this approach is generalized. Without One of the major purposes of this paper is a thorough understanding of the working to address the so-called “China Puzzle.” It is mechanisms of institutions in developed and undisputed among economists that the qual- developing economies, such mechanical and ity of institutions is important for reform and narrow interpretations of institution ignore development because they determine incen- the essence of these institutions. This kind of tives for executives and all the players in an research, to some extent, is not only at odds economy. China is regarded in cross-country with the theoretical literature on institutions study literature as having poor institutions, (a la North 1990, Coase 1992, Stiglitz 2002, such as poor legal protection of property Hurwicz 2007, etc.), but also can be mislead- rights, poor corporate governance, lack of ing in general. 6 For instance, the concept of, democratic accountability, and an absence of and the mechanism by which, the rule of law the rule of law. The resulting forecast is that Chinese officials will be corrupt, will not work hard, and will not collect and report informa- 6 “The value of including such institutional factors in the corpus of mainstream economics is made clear by recent tion correctly, all of which are partly correct events in Eastern Europe. These ex-communist countries empirically. However, much more impor- are advised to move to a market economy, and their leaders tantly, this theory would also suggest that, wish to do so, but without the appropriate institutions no market economy of any significance is possible. If we knew under poor institutions, executives in China more about our own economy we would be in a better posi- would block reforms, therefore preventing tion to advise them” (Coase 1992, p. 714).

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affects economies has been the subject of may be very difficult, time-consuming, or many debates. However, most of the popular even counterproductive under certain politi- empirical cross-country studies apply a nar- cal conditions. row definition of the rule of law and ignore How should a country transform a cen- the debates on the subject, such that the trally planned economy into a market United States is often taken as the ideal (or economy? What are the most important almost ideal) model in those studies. Yet, if and effective reforms for economic devel- we look at the widespread financial fraud and opment? How can a reform motivate sub- the deep corruption from the grassroots to national governments and at the same time the top executives on Wall Street revealed coordinate and control them? These subjects throughout the 2008 financial crises and the have been debated by economists, political Enron–WorldCom scandal in 2002 etc., the scientists, historians, sociologists, and others contrast between this illusion and reality is for decades, both in general and in the con- striking. text of China. Their viewpoints are, however, Moreover, very often the empirical mea- scattered, and very often scholars in dif- surements used in cross-country studies are ferent disciplines do not talk to each other. too narrow to capture the functioning of This paper attempts to develop a coher- institutions in developing economies, such as ent conceptual framework that synthesizes in China. As a result, all the functioning insti- a multidisciplinary discussion on China’s tutions that are beyond the scope of those institutions, reforms, and development. In narrow definitions are ignored, as if they addition to improving our understanding of did not exist. Consequently, China’s perfor- China’s reforms and economic development, mance becomes inexplicable and it becomes by doing so, I also hope to deepen our gen- either an outlier to be ignored or a puzzle in eral understanding of political and economic cross-country studies. institutions, and on the evolution of these The empirical study of the protection of institutions. private property rights and contract enforce- This paper is not an attempt of an exhaus- ment is a concrete example. It is true that in tive literature survey. Such a full-scale survey China there was no formal or constitutional would require multiple volumes. Therefore, protection of private property until 2004, many important contributions are not cov- and commercial codes related to contracts ered due to space restrictions and my igno- were not enacted until the late 1980s, and rance on the subject, particularly beyond the moreover remained unimportant until the field of economics. For this reason, I have late 1990s. However, there was semiformal only discussed some of the very serious prob- and informal protection of private property, lems that China is facing briefly. For many and contract enforcement mechanisms were others, I have only mentioned them without exercised by some subnational governments elaboration, such as problems of election, under a special social context in Chinese his- judiciary, corruption, social security, and the tory or by social norms. Yet, these institu- environment. tions often are unaccounted for in almost all cross-country studies. Even worse, according 2. The Fundamental Institution: to some “standard” policy advice, these more Regionally Decentralized Authoritarianism informal institutions might be regarded as obstacles that should be replaced by “stan- Transformation from a centralized econ- dard” institutions as quickly as possible, even omy to a market economy requires both insti- though setting up “standard” institutions tutional support and institutional change. In

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addition, developing from an agrarian econ- from a federal state, a unitary state, and a omy into a modern market economy also totalitarian regime. entails creating better institutions. However, 2.1 Decentralized Economic Governance: reforms have never started from an insti- Regional Decentralization tutional vacuum. All reforms have to begin with existing institutions, and any institutional A salient feature of the Chinese gover- change has to be initiated and implemented nance structure is the relatively hands-off by agents within these existing institutions approach taken by the national government (even in the case of a revolution, existing insti- with respect to most of the national economy, tutions still have profound long-run impacts). while subnational governments are deeply For all of these reasons, historically inherited involved in the economies within their institutions have far-reaching impacts on an jurisdiction, including regional firms. The economy, sometimes long after those insti- Chinese government consists of a region- tutions have been changed or abandoned based multilevel hierarchy. Below the central (Richard R. Nelson and Sidney G. Winter government, there are four levels of subna- 1982; North 1990). No major distinctive fea- tional governments: the provincial level, the tures of an economy—including reforms and municipal level (or prefecture level), the subsequent changes—can be properly under- county level, and the township level. The stood without understanding the fundamental central government directly controls only a institutions that underpin the economy; more- small proportion of the Chinese economy. over, this is especially true when considering The largest economic sector that the central China’s spectacular and prolonged growth on government controls directly is industry, and the one hand, and its serious socioeconomic even within this industry the central govern- problems on the other. ment directly employed less than 4 percent In this section, I introduce the funda- of all the industrial employees nationwide mental institution of China, which I call (National Statistical Bureau 2006a). the regionally decentralized authoritarian Most government functions are carried (RDA) system.7 The RDA system is charac- out by subnational governments. Although terized by highly centralized political and by constitution China is not a federal state, personnel controls at the national level, and in many important economic issues Chinese a regionally decentralized administrative and subnational governments are more powerful economic system. Both decision making and than their counterparts in federal countries policy implementations in the RDA regime, around the world since they are responsible from national strategic issues to concrete for much broader regional matters than sim- local matters, are deeply influenced by this ply fiscal issues. Unfortunately, almost all the combination of political centralization and empirical papers in the literature of decen- economic decentralization. These features tralization look at only fiscal decentralization qualitatively differentiate China’s regime since there is no well-accepted methodology to measure broadly defined regional decen- tralization. In the context of China’s decen- 7 The concept of regionally decentralized authoritari- tralization, although fiscal decentralization is anism was coined to characterize China’s institution in 2006 in the first draft of this paper. In 2009, I read Pierre sometimes a reasonable proxy for decentral- F. Landry (2008), where he uses the word decentralized ization more generally, other times regional authoritarianism. Although looks similar on the surface, decentralization in other dimensions is more the meaning of RDA is substantially different from the words of Landry (2008) just like the extensive differences important than fiscal decentralization. Thus, between this paper and his book. focusing on fiscal decentralization alone can

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Table 1 Annual Growth of China’s GDP, Fixed Capital, Labor, and TFP, 1951–2005

Percentage shares of GDP Annual growth of inputs growth attributable to Labor input Average Education Fixed Raw Education TFP Fixed enhanced Period GDP capital labor enhanced growth capital labor TFP K L H K H

1952–2005 7.0 7.7 1.9 2.6 2.1 47.7 21.4 30.9 1952–1978 4.4 5.8 1.9 2.5 0.5 56.3 32.7 11.0 1952–1957 6.5 1.9 1.2 1.7 4.7 12.7 14.9 72.4 1957–1978 3.9 6.7 2.0 2.7 0.5 73.7 39.7 13.4 − − 1957–1965 2.4 5.2 1.5 2.1 1.0 93.1 49.5 42.6 − − 1965–1978 4.9 7.7 2.4 3.1 0.2 67.7 36.7 4.4 − − 1978–2005 9.5 9.6 1.9 2.7 3.8 43.7 16.2 40.1 1978–1985 9.7 9.2 3.4 4.5 3.2 40.6 26.6 32.8 1985–1990 7.7 6.9 2.5 2.9 3.1 38.8 21.5 39.7 1990–1995 11.7 9.1 1.4 1.9 6.7 33.3 9.5 57.3 1995–2000 8.6 10.5 0.9 1.6 3.2 52.7 10.5 36.8 2000–2005 9.5 12.6 1.0 1.8 3.1 57.1 10.6 32.3

Source: Perkins and Rawski 2008.

be misleading (this will be elaborated in later Figure 1 depicts the governance struc- sections). ture of the Chinese economy. The statistics China’s governance structure does not in the figure reflect the situation in the year fit neatly into standard conceptions of 2005, though the structure has been stable authoritarian regimes. According to cross- throughout the reform era.8 This governance country studies, fiscal decentralization is structure is the result of a half-century of closely linked with democracy. However, political development (Perkins 1977, 1988; China’s authoritarian regime is one of the Elizabeth J. Perry and Wong 1985; David fiscally most decentralized countries in the Granick 1990; Barry J. Naughton 1995; world. Contrasting China’s fiscal decentral- Guoguang Liu et al. 2006; Jinglian Wu ization with its counterparts in the rest of the world during the early 2000s, the total 8 The total number of central state-owned enterprises expenditure of Chinese subnational govern- (SOEs) listed in figure 1 is 2,128, which is from the NSB. ments accounted for about 70 percent of the However, according to the SASAC (State-owned Asset Supervision and Administration Commission), the number national total, which was far larger than that should be less than 170 in 2005 and 151 in 2007 (http://www. of the world’s largest federal countries such as sasac.gov.cn/zyqy/qyml/default.htm). The latter is the total the United States (46 percent), Germany (40 number of parent companies controlled directly by the cen- tral government, which supervises a large number of sub- percent), and Russia (38 percent) (Christine sidiary companies; whereas the former is the total number P. W. Wong 2006). of all establishments managed by the central government.

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Central government (Pop: 1.31 billion) Central rms: 2,128 central SOEs Employment: 2.75 million: Fixed assets: 1,314 billion Yuan

22 provinces and 5 autonomous regions 4 Provincial-level municipalities: (Average pop: 45.7 million) Beijing, Shanghai, Tianjin, Chongqing (Average pop: 17.9 million) Regional level rms: 269,707 including local SOEs, collectives, joint, private, foreign, others. Employment 66.21 million Fixed assets: 9,281 billion Yuan

333 Municipality-level units (283 cities) average pop: 3.71 million

2,862 County-level units (374 cities) average pop: 431,426

41,636 town-level units (19,522 towns) average pop: 29,656

Figure 1. Regional Governance Structure of Chinese Economy Source: National Statistical Bureau, 2006a, 2006b, 2006c.

2009); moreover, many important features of During the GLF campaign, central min- it can be traced back to imperial times (to istries handed over most centrally con- be further discussed later). Not long after a trolled SOEs to subnational governments. full-scale transplantation of the Soviet model As a result, the subnational governments’ in the early 1950s, there were two major tax revenue increased from 20 percent of campaigns that lead to vast waves of decen- the national total in 1958 to 76 percent in tralizations at extremely high costs. The first 1959 and 79 percent in 1961, much higher started in the late 1950s (the Great Leap than those in the post-Mao reform period Forward (GLF)), and the second in the late (table 2). Central planning was replaced by 1960s (the Cultural Revolution) (Susan L. regional competition. Subnational govern- Shirk 1993; Liu et al. 2006).9 ments were encouraged to compete with each other to over-fulfill planning targets, to establish “communes” earlier or at a larger 9 The GLF established the People’s Commune, thus the Commune-Brigade Enterprises (the predecessor of the TVEs); and expanded local industries under state and of the GLF is the Great Famine (see Justin Yifu Lin 1990 collective ownership. An essential part of the human cost and Wei Li and Dennis Tao Yang 2005).

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Table 2 Evolution of Chinese Fiscal Decentralization, 1953 to 2005

Subnational/ Subnational/ Year total revenue total expenditure GDP/capita GDP/capita grw Institutional changes

1953 17.0% 26.1% 554 3.2% 1st five year plan 1958 19.6% 55.7% 693 8.8% 1959 75.6% 54.1% 697 0.6% Great leap forward 1961 78.5% 55.0% 673 0.0% 1966 64.8% 36.9% 753 6.7% Cultural revolution 1975 88.2% 50.1% 874 4.5% 1978 84.5% 52.6% 979 9.4% Reform starts 1980 75.5% 45.7% 1,067 2.6% Fiscal reform starts 1984 59.5% 47.5% 1,396 10.4% 1988 67.1% 66.1% 1,816 6.4% 1993 78.0% 71.7% 2,277 8.5% 1994 44.3% 69.7% 2,475 8.7% Fiscal sharing rule 2004 45.1% 72.3% 2005 47.7% 74.1%

Sources: China 50 Years’ Statistics; GDP/capita: 1990 international dollars, Maddison (2003).

scale, to close down markets, etc. They were Corresponding with the second wave of also encouraged to try out different com- decentralization in the “Cultural Revolution,” mune organizations, different ways of orga- the subnational fiscal revenue (expenditure) nizing production and collective life (e.g., to national fiscal revenue (expenditure) ratio public canteen systems in communes), etc. increased from 65 percent (37 percent) in The central government’s bureaucracy was 1966 to 88 percent (50 percent) in 1975 trimmed; supervision of most state-owned (table 2). enterprises was delegated from the minis- As a result, China had already established tries to provinces and cities, and subnational hundreds of relatively self-contained regional governments’ responsibilities were substan- economies at the outset of the reforms. The tially enlarged. Reflecting the first wave of majority of the two thousand counties had decentralization in the late 1950s, the sub- SOEs producing agricultural machinery, national fiscal revenue to total national fis- while 300 counties had steel plants. Small cal revenue ratio jumped from 20 percent in regional SOEs produced 69 percent of 1958 to 76 percent in 1959 (table 2).10 China’s total fertilizer output and 59 per- cent of its total cement. More than twenty 10 By disturbing central planning and destroying mar- provinces had SOEs producing automobiles kets, while simultaneously removing local financial respon- or tractors (Xu and Juzhong Zhuang 1998). sibility, these campaigns degenerated into competitions of exaggerations and lies among subnational officials, which ended up in chaos and eventually created one of million people died of starvation between 1959 and 1961 the worst catastrophes in world history, in which about 40 (Roderick MacFarquhar 1974, 1983, 1997).

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This is in sharp contrast to all other formally during which time the subnational fiscal rev- centralized economies in which special- enue (expenditure) to national fiscal revenue ization and monopoly are hallmarks. With (expenditure) ratio was 78 percent (72 per- greatly reduced responsibilities, the Chinese cent) (table 2). central government was much smaller than To analyze the economic incentive and its counterparts in other centralized econo- coordination mechanisms of the Chinese mies. When the Chinese reforms started, the RDA system, the governance structure is number of products directly under the cen- modeled as a stylized multiregional gov- tral plan was only 791 (the number was never ernance form (M-form) (e.g., Qian and Xu more than one thousand in the Chinese cen- 1993; Eric Maskin, Qian, and Xu 2000; and trally planned system) and the number of Qian, Gerard Roland, and Xu 2006, 2007). ministries at the center was less than thirty In the M-form hierarchy, every region is (Yingyi Qian and Xu 1993).11 controlled by the central government politi- When the reforms took place, after the end cally, whereas each region not only enjoys of the Cultural Revolution, subnational gov- a certain degree of autonomy but also is ernments already de facto controlled a great self-contained in its functions.12 Figure 2 deal of resources in China. Given this inher- depicts a highly stylized Chinese regional ited governance structure, for both political governance structure in which each region is and economic reasons, granting more auton- self-contained (in contrast to specialization): omous powers to subnational governments is each subnational government controls major one of the major strategies in the post-Mao functions within its jurisdiction, such as per- reforms, particularly during the first fifteen sonnel, finance, industry, and agriculture. As years of the reforms (Xiaoping Deng 1980, a comparison, specialized ministries control 1986; Shirk 1993; Liu et al. 2006; Wu 2009). industrial firms and the central government Subnational governments were given strong is responsible for coordinating the comple- incentives and were directly involved in man- mentary tasks of various ministries in other aging or setting up firms, forming joint ven- formally centralized economies. tures with domestic or foreign investors, etc. 2.2 Centralized Political Governance Many subnational governments have granted de facto property rights to local SOEs and Although highly decentralized economi- collectively owned firms (COEs) within their cally, China is neither a de jure nor a de facto jurisdictions (Granick 1990), which account federal state. The backbone of China’s RDA for most of the firms in the nation. Moreover, regime is the Chinese Communist Party subnational governments have become more (CCP), which controls the personnel matters important in all regional affairs, from land of subnational governments and commands allocation, business development, infra- high economic sectors (e.g., banking, energy, structure construction, and fiscal matters, telecommunication, railway, etc.), as well as to law making and law enforcement. Fiscal controlling ideology and the mass media. decentralization reached its peak in 1993, The dominant role of the CCP makes the RDA regime of China fundamentally

11 As a comparison, in the Soviet Union the central ­planning system was based on the principle of functional 12 The term M-form was first used by Alfred D. specialization, and the central government directly con- Chandler (1967) and Oliver E. Williamson (1975) to char- trolled most of the SOEs. In the late 1970s, there were acterize multidivisional structure of large corporations, sixty-two ministries under the Gosplan, which were where divisions are self-contained and are granted auton- responsible for 48,000 plan “positions” or twelve million omous power, while division chiefs are appointed by the products (Alec Nove 1983). headquarters.

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Central government

Central adm. function Territorial control

Personnel Finance Agriculture Industry Province A Province B Province C

Personnel Finance Agriculture Industry

Figure 2. Stylized Governance Structure of China

different from a federal system. Firstly, by practice, the central government makes deci- constitution, China is not a federal state. sions on appointment and removal of provin- The Chinese constitution has been amended cial leaders, e.g., governors. Similarly, most during the reforms, reflecting the changes municipal leaders, e.g., mayors, are directly of Chinese political and economic institu- controlled by corresponding provincial gov- tions. However, both the prereform version ernments. This nested network extends the and the latest version of the Constitution central government’s personnel control to stipulate that regions have no inherent officials of all levels of regions, from provin- power, and regional power is granted by cial to municipal, then to county until the bot- the central authorities. The central govern- tom of the hierarchy, township government ment is empowered to delegate power to (John P. Burns 1994). Moreover, reshuffling regions and also to rescind this power (for and cross-region rotation of regional leaders the PRC Constitution 1975 Amendment, is a common practice to keep central control see Chongde Xu 2005; for PRC Constitution over subnational officials. From 1978 to 2005, Amendment, see Falv Chubanshe 2009). 80 percent of provincial regions have experi- Secondly, China’s RDA regime is not a enced rotation of governors imposed by the de facto federal state either. Within the central government (Xianxiang Xu, Xianbin RDA regime, Chinese regional leaders Wang, and Yuan Shu 2007). This personnel are appointed by upper-level governments control approach is the major instrument through the CCP system—not by regional used to make regional officials comply with elections—despite devolution of much the central government’s policy and also to power over economic matters to the sub- provide incentives for regional experimenta- national governments. While subnational tion, which I will elaborate on in a later sec- governments obtain highly autonomous tion. Moreover, personnel control allows the economic power, the central government central government to achieve some macro maintains its influence on regional officials’ control, such as controlling inflation (Huang incentives by determining their career paths 1996b). Furthermore, through this mecha- (Yasheng Huang 1996b; Landry 2008). In nism, the central government has maintained

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considerable influence in consensus build- fast growing was not fulfilled in the last fif- ing with subnational governments in order teen years of their reforms in former Soviet to push through policies that are favorable Union and Central-Eastern Europe until the to the central government (Naughton and collapse of the system (Kornai 1986, 1992). Dali L. Yang 2004). Nevertheless, it must What makes China different is that they have be pointed out that, although this approach transformed the system into a mixed econ- worked sometime on high priority issues, it omy with an overwhelming private sector frequently failed on many other important and integrated into the global economy issues (section 6 further discusses this). However, this transformation evolved and is not designed by anyone. On the surface, 2.2.1 Evolved Decision-Making Process of China’s reform looks like a “pure” economic the Central Leadership reform without a major corresponding politi- In this subsection, I will discuss how the cal change.14 Nevertheless, as a matter of decision-making process of the CCP cen- fact, the post-Mao reform started from tral leadership evolved and how it works. astonishing political changes, which resulted In the post-Mao era, China’s central lead- in the change of the central leadership and ership sees economic growth as a life and the change of the central decision-making death matter for the regime. It is important process of the CCP. After three decades’ to point out that they are not unique among evolution, today’s RDA regime is fairly dif- socialist leaders in this aspect. In discuss- ferent from the CCP regime during the Mao ing the general features of socialist systems, era, although the political changes were Janos Kornai (1992, pp. 160–61) explains restricted to those necessary for enabling that the socialist leaders promise to “elimi- economic reform, with focuses on establish- nate the backwardness very quickly.” And ing the party rules, on personnel changes to the promise “rests on a belief that they can weaken those who might block reforms, and catch up with the developed countries quite on the selection mechanism of leadership fast by virtue of the socialist system’s supe- succession. riority. This belief is a major constituent of In the prereform era, the central decision the official ideology. The leaders insist on making of the CCP was dominated by a char- fast growth because it will provide further ismatic figure, Mao Zedong. In the revolu- evidence of that superiority.” There is a tionary era, the CCP was fairly decentralized large literature on “forced growth” in for- in that many important decisions were jointly mer socialist economies (Kornai 1971, 1992; made between central and regional lead- Gur Ofer 1987). Indeed, many speeches by ers, or made by regional leaders. Regional Deng (e.g., 1987) and other Chinese central power was a very strong element in the leaders concerning the central importance of growth echo those of Josef V. Stalin and Nikita S. Khrushchev.13 Yet, the promise of 14 Given the nature of communist ideology and the radical practice of the CCP in the Mao era, if there was indeed no important political change then China’s market reform would indeed look puzzling. Shirk (1993) notes 13 Stalin (1931 [1947, p. 356]) said “One feature of the that “ . . . the Chinese strategy of economic reform with- history of the old Russia was the continual beatings she out political reform appeared to have worked . . .” (p. 4); suffered . . . for her backwardness . . . We are fifty or one “The overall economic success of the Chinese economic hundred years behind the advanced countries. We must reform experience is surprising because we usually think make good this distance in ten years. Either we do it or of communist political institutions as rigid and hostile to they crush us.” Khrushchev (1959, pp. 76–77) claimed that innovation” (p. 5); and “We expect communist party and the socialist system will outcompete the Western world by government officials to defend their vested interests in the faster growth and eventually bury them. command economy by blocking market reforms” (p. 399).

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central decision-making body of the CCP.15 the central government (MacFarquhar 1974, Soon after the CCP took power in 1949, a 1983, 1997). The personal control and cam- dramatic political centralization took place. paigns mutually reinforced each other, and Although a region-based organizational the influence of the campaigns was far reach- structure was kept, the most influential ing. In addition to changing the behaviors of regional leaders were “promoted” as central the subnational officials, it deeply affected leaders and were physically moved to Beijing the governance structure of the party and of in the early 1950s.16 Simultaneously, China the state. transplanted the Soviet central planning With an extremely ambitious economic regime and the first five year-plan of China growth plan for speeding up China’s transi- was instituted. This centralization served to tion to a Communist society, the Great Leap establish a centrally planned economy and Forward (GLF) and the People’s Commune was welcomed by the CCP elites. As in the Campaigns were launched in the late 1950s. Soviet Union, the objective of the CCP was Not only did the campaigns once again dramat- “to build a strong socialist economy” [the ically decentralize the economy as discussed 8th National Congress of the CCP in 1956, previously, they also changed the central deci- see Research Center of CCP History 2009]; sion-making process. Since then, the Chinese and most SOEs were controlled centrally by economy has sharply deviated from the classi- ministries. cal Soviet central planning model. Through significantly weakening regional The “Cultural Revolution” (CR), launched leadership, this centralization substantially in 1966, is much more than another wave of strengthened Mao’s personal control over decentralization. To a large extent, it uninten- the party, from personnel matters to the cen- tionally prepared the necessary political and tral decision-making process.17 Mao man- institutional conditions for post-Mao reforms. aged to strengthen the cult of his personality The CR campaign mobilized the masses and by transforming the central decision-making CCP leaders at all subnational levels to fol- process into a series of political games in low Mao directly to fight against party and which his potential rivals were weakened government bureaucrats.18 There was an through fighting with each other. Without anarchy-type of decentralization through any rival at the subnational level, Mao which party/government organizations at the launched campaigns that delegated substan- central and subnational levels were replaced tial power to subnational governments, thus by mass organizations. The mobs enforced further weakening the power of his rivals in strict censorship that any idea different from Mao’s was absolutely not tolerated. During this period, with the slogan “down with 15 For example, in 1949, eight out of the fifteen Politbureau members of the 7th CCP Central Committee capitalist runners,” most of the party appa- were regional leaders. ratuses and central government bureaucra- 16 The most prominent figures include Deng—became cies were dismantled; most party/state/social the CCP General Secretary and was purged in 1967, Gao Gang—became the vice President of China and was elites were purged, including the president purged/died in 1954, Chen Yi—became vice Premier and of the country; regional “revolutionary rebel- was purged in 1967, Xi Zhongxun—became vice Premier lions,” with self-proclaimed loyalty to Mao and was purged in 1962, and Deng Zihui—became vice Premier and was purged in 1962. 17 In China’s imperial history, during the onset of each dynasty, it was typical that a new emperor would centralize 18 Two years before launching the CR, Mao warned power to weaken powerful regional rivals, such as warlords, subnational officials including county level officials that for the sake of consolidating the regime. Mao discussed they should refuse to follow and should resist the revision- this issue many times. ist central leadership (Quanxing Xu 1995).

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were supported by Mao’s lieutenants and the CR and were keen to make a radical “seized powers (duoquan)” at all levels of change, returned to power, and propaganda subnational governments from the CCP, campaigns were launched to change the ide- sometimes through civil wars (MacFarquhar ology of the CCP from one of class struggles and Michael Schoenhals 2006); and finally, to one of economic development.21 The CCP subnational governments became the most central leaders forged a new consensus on important level of government for manag- the following major issues: (a) the monopo- ing the economy, given that most ministries listic political power of the CCP must not be closed down.19 The devastation awakened challenged; (b) within the confines of, and to the majority of the party and social elites and strengthen, condition (a), economic develop- the legitimacy of the CCP was deeply shaken ment should be interpreted as the essence through the CR’s overwhelming destruction. of socialism, and thus of the utmost impor- All of these paved the road to making major tance; and (c) regarding the central decision- changes, to changing the decision-making making process, personalistic regime should rules and the objectives of the CCP after the be replaced by party rule, i.e., a consensus- death of Mao.20 based collective decision-making process The coup d’état of 1976, a few weeks after (Deng 1984; Ziyang Zhao 2009; Rui Li 2008; the death of Mao, in which Madam Mao and Zemin Jiang 1997).22 This was a watershed her lieutenants were arrested, eliminated period in which the CCP began to trans- those who insisted on continuing the CR form itself from a personality-ruled party from both the central leadership and subna- into “a system governed by rules, clear lines tional levels. Consequently, a large number of of authority, and collective decision-making CCP high officials, who were purged during institutions” (Shirk 1993, p. 399). Moreover, economic development has become the objective of the party and the state. 19 The self-contained and self-sufficient regionally These critical personnel and ideologi- decentralized structure was further reinforced in the early 1970s when most of the counties in the nation were cal changes were consolidated in the Third encouraged to setup small industrial firms in five major Plenum of the 11th CCP Central Committee sectors (Wong 1987). in December 1978.23 The communiqué of 20 A failed attempt to change the central focus of the CCP before Mao’s death is more than a prelude of the this plenum became the official manifesto for post 1978 reform. There was a belief among the top CCP political, ideological and economic change. leaders that the CR has brought the Chinese economy to Consequently, the “Four Modernizations,” the verge of collapse and refocusing the central task of the CCP to the economy is a matter of life and death to the party (in later years Deng repeated these arguments many times, e.g., 1980, to justify the changing of the central task 21 Before Deng returned to power in late 1978, most of of the CCP). In 1975, the premier Zhou Enlai, together the major changes were lead by Hu Yaobang, the minister with Deng, a deputy premier after being purged for many of the CCP personnel department and the de facto head of years, launched the so-called “Four Modernizations” (mod- the Central Party School (Jiwei Hu 2008, 2009). ernization of agriculture, industry, science and technology, 22 The following argument of Deng (1994b) well and defense) campaign. This campaign represented a ris- represents the goal of the CCP: “to build socialism it ing consensus among most CCP elites. More importantly, is necessary to develop the productive forces . . . Not they underlay a competing legitimacy for the future party until . . . we have reached the level of the moderately devel- leadership. Challenging the revolutionary theme of the oped countries, shall we be able to say that we have really CR, this de facto reform incited intensive political fights built socialism and to declare convincingly that it is supe- as part of the succession of the CCP’s leadership. Although rior to capitalism. We are advancing towards that goal.” this reform attempt was crushed politically by the left-wing 23 Although the Third Plenum of the 11th Central faction with formidable support from Mao, this aborted Committee of the CCP officially changed the objective of agenda became a platform for changing the CCP and it the CCP to economic development under the slogan “the reminded the CCP reformist elites that a pure economic Four Modernizations,” reform was not in the agenda of the reform would be blocked without political change. Plenum (Hu 2009).

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the slogan of the Third Plenum of the 11th as China did in the first five-year plan? Or Central Committee of the CCP, and later should it be developed by transforming the “Reform and Open-up,” which replaced economy into a market system? Should the the “Four Modernizations” after the 13th political system be reformed together with Congress of the CCP in 1987, emerged as economic reforms? What should be the direc- the official objective of the CCP. tion for a political reform? There were sharply To some extent changing the foundation different views on these issues among the of legitimacy of the CCP to one of economic CCP central leaders; more importantly, there development does not contradict commu- were power struggles associated with these nist ideology and is not unique to the post- differing views.25 Mao CCP, although this may be at odds with Given the inherited RDA institution, deal- other types of dictatorships.24 Perhaps more ing with political risk and technical uncer- important than ideology, economic develop- tainty, a general reform strategy, marked ment is regarded as essential for the survival by a local experiment-based collective­ of the regime. Yet, the much more challeng- central decision making process, emerged. ing issue is to find a way to fulfill the objective Decision-making powers for trying out of economic development. Essential issues concrete measures were delegated to sub- of how to reform the economy and through national governments, whereas the cen- which approach the economy should be or tral government kept control of strategic­ can be developed were indeed highly con- political and economic issues (Deng tentious among the top CCP leaders (Zhao 1984). This approach makes a consensus- 2009). Should the economy be developed by building-based decision making more restoring the Soviet central planning model, progressive.26 Therefore, most strategic decisions on China’s market reform were

24 According to Marx, one respect in which socialism is better than capitalism is its higher capacity for advancing in the sense of neoclassical economics. In reality, all “productive forces.” Thus, in order to prove the validity of socialist economies have substantially smaller shares of the communist party’s doctrine, it is necessary to deliver a consumer consumptions in their GDPs than those of mar- higher growth rate than those of capitalist economies. For ket economies. This indicates that growth maximization this reason, most communist leaders in Soviet Union and of socialist economies is divorced from pursuing social Eastern Europe, even including Mao in the 1950s, tried welfare. For further analysis and more details on forced hard to make their economies to grow faster, although growth in socialist economies, see Kornai (1980, 1992). they all failed eventually. The following argument of Deng 25 Deng, Zhao Ziyang, and Hu Yaobang etc. shared a (1994b) well represents the ideology of the post 1978 CCP, pro-market approach, whereas Chen Yun, Li Xiannian, Bo “to build socialism it is necessary to develop the productive Yibo, and Hua Guofeng etc. had a strong view insisting on forces . . . Not until . . . we have reached the level of the mod- central planning (Deng 1984; Zhao 2009; Li 2008). On erately developed countries, shall we be able to say that we political aspects, Hu and Zhao pushed for political plural- have really built socialism and to declare convincingly that ism within the one-party system as a part of the reform. it is superior to capitalism. We are advancing towards that Sometimes Chen Yun also proved more amenable to other goal.” Indeed the multiple decades’ unsuccessful reform views for maintaining the party rule rather than promoting efforts in Soviet Union and Eastern European countries political pluralism. However, Deng, Li, Bo, and most other were all driven by their attempts to regain growth impe- elder CCP top leaders had strong views insisting on strict tus in those economies. The collapse of the Soviet Union ideological control combined with repression of political and the whole Eastern Bloc made the CCP top leaders feel dissidents (Zhao 2009; Li 2008; Tong Bao 2009). Here, that continued economic development was crucial for the ideological control is essentially about the compliance to survival of the regime. For example, former vice premier the voice of the CCP central leadership, rather than any Tian Jiyun attributed the collapse of Soviet Union and the particular theory or doctrine. Eastern Bloc to their decades’ failures in improving their 26 “The Chinese government bureaucracy . . . always productivities (Mingming Du and Qingquan Xu 2009). Yet made decisions by consensus.” “Consensus decision mak- it should be noted that, in both communist ideology and ing institutions tend to be conservative because radical policy, neither “advancing productive forces” nor pursu- departures from the status quo are blocked by vetoes from ing high growth rates implies social welfare maximization groups who stand to lose” (Shirk 1993, p. 15).

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made “collectively” in the form of com- often dominated other experiments in promises among the top CCP leaders in a regional competitions, and most of the time trial-and-error process. “Collective” here what matters most in the decision-making has a broad meaning in that it includes also process is performance. subnational officials’ contributions through This local experiment-based central their local policy experiments. decision-making process also makes reform Political challenges and resistance to a progress more stable, since the early reforms reform are weakened when a new reform is created strong interest groups not only tried only in a few regions as experiments, among central leaders but also among sub- such as the special economic zone experi- national officials, particularly those who ments (to be further discussed in section initiated “their own experiments.” Through 4.2). More importantly, for reforms bear- the basic operating mechanisms of the RDA ing high political risks, the reformist cen- regime, the built-in interests and pro-reform tral leaders could be vague without making interest groups among subnational officials an explicit decision when local experiments became a valuable stabilizer for the reform were allowed without an official endorse- policies. Another important decision pro- ment, which implies a central leader will cess, which establishes the continuity of not take serious responsibility if something reform policies in the long run, is the way goes wrong with the experiment. The pro- the future central and subnational leaders cess of the land reform in the early 1980s are selected (I will discuss this in the next and privatization in the late 1990s, which part when I deal with the central–regional were major breakthroughs if we compare relationship). Economic development as the them with the two decades’ reforms in base of legitimacy for the CCP central lead- CEE–FSU before 1989, are illustrations of ership has been reinforced during decades of the advantage of local experimentation (to reforms. As a result, this objective is codified be elaborated in sections 4.2 and 5.4). It is into the amended constitutions of the Party also pragmatic because the CCP top lead- and the state. Capitalist entrepreneurs are ers, including those who pioneered market officially regarded as part of “advanced social reform in China, knew little about how to productive forces” and are recruited into the transform the Chinese economy into a mar- party (the CPC Constitution, the 16th CPC ket economy (Zhao 2009). It was much safer Congress 2002) (see Bruce J. Dickson 2003). for them to follow some successfully tested The Chinese constitution has also been reform measures than to implement some amended to protect private property rights designed programs. (Constitutional Amendment 2004). Moreover, regional competition helps to 2.2.2 Personnel Control contain the impact of conservative ideology, and thus is a de facto selection mechanism Personnel control is a major channel in local experiment-based central decision through which the central government con- making. Indeed, not all central and subna- trols, coordinates, and motivates subnational tional officials are pro-market reformists officials. With this instrument, the Chinese and not all local experiments are market RDA regime implements a centrally con- reform trials. Just as Chinese regions are trolled decentralization in which most tasks heterogeneous, there were all kinds of of reforms and economic development are experiments being tried, from egalitarian carried out by subnational governments. collectives to private businesses. However, On the one hand, regional officials control outcomes of market reform experiments huge amounts of resources and they enjoy

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fairly broad autonomies within their jurisdic- targets related to economic construction tions; on the other hand, their career paths (Tsui and Wang 2004). In general, per- are controlled by the central government. formance criteria are broader for leading Specifically, appointments, promotions, and officials at higher-level subnational gov- demotions (or more severe punishments, ernments, while the targets set for leading such as imprisonment for serious violations officials at lower level subnational govern- of the rules) of subnational officials in China ments tend to be more precisely defined. are ultimately determined by the central According to a handbook issued by the government, and their career paths are tied Party, work achievement accounts for 60 to the performance of their jurisdictions. to 70 percent of the evaluation of regional This makes Chinese economy fundamentally officials, while other aspects, such as politi- different from a federal system.27 cal integrity, competence and diligence This personnel control system is a nested together account for the rest, 30 to 40 per- network in which the center directly con- cent (Maria Edin 2003). trols the key positions at provincial level and It is also documented that county govern- grants each tier of subnational government ments control township and village officials the power to appoint key officials one level by linking their performance to promotion below it. Each level of subnational govern- (Susan H. Whiting 2000). In field works at ment oversees the appointment, evaluation, township-level governments, it has been promotion, and dismissal of its subordinate- found that party secretaries and township level regional leaders. heads sign performance contracts with the A set of performance criteria for lead- county level. In these contracts, township ing officials at subnational governments officials pledge to achieve targets estab- is stipulated by the level of government lished by county officials, and are held above it. Regional officials are assessed in personally responsible for attaining those accordance with the important tasks and targets. Performance targets are ranked in targets laid down by their superior level three categories: soft targets, hard targets, of governments. Level by level, each level and priority targets with veto power. Hard of subnational government negotiates with targets tend to be economic, such as an eco- their subordinate subnational government nomic development plan and tax revenue, for performance targets. Then, regional whereas priority targets are often politi- officials at different levels sign target cal, such as keeping social order. Fulfilling responsibility contracts with their superi- hard targets is important for bonuses and ors. The targets for the tasks to be attained for political rewards, whereas completion of as well as rewards/penalties contingent on priority targets affects personnel decisions the fulfillment of those targets are speci- (Edin 2003). fied in those contracts (Kai-yuen Tsui and Moreover, competition between regional Youqiang Wang 2004). For example, in a officials among the same level, such as at the scheme for provincial leading officials, 60 county level or township level, is an essen- percent of these leaders were assigned to tial part of the cadre management system. As discovered in fieldwork in one county, lead- 27 It is interesting to note that this governance structure ing cadres of the first three ranked townships of Chinese government, i.e., a combination of a centralized in the annual evaluation were recognized as personnel control and a decentralized operation/imple- “advanced leaders,” whereas the bottom 5 mentation, shares some similarities with the Japanese cor- porate governance structure, particularly before the 1990s percent of officials on the list were disgraced. (Masahiko Aoki 1990). To be a top-ranking township leader and

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to be awarded with the title of “advanced former party secretaries of Suzhou, one of leader” enhances the chances for promo- the best-performing municipalities in China, tion substantially, and thus it is regarded as a were promoted to become provincial gover- “political bonus.” Indeed, some first-ranked nors of Jiangsu, Shaanxi, and Jilin. Between township officials were promoted within the 1998 and 2002, a former mayor of Wenzhou, county (Edin 2003). another top-performing municipality, was To enhance the effectiveness of the per- appointed as vice-governor and then gover- sonnel control system, rotation and cross- nor of Sichuan (Shiuh-Shen Chien and Litao region transfer are also deployed. The Zhao 2007). practice of rotating provincial-level offi- 2.3 The Central–Regional Relationship cials has always existed, and it has been further institutionalized since the 1990s. The central–regional (or central–local) The Central Committee of the CCP has relationship has always been one of the most issued Party decrees on the rotation system important issues when considering China’s in 1990, 1994, 1999, and 2006. The Party governance. Although the formal structure decrees announce that a major purpose of is hierarchical between central and regional rotating regional officials is to promote eco- governments, the authority of the central nomic development through diffusion or government is endogenized insofar as the duplication of regional reform experiences power of the national leadership depends (Xu, Wang, and Shu 2007).28 Directed by on the collective support of the regional this policy, during the period between 1978 leaders as well. This sophisticated structure and 2005, about 80 percent of governors plays important roles in the operation of the were promoted or transferred from other RDA regime, such as continuing effective provinces, i.e., many of them were not pro- national macroeconomic policies, encourag- moted within the same province. The aver- ing regional initiatives, and balancing cen- age duration of their tenures within a given tral–local interests. province is close to four years, while rang- One of the most important governance ing from as little as one year to as many as mechanisms of the RDA regime is the ten years (Xu, Wang, and Shu 2007). selection process for the future central and It has been documented that, during the subnational leaders. The process includes reform era, rotation was often combined nominations and approvals. Nomination with promotion. The rotation/promotion by top leaders is necessary for anyone to combination was frequently used to pro- become a central leader candidate, but mote mayors of successful municipalities to nomination alone provides no guarantee be governors of other provinces, particularly for the future of the candidates. A nominee underperforming provinces. This promotion must convince most of the top leaders that path creates incentives for regional lead- he both shares their core values and prin- ers to work hard. Moreover, this may also ciples, and he has the capability to perform. serve as a mechanism to diffuse success- As such, excellent performance at the pro- ful regional experimentation (I will further vincial level becomes necessary for anyone discuss regional experiments in section 4). to be nominated and eventually promoted as For example, between 1998 and 2004, three a top leader. Although this requirement may not be codified formally, without a single exception, from 1992 to 2008 every presi- 28 Historically, rotation was a common practice in the Chinese Empire to prevent regional officials from cultivat- dent, every premier, and every newly elected ing strong political power bases within their jurisdictions. Politbureau Standing Committee member of

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the four CCP congresses29 during this period gaps in other issues—the delegation of was promoted from a provincial position; power to regional governments is also highly i.e., none of them were from a ministerial or incomplete (a la Katharina Pistor and Xu other central agency position. The appoint- 2003). For most issues, as long as the central ment of subnational level officials follows a government does not have an explicit policy, somewhat similar consensus-based selection by default the regional governments would process, with intensive interactions between be in the position to make decisions within upper and lower-level governments. In addi- their jurisdiction. However, the central gov- tion to major impacts on both the subna- ernment retains the power to intervene. The tional officials’ career paths and the pool of incompleteness of personnel control and future top national leader candidacy, these power delegation is partly a result of com- procedures also act as institutions that bal- promises and partly a design for encouraging ance national and regional interests. more local initiatives from local govern- Supported by commonly shared col- ments, while still remaining open to central lective interests among most national and control. At the same time, this regime also subnational officials, the central leadership makes it possible for subnational govern- enjoys considerable authority over poten- ments to maneuver against, rather than to tially disobedient regional leaders. With simply comply, with policies of the central this authority, the central government takes government. a tough stand to make the subnational gov- To understand the distinctive feature of ernments comply on the most important China’s RDA regime, such as the enable- issues, such as national (or political) unity ment of local governments, it is worthwhile and macro stability. Personnel control is to point out its origin and its robustness in often used as the last resort for enforce- history. The basic governance structure of ment to guarantee the implementation of China’s RDA regime originated from the central policies.30 birth of the Chinese empire and has evolved At the same time, as previously discussed, over two thousand years, which has sup- the central government is often fairly hands- ported the empire to last so much longer off on regional economic issues. Subnational than all other empires in world history,31 and governments are granted sizable de jure has a long lasting impact on the governance control rights and endowed with even of today’s China.32 greater de facto control rights over most Designed at the beginning of the Qin economic issues and resources within their Dynasty (221 BC), subnational government jurisdictions. Together with a highly incom- plete personnel control regime—although 31 It is well known that institutions of most of the coun- it is highly structured and effective, it is tries in the world have a European origin through their ambiguous on many issues and there are imperial histories, e.g., the United Kingdom and France; or colonial histories, e.g., the Americas, Africa, and South Asia; or voluntary adoptions of the European institutions, e.g., Russia, Japan. But it is well noticed that China has 29 A common practice of the CCP is to put the neither been colonized by Europe nor adopted European selected next top leader(s) into the Politbureau Standing institutions systematically before the 1950s, when it Committee. adopted an institution from the Soviet Union. This is the 30 When a few regional leaders defy the central gov- underlying reason why, on many facets, China looks incon- ernment and challenge the power of the central govern- sistent with the regularities discovered in cross-country ment, they are punished severely. Recent examples include studies. the dismissal and imprisonment of the former mayor of 32 Indeed Mao frequently referred to the governance Beijing, Chen Xitong, in 1995, and the former mayor of approach of imperial times, perhaps more than his discus- Shanghai, Chen Liangyu, in 2006. sions on Marxism and the Soviet system.

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Emperor

Central adm. function Territorial control

Personnel Finance Justice Industry Province A Province B Province C

Personnel Finance Justice Industry

Figure 3. Stylized Governance Structure of Imperial China

officials were appointed by the Emperor (Gang Bai 1996).33 A caveat is in order that (Qian Sima 1993 [109 BC]). This assures the during imperial times there was no political emperor’s strategic control over the nation. party, such as the CCP, which makes today’s Given the primitiveness in communication RDA regime historically unique. and transportation at that time, most local The consensus-based decision-making affairs were delegated to subnational gov- process and personal control system of ernments, conditional on their loyalty to the the RDA regime provide mechanisms for Emperor. To enable subnational govern- upholding a balance between economic ments’ effective control, they are assigned decentralization and political compliance. with self-contained functions that each of These mechanisms allow the regime to them was able to coordinate operations evolve while keeping the central–regional within its jurisdiction. This is true at all levels relationship basically stable.34 There were of subnational governments. To illustrate the deep worries that delegating economic pow- self-contained governance structure at every ers to regions undermined the capacity of level of subnational governments, figure 3 the central power (Shaoguang Wang 1995). depicts a stylized structure similar to that of And in the early period of the reform, the imperial China during the Ming and Qing dynasties (1368–1910) in which the empire 33 The six ministries at the central government are divided the central government’s functions Ministries of Personnel (li), Finance (hu), Civil Service into six ministries. The most important min- Exam and Foreign Affaires (li), Military (bing), Justice (xing), and Manufacturing (gong), i.e., li-hu-li-bing-xing- istry was Personnel (li bu), which deter- gong liu-bu. The six similar offices at each county govern- mined the appointment and promotion of ment are li-hu-li-bing-xing-gong liu-fang. Here, bu and central and provincial officials. This structure fang are in bold to highlight the difference between the central government (six ministries, liu-bu) and a local gov- extends to the bottom administrative level, ernment (six offices, liu-fang). the county level. Just like in the central gov- 34 It has been reported that during the reform era, in ernment and at the provincial level, a typical a period of more than two decades, the provincial share in the Politburo of the CCP increased slightly; meanwhile, county (xian) government controlled the six the provincial share in the Central Committee of the CCP corresponding offices within its jurisdiction declined by a similar magnitude (Yumin Sheng 2005).

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time associated with much regional decen- were compensated by other means, such as tralization, the central government’s share of extra-budgetary and nonbudgetary revenues national total fiscal revenue declined substan- (Wong 1997), and their losses in controlling tially. When the economy was growing rap- bank lending were compensated by stronger idly and some regional governments enjoyed controls over land and state assets within high surpluses, the national government ran their jurisdictions (subsection 6.1 discusses deficits and had to borrow from some prov- the consequences of these changes). inces. Moreover, central power could be 2.4 General Remarks further weakened by the enfranchisement of regional leaders in Party institutions dur- The decision-making process of China’s ing national-level successions (Shirk 1993).35 RDA regime relies on building consensuses It was argued that capacity of the central among the top leaders—often including pro- government was undermined so severely vincial leaders—and regional experiments, during the reform era that this weakened which keeps a balance between national and capacity threatened Chinese political unity regional interests. This mechanism generates in a manner similar to the situation before outcomes that are somewhat similar to what the disintegration of Yugoslavia (Wang and occurs through negotiations in a legislative Angang Hu 2001). Responding to the wors- body. Moreover, together with the selection ened central fiscal capacity and weakened process of national and subnational leaders, central control over bank lending—which these mechanisms nurture interest groups led to central government deficits, excessive of market-oriented and growth-oriented lending, and inflation in the early 1990s—the reforms within the party, which contributes to central government increased its political stable market reforms over several decades. and administrative control over provincial Although China’s RDA regime is evolved government leaders to coordinate and imple- from China’s unique history (e.g., the longest ment national economic policies (Huang imperial history in the world and the unprec- 1996a, 1996b; Naughton and Yang 2004; edented events of the Cultural Revolution), Landry 2008). During this time, the central which makes its policy lessons less rel- government took away some powers from evant directly for other countries, there subnational governments. Tax collection was are important general lessons for debates recentralized in 1994, and control over bank on decentralization. Firstly, for developing lending was also shifted away from subna- and transition economies, focusing on fis- tional governments (Tsui and Wang 2004). cal decentralization can be misleading for However, this fiscal recentralization did not both understanding and policies. Secondly, fundamentally change the RDA regime and extreme decentralization in general may not did not terminate regional decentralization. be optimal. If China went down a path of These should instead be viewed as efforts extreme decentralization in which all prov- to maintain a balance between the interests inces became completely autonomous except of national and subnational governments. in military and foreign affairs, even assuming Regional governments’ losses in tax revenue away potential political instability, without an active central government all the benefits from the combination of collective decision 35 Shirk (1993) argues that the content and sequencing making and regional experimentation would of China’s economic reforms are determined by the ongo- disappear; negative externalities across ing succession struggles of the Party, whereas devolution gave central politicians the opportunity to win the gratitude regions would become prevailing; and no and the political support of officials from the provinces. one would take care of positive externalities

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across regions. Moreover, the nature of with intrinsic motivations to reform, the only regional competition and regional experi- incentive that needs to be devised is to give ments would be fundamentally weakened (to them the power to initiate and to imple- be discussed in sections 3 and 4). ment reforms. However, extra incentives, i.e., extrinsic incentives, are necessary for most subnational officials to take risks and 3. Regional Competition and Subnational to work hard for reforms. Furthermore, very Governments’ Incentives for Reforms often well-devised extrinsic incentives can A distinctive feature of China’s reform is induce stronger intrinsic incentives and vice the vital roles played by highly motivated versa, so that the two incentives often rein- subnational governments. Governors Zhao force each other at equilibrium (a la Roland Ziyang of Sichuan and Wan Li of Anhui Bénabou and Jean Tirole 2003). By the same initiated land reform experiments in a few logic, poorly devised or destructive extrin- localities within their jurisdictions in the sic incentives could weaken or even destroy late 1970s when the national policy, includ- intrinsic motivations for reforms. In this sec- ing the Party’s “reform” manifesto, did not tion, I will focus on the extrinsic incentives allow any ownership change to collective provided to Chinese subnational officials. farming. Similarly, governor Xi Zhongxun of My major argument is that interregional Guangdong proposed the special economic competition has motivated subnational zone reform while some top central leaders officials to push forward reforms. Chinese were hostile to this reform plan (sections 4 regions (provinces, municipalities, counties, will elaborate on this below). Later, when and townships) compete against each other those locally initiated reforms were endorsed for performance rankings and regional offi- by the central government as national poli- cials’ careers are linked to their performance cies, the reforms were implemented by in the “tournaments.” 36 all levels of government nationwide. After As bureaucrats appointed by their upper the initial success of the regional reforms, level governments, most Chinese subnational these reform pioneers were all promoted to officials are very much motivated by their national level posts. Zhao and Wan became career concerns, which are basically about the premier and executive deputy premier climbing ladders within the government of the state council, respectively, respon- hierarchy. Through this channel, the central sible for national reform; Xi became a vice government affects the ultimate incentives of Chairman of the National People’s Congress. the subnational officials. It is noteworthy that As the pioneers and architects of regional this mechanism is fundamentally different reform, the political risks they faced were from the well-known jurisdictional Tiebout substantial. The key issue I will address in competition, or in general fiscal jurisdic- this section is how subnational government tional competition in the fiscal federalism officials are motivated to initiate and to implement reforms. Without a solution to 36 The most popular performance indicators used in incentive problems of government officials regional rankings are GDP (total or per capita), GDP at all levels of government, reform would growth rate, and FDI. In addition, some other indica- tors, such as regional competitiveness in various aspects, not be carried out successfully or potentially are also widely reported. For example, in a recent rank- not even be attempted. There is no question ing, Shanghai, Beijing, and Guangdong were ranked as the that some reformists have intrinsic personal first, second, and third most competitive regions in China in 2007, which is unchanged from those in 2006; whereas motivations (a la Canice Prendergast 2007) inland provinces Anhui and Hubei improved their rankings to push forward reforms. For those officials significantly (Xinhua 10/03/2008).

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literature. The latter has nothing to do with incentives to regional officials for regional the internal promotion of the local govern- economic growth, as can be seen in most ment officials. Instead, local officials are other countries. What makes China special driven by their fiscal motives, e.g., maximiz- in providing strong incentives to regional ing property values within their jurisdictions officials for economic development? by attracting additional residents (Charles Furthermore, there are serious potential M. Tiebout 1956; Wallace E. Oates 1999) or problems associated with decentralization, by winning votes from their constituencies such as regional protection and regional (Dennis Epple and Allan Zelenitz 1981). environment problems. What are the con- ditions under which regional competition 3.1 The Institutional Foundation for leads to desirable outcomes? Regional Tournament Competition To address the first question, let me start In this subsection, I elucidate how China’s with a summary of the major features of RDA institution creates the conditions for Chinese institutions that facilitate regional regional competition, as well as the trade- competition. First, Chinese subnational offs of this regional competition. When the officials are subject to incentive schemes reform era started in the late 1970s, regional managed by the central government. With governments were encouraged to find ways centralized personnel management for sub- to develop faster than other regions. Policies national officials, regional competition under on special economic zones and other eco- this institutional structure is qualitatively nomic development zones were imple- different from fiscal federalist regional com- mented, enabling subnational governments’ petition in which local officials are elected competition for investments. Regions com- (Epple and Zelenitz 1981). Second, the pete for economic growth and for attracting Chinese national government not only pos- FDI, etc. Since the mid-1980s, many better- sesses superior powers of appointment, performing counties were upgraded to the promotion, and dismissal of subordinate municipal level, which further enabled and government officials, but it is also strong empowered these local governments. At the enough to eliminate collusions between same time, this city status upgrading also lower level subnational governments. This provides high incentives to all the county preserves tournament-like regional com- governments to compete for the opportu- petition since collusion among subnational nity to be promoted. Government statistics officials can make competition impossible. and mass media regularly publish rankings Third, Chinese regions, particularly county- of regional performance, which become an level or higher-level regions, have historically important part of evaluations for determin- been and remain relatively self-sufficient in ing the promotions of subnational govern- that each region contains multiple economic ment officials. sectors. Therefore, most Chinese regions are In contrast to the prevalence of regional alike in their economic structures, which is a competition and initiatives taken by subna- critical condition for tournament like com- tional governments in Chinese reforms, offi- petition to function (discussed in more detail cials in other reforming countries or other below). Moreover, this greatly weakens transitional economies were not given simi- interdependence among Chinese regions lar competitive incentives and they were, in and enables subnational governments to general, less active in taking initiatives than coordinate most of the economic activities their Chinese counterparts. Yet, decentral- within their jurisdictions. Finally, Chinese ization does not automatically create strong subnational governments are both enabled

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and empowered to take responsibility for the specific mechanism that makes regional economies within their jurisdictions. They competition effective in China? And what are granted a fairly high degree of autonomy prevented the FSU-CEE countries from on economic activities. Enablement and deploying a similar approach? empowerment themselves are vital sources As in any incentive theory, the outcomes of incentives. Ultimately, incentives for offi- of the tasks are determined jointly by the cials can play important roles only when managing efforts of the relevant officials those officials are enabled and empowered and outside random factors. The officials’ to take reform initiatives or growth-enhanc- efforts are not observable to others and are ing measures, etc. costly to them; therefore, when there is no The theoretical model of Maskin, Qian, proper incentive scheme, there will be no and Xu (2000) highlights the relationship reform efforts. It is known that when facing between China’s RDA regime and high- unobservable efforts, tournament competi- powered incentives associated with regional tion can motivate agents better than other competition, which includes tournament- incentives schemes (e.g., Edward P. Lazear like competition.37 The stylized hierarchi- and Sherwin Rosen 1981). However, an cal organization modeled by Maskin, Qian, effective tournament competition requires and Xu captures the feature of the RDA that the tasks of the agents should be similar regime.38 There are two types of authori- and that the outside random factors faced by tarian structures considered in the model: the agents should follow the same distribu- a multiregional organizational form tion. The rigidness of these conditions makes (M-form), such as China, in which there are these models hard to apply directly to real- two unspecialized subnational regions, each world institutions. of which is assigned to manage similar tasks The Maskin, Qian, and Xu model extends such as manufacturing and agriculture; and the basic idea of tournament competition a unitary form (U-form), such as the former to different institutions organized in differ- Soviet Union before 1991, in which there ent ways, which determines how tasks are are two specialized subnational units— assigned and how information is used by ministries—each of which is assigned with each official. These in turn determine the managing a specialized task such as manu- effectiveness of different incentive schemes facturing or agriculture. In contrast with for the officials in the regime. Given that China, in those economies there were no Chinese regions are alike in their economic ministerial or regional competitions in compositions, which implies that shocks reform measures or growth-enhancing to regions are highly correlated, by assign- efforts, even though they started reforms ing similar tasks to regional officials and much earlier than China. The Maskin, delegating power to them in order to carry Qian, and Xu model focuses on incentive out regional reforms, regional competition issues of subnational officials in order to among them can serve as an effective incen- address the following questions: What is tive scheme. To understand the mechanism, let us suppose a governor performs poorly and tries to blame the outcome on bad luck 37 Interpreting the Maskin, Qian, and Xu model as a mechanism of the RDA regime is my personal view. in his region. This excuse is unconvincing, 38 In addition to authoritarian regimes, the Maskin, however, if all other similar regions are pros- Qian, and Xu model also applies to large corporations. This pering. Therefore, facing the comparison (or is not coincidental as the Chinese authoritarian regime is sometimes regarded as corporate technocrat-ship or cor- competition) with other regions should force poratism in the literature (e.g., Jean C. Oi 1999). every governor to work hard.

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On the contrary, if subnational units are industrial shocks are denoted as ​​​ and ​​ ​. ε1 ε2 highly specialized so that they are not com- The information relevant to the incentives parable or if tasks assigned to every official of the two ministers is summarized by the are idiosyncratic, which implies that shocks conditional variances Var(​ ​​ ​​) for minister ε1|ε​ 2 to these tasks are not correlated, such as 1 and Var(​ ​​|​ ​​) for minister 2. For an econ- ε2 ε1 ministries in former Soviet Union and omy organized in M-form, the middle offi- Central-Eastern Europe before 1989, it is cials are governors responsible for regions easy for a minister to blame a poor outcome A and B, and the corresponding regional on bad luck in his industrial sector and it is shocks are denoted as ​​ ​ and ​​ ​. The infor- εA εB difficult to object to his excuse, given that mation relevant to the governors’ incentives performance is imperfectly correlated with is summarized by the conditional variances officials’ efforts. That is, ministerial tourna- Var(​ ​ ​ ​ ​) for governor A and Var(​ ​ ​ ​ ​) for εA|ε​ B εB|ε​ A ment will not be efficient when tasks and governor B. information of ministries are sufficiently dif- Therefore, if Var(​ ​​ ​​) Var(​ ​ ​ ​ ​), then ε1|ε​ 2 > εA|ε​ B ferent from each other. Therefore, although the information quality for evaluating gov- distributions of industry-specific shocks and ernor A in the M-form is higher than that of region-specific shocks are exogenous, they for minister 1 in the U-form. In general, if affect officials’ incentives differently under Var(​ ​​| ) Var(​ ​​ ​​) (hereafter this condi- εi εj > εr|ε​ s different organizational forms. tion will be referred to as condition A), for Two types of incentives are analyzed in the all i, j 1, 2 and for all r, s A, B, we will = = Maskin, Qian, and Xu model: the absolute conclude that, everything else being equal, performance incentive, which ties an offi- regional competition with relative perfor- cial’s compensation to his own outputs, and mance evaluations under the M-form is more the relative performance incentive, which effective than ministerial competition under links an official’s compensation to other’s the U-form. Therefore, the M-form will be outputs in a negative way. The absolute able to provide better incentives to their performance incentive is inversely related governors than the U-form for ministers. Of to the noise level of each official’s own per- course, if condition A is reversed for every formance, while the relative performance pair-wise comparison, the conclusion will incentive is positively related to the correla- be reversed. Therefore, ultimately, whether tion between the performances of two offi- regional decentralization is more beneficial cials. In summarizing the two factors, the than a centralized regime is an empirical incentives of officials in any regime depend matter, and the Maskin, Qian, and Xu model on the variance–covariance matrices of the provides a methodology to test it. exogenous random shocks. Fortunately, the 3.2 Evidence essential information of variance–covariance matrices can be sufficiently compressed into Three forms of systematic evidences a scalar, the conditional variation measure- on the relationship between China’s RDA ment. A smaller conditional variation implies regime and regional competition will be pre- a smaller variation and a larger correlation, sented in this subsection. The first evidence i.e., a higher quality of information for incen- concerns whether or not China’s RDA regime tive purposes. provides better conditions, in terms of con- In a highly simplified version of the model, dition A, for jurisdictional competition than for an economy organized in U-form, the a centralized authoritarian regime. Then, I middle officials will be ministries responsible survey evidence that regional competition for industries 1 and 2; and the corresponding provides incentives to regional officials. The

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last evidence suggests that China’s RDA Similarly, using data covering 344 top pro- regime has made a significant contribution vincial leaders (187 party secretaries and 157 to China’s growth. governors) from China’s twenty-eight prov- Using a firm-level dataset of Chinese inces for the period from 1979 to 2002, Ye state-owned enterprises from 1986 to 1991, Chen, Hongbin Li, and Li-An Zhou (2005) Maskin, Qian, and Xu find that Chinese find that provincial officials’ performances regions are indeed “alike” in the sense that relative to the national average and to their regional competition should work better immediate predecessors had significant than ministerial competition. The dataset impacts on their promotions (columns 5 and contains industry classification codes and 6 in table 3). The left-side variable of all the location codes for each firm, and industry- regressions in the table 3 is turnover, i.e., specific shocks and region-specific shocks the probability of termination, staying at the are estimated by running the log-linear same level, or promotion. Cobb–Douglas production function. This Using a panel dataset covering 254 pro- allows for calculation of regional and indus- vincial leaders (provincial party secretaries trial conditional variations. In their sample, and governors) who served in twenty-eight 70 percent of the results satisfied condition A Chinese provincial units from 1979 to 1995, and there is no single case that the condition Li and Zhou (2005) find that regional offi- A is reversed. cials’ promotions are determined by the To address the question of whether rela- performance of their jurisdiction relative to tive performance evaluations are actually the national average. Everything else being used in China, Maskin, Qian, and Xu investi- equal, for those provinces that surpass the gate the relationship between the promotion average growth rate by one standard devia- of regional officials and regional economic tion from the mean, their leader would performance. They use regional represen- increase the probability of his promotion tation in the CCP’s Central Committee as a by 33 percent of the average probability of proxy for the promotion chances of officials promotion; and those that performed worse in that region and measure the economic than the mean by one standard deviation performance of a region by its growth rate would increase the probability of termina- in national income. Then they investigate tion by 30 percent of the average probability how the improvement of a region’s perfor- of termination (columns 3 and 4 in table 3). mance relative to other regions would later In the table, the punishment for the worst affect the promotion of this region’s officials. performers is shown as an estimated coef- Specifically, they constructed a national rank- ficient with cut-off point 1. Overall, the ing index of each province’s representation at marginal effects of growth performance on the 11th Party Congress in 1977 and in the turnover are large. 13th Party Congress in 1987, and constructed By separating provincial party secretaries a national ranking index of provincial eco- from governors, Sheng (2009) finds evidence nomic performance lagged by one year, as that provincial GDP growth mattered for the measured by growth rates in the year before political fortunes of governors but not those the Party Congress, that is, in 1976 and in of party secretaries. This may capture the 1986. The evidence shows that officials from division of labor between party secretaries relatively better-performing regions have a and governors in the RDA regime given that better chance of being promoted, suggesting the former were responsible for party affairs, that tournament-like regional competition is such as personnel control, whereas the latter at work. were put in charge of running the provincial

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Table 3 The Effect of Economic Performance on the Turnover of Provincial Leaders (Ordered probit regressions)

Dependent variable: turnover (0 termination, = 1 same level, 2 promotion) = = (1) (2) (3) (4) (5) (6)

Provincial annual GDP 1.615** 1.581* growth rate (2.05) (1.87) Provincial average GDP 4.727*** 4.540*** growth rate (4.34) (3.90) Provincial average per capita 3.001** GDP growth rate (A) (2.10) Provincial average per capita 3.584** − GDP growth rate of the (2.36) immediate (B) predecessor (B) (A) (B) 3.309*** − (3.41) Age 0.026* 0.023* 0.071*** 0.070*** − − − − ( 1.91) ( 1.68) (6.81) (6.77) − − Age 65 0.974*** 0.976*** 0.303** 0.303** − − − − ( 5.27) ( 5.25) (2.07) (2.07) − − Education 0.154 0.187 0.183 0.184 (0.96) (1.17) (1.48) (1.50) Central connection 0.384*** 0.404*** 0.082 0.085 (2.79) (2.89) (0.74) (0.77) Tenure 0.053* 0.055* 0.062** 0.062** − − − − ( 1.74) ( 1.78) (2.44) (2.45) − − Lagged per capita GDP 0.080 0.010 (million yuan) (0.43) (0.05) Cutoff point 1 1.320*** 3.162*** 2.850*** 2.850*** 6.992*** 6.929*** − − − − − − ( 3.67) ( 2.98) ( 2.64) ( 2.63) (8.42) (8.66) − − − − Cutoff point 2 1.621*** 0.106 0.455 0.455 3.736*** 3.662*** − − (4.63) (1.01) (0.43) (0.43) (4.64) (4.70) Number of observations 864 864 864 864 1,227 1,227

Notes: The numbers in parentheses are t-ratios based on robust standard errors. The significance levels of 1 percent, 5 percent, and 10 percent are noted by ***, **, and *. All regressions include the provincial and year indicators. Columns (1)–(4) are based on Li and Zhou (2005). Columns (5) and (6) are based on Chen, Li, and Zhou (2005).

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economy. Nevertheless, considering the fact autonomy and are treated separately from that most provincial party secretaries served the province in which they are located. Since previously as governors, their records on 1984, fourteen cities have obtained deputy provincial economic performance must have provincial rank (Yupeng Shi and Zhou 2007). already played a role in their promotion to Using a large panel data set covering all become secretaries. counties in China from 1993 to 2004, after Of course, the promotion of regional offi- controlling for the official upgrading require- cials is not solely determined by their perfor- ments, such as industrialization, population, mances in economic affairs. In most columns and fiscal strength, Li (2011) finds that, of table 3, many of the noneconomic perfor- everything else being equal, counties with a mance factors are controlled. One of them higher growth rate were more likely to get is the impact of regional officials’ connec- city status. He interprets this as evidence that tions with the central government on their upgrading is used by the central government promotion, which is measured by their as an incentive mechanism to align regional previous or current work experience in the interests with the national ones. Shi and Zhou central government. The central connec- (2007) show that everything else being equal, tion indicator has a positive and significant cities obtaining deputy provincial rank, i.e., a impact. Comparing columns 3 and 4 with greater degree of autonomy, increased per columns 1 and 2 of table 3 indicate that pro- capita GDP by an additional 9.3 percent, per motion and termination appear more sensi- capita FDI by more than 50 percent, and tive to the average growth rate than to the per capita investment by about 80 percent. annual growth rate. They suggest that the This indicates that enabling and empower- long-run or average measure weigh more in ing subnational governments by granting turnover decisions than those of short-term them more autonomy power together with shocks. high-powered incentives enhances regional In addition to providing incentives through economic growth effectively. appointment and promotion within the All of the above surveyed papers do not hierarchical structure, the decentralization- pay special attention to the potential reverse based reforms also further delegate autono- causality problem, except for applying some mies to subnational governments through time lags. One might challenge these find- various channels. One of those is the city ings by imagining that a governor who was status upgrading scheme. In the city status already picked to assume important posi- upgrading scheme, municipal governments tions in the central government in the future are granted more administrative authority being assigned to a province with fast eco- and the political position of a city is raised, nomic growth to show his performance. thus more strongly incentivizing its officials. That is, instead of career concern motivating One of these kinds of practices is to upgrade regional development, the findings may be some county governments as city govern- interpreted as placing favorable future lead- ments (county-to-city upgrading). From ers into easy performing regions to justify 1983 to 2001, 430 county-level cities were their later promotion. established, mostly by upgrading (Lixing Indeed, a clear-cut econometric study Li 2011). Another method is to upgrade that rules out a reverse causality has yet to some prefecture level municipalities to the be done. Nevertheless, if we combine all the deputy provincial rank city, which is offi- results from the literature, the overall pic- cially called separately itemized cities (jihua ture should be reasonably convincing that danlie), meaning that they enjoy substantial a reverse causality is not most likely. First,

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to improve the chance of being promoted, R. Weingast 1995). China is often seen as a a governor not only should perform better major example of market-preserving fiscal than average (Li and Zhou result); but also federalism (Gabriella Montinola, Qian, and should be better than his/her immediate Weingast 1995; Qian and Weingast 1997; predecessor (Chen, Li, and Zhou results), Hehui Jin, Qian, and Weingast 2005). which makes the reversed causality argu- At the same time, there is also a fairly siz- ment uneasy. Second, if a governor per- able literature that challenges fiscal federal- formed really poorly for several years, the ism on many aspects. First, interjurisdictional likelihood of his/her losing the governorship competition for capital may lead to a “race- is substantially increased. It is hard to imag- to-the bottom” in local tax rates or in reduced ine that poor performance for many years is provision of some local public goods (Michael unrelated to this governor’s own actions. Keen and Maurice Marchand 1997). It may Finally, in the analysis and evidence dis- prompt local governments to exploit possible cussed in sections 3.1 and 3.2, the govern- spillover to other jurisdictions, exporting taxes ment is focused on economic growth or or pollution to their neighbors (Roger H. growth-enhancing reforms. Under this con- Gordon 1983; Oates and Robert M. Schwab dition, tournament-like regional competi- 1988), and central government intervention tion creates powerful positive incentives to may be necessary to solve such problems subnational officials. However, when the (John H. Cumberland 1981; Gordon 1983; government’s task is expanded to many other Alice M. Rivlin 1992; David E. Wildasin potentially conflicting tasks, such as manag- 1989). Without a strong central government, ing inequality, protecting environment, and fiscal federalism alone will not lead to effi- maintaining social stability, regional com- cient results and will not be market preserving petition may create strong negative effects. (Olivier Blanchard and Andrei Shleifer 2001). This is discussed in section 6. Second, interregional competition for capital may encourage subnational governments to 3.3 Chinese Regional Competition and the act in ways that corrode the capacities of the Debate on Fiscal Federalism central state such that fiscal federalism will There is a large literature that debates not be market preserving (Hongbin Cai and whether the quality of public fiscal policy Daniel Treisman 2004, 2005). can be improved through regional compe- Evidence from cross-country studies is tition or fiscal federalism in general. The mixed: fiscal federalism in many countries seminal Tiebout model (1956) shows that often is found to be inefficient (Francesca jurisdictional competition among subna- Fornasari, Steven B. Webb, and Heng-fu Zou tional governments can make the provision 1999; Jonathan Rodden 2002; Rodden and of public goods more efficient. Along this Susan Rose-Ackerman 1997). Furthermore, line of thinking, a market-preserving fiscal arguments have been made and evidence federalism develops an argument that says has been found to show that Chinese fiscal that, under certain conditions, fiscal federal- decentralization is neither self-enforcing ism is self-enforcing and is market preserv- nor market preserving (Wong 1991; Cai and ing. The core mechanism is the commitment Treisman 2005; Tsui and Wang 2004). mechanism created by certain fiscal federal- However, this kind of debate could be mis- ism that prevents the national government leading if one ignores the fundamental differ- from intervention, which in turn provides ence between the Chinese RDA regime and proper incentives to government officials at a federal state. In the Tiebout branch of fis- all levels to encourage market growth (Barry cal federalism theory, the economic gains to

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subnational officials from attracting additional basic condition of ­market-preserving fiscal residents is central (Tiebout 1956; Oates federalism is violated is the recentralization 1999), voice or exit. In a more general version of tax-collection power after more than a of fiscal federalism, subnational government decade of fiscal decentralization. Facing a officials are elected and they are accountable decline on the central government’s fiscal to their constituencies (Epple and Zelenitz revenue while the economy was growing 1981). In contrast, Chinese officials face no rapidly (Wong 1991), in 1994 a reversal of pressure due to voice, exit, or election, sug- the fiscal decentralization took place in cen- gesting they should perform poorly. Yet, they tral government’s attempts to overcome this face strong incentives to meet the promotion problem (Tsui and Wang 2004). As a result, criteria defined by higher officials. Under the share of subnational governments’ tax certain conditions, these promotion incen- revenue in national tax revenue was reduced tives could be strong enough to replace the substantially from 70 percent to 40 percent incentives derived from voice, exit, or elec- (World Bank 2002). This implies there is no tion. But this is not always the case as some commitment to limiting the central author- later sections will discuss. ity’s power in fiscal policy. Moreover, the condition of market-pre- In addition to the nature of the basic serving fiscal federalism requires that “[t]he institution, there is an important technical allocation of authority and responsibility has assumption necessary for Tiebout competi- an institutionalized degree of durability so tion to work: factor mobility. Similarly, one of that it cannot be altered by the national gov- the five fundamental conditions of market- ernment” (Montinola, Qian, and Weingast preserving fiscal federalism requires that 1995, p. 55).39 This requirement “provides “[t]he national government has the authority for credible commitment to the federal to police the common market and to ensure system and thus for limits on the national the mobility of goods and factors across government’s discretionary authority. Not sub-government jurisdictions” (Montinola, only must there be decentralization, but Qian, and Weingast 1995). However, when that decentralization must not be under the reforms started regions competed fiercely discretionary control of the national govern- without factor mobility, and factors gradu- ment” (Montinola, Qian, and Weingast 1995, ally became more mobile as a result of p. 55). This is “a necessary component of the reform—not as a starting point of the federalism’s market-preserving qualities” reform. For example, labor in China has (Montinola, Qian, and Weingast 1995, p. 57). only become partially mobile since the mid However, under the Chinese constitution 1990s (John Whalley and Shunming Zhang and in line with general Chinese government 2004). Moreover, capital is even more immo- policies—both de jure and de facto—the bile than labor, and segmentation of capital central government preserves its discretion- markets is still a problem today (Gordon ary power over regions, and this power has and Li 2003). Although the direction of the been exercised during the reform era (PRC trend of trade barriers across regions and the Constitution 1982 Amendment, see Xu direction of the trend of factor mobility are 2005; PRC Constitution 2004 Amendment, debatable subjects, the existence of severe see Chubanshe 2009; Andrew C. Mertha factor immobility and regional trade barriers 2005). A prominent example in which this in China is indisputable (Alwyn Young 2000; Naughton 2003; Chong-En Bai et al. 2004). 39 Kellee S. Tsai (2004) argues that China violates basic Within the theoretical framework of fis- assumptions of market-preserving federalism. cal federalism, a violation of factor mobility

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makes interjurisdictional competition among governments are responsible for much regions impossible. Without factor mobility, broader roles in the economy, of which fiscal citizens would not be able to “vote with their policies are only a subset. Therefore, apply- feet,” and thus there would be no Tiebout ing fiscal federalism models that focus on fis- competition. Similarly, in the framework of cal policy alone will miss large parts of the market-preserving fiscal federalism, inter- reforms and will not be able to explain China’s jurisdictional competition would fail to serve economic reform and growth. This point is as an important incentive device without a also valid for most transition economies, at national common market and factor mobil- least during the process of transforming the ity (Jin, Qian, and Weingast 2005). However, economy into a market economy. economic development and the development of a national common market could be char- 4. Regional Institutional Experiments acterized as something of a chicken-or-egg dilemma. Therefore, a recipe for economic Regional experimentation is an essential development conditional on the existence of part of the central decision-making process a common market or factor mobility would in China (section 2.2.1). Starting from 1978, be difficult to apply usefully to real-world almost every major step on the path of reform situations.40 was tried out by a few regions first before What happened during the Chinese being launched nationwide. This is well reforms is that when factors were highly echoed by the well-known “slogan” of the immobile, i.e., when Tiebout conditions were Chinese reforms: “crossing a river by touch- violated, Chinese regions started to compete ing the stones.” To some extent, the “stones” fiercely with each other. Moreover, not only are reform measures and these “stones” are did the RDA regime manage regional com- “touched” through regional experiments. petition in a growth-enhancing manner, but Subnational governments play a critical also allowed factors gradually to become role in attempting reforms due to the uncer- more mobile, thus encouraging the evolution tainty of new reforms. One of the major of a national common market. The key point uncertainties is related to the challenges here is that factors became more mobile as of political resistance because reforms cre- an outcome of the reforms, rather than as a ate winners and losers in changing institu- precondition for them. tions. The political economy of institutional Finally, it is important to note that fiscal changes affects paths and strategies of federalism theory is based on the very fea- reforms. Under certain conditions, regional ture of market economies that requires that reform experiments are used as a strategy to the economic roles of local governments be weaken political resistance and to reduce the restricted to fiscal policies. Thus, the key uncertainties that come from a new reform. issues of fiscal federalism theory revolve A successful experiment outcome not only around fiscal policies such as taxation and provides information on which reform pro- the provision of public goods by local gov- gram works but also can be used to support ernments. However, Chinese subnational the reform and to persuade the unconvinced. Moreover, compared with a nationwide full-scale reform, when a regional experi- 40 In almost all developing economies, factor mobil- ment fails the drawbacks may be contained ity is limited and a national common market has yet to be to the experimenting region. In addition, developed; this makes people doubt the usefulness of the fiscal federalism model for economic development (Pranab some compromise policies or compensa- Bardhan 2002). tion schemes aimed at opponents of a given

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policy may be attempted as a way to ease the However, this potential benefit will be opposition toward starting a reform. That is, realized only when results can be obtained the option value carried with regional experi- through experiments that do not disturb the mentation may bear weight to tip the politi- rest of the economy, particularly in case of cal balance in favor of those reforms that experiment failures. It turns out that how may otherwise have been discarded. an experiment is coordinated determines However, it seems that China is unique whether an experimental approach will be in deploying regional experimentation as a fruitful and, in turn, the way experiments are reform strategy, while it is usually agreed that coordinated is determined by the way the Eastern Europe and the former USSR fol- economy and the government is organized. lowed the “big bang” strategy. Moreover, this Conventional economic wisdom may lead difference of approach is usually regarded as people to wonder why a market should not an explanation of why China’s reforms per- be used to coordinate a reform experiment. formed so differently than those of Eastern However, it has been argued that many Europe (John McMillan and Naughton essential coordination tasks often have to 1992; Jeffrey D. Sachs and Wing Thye Woo be carried out through nonmarket mecha- 2000). Yet, the experimental approach was nisms, even in developed market economies in fact utilized in the pre-1989 reforms in (Coase 1937; Weitzman 1974; Williamson Eastern Europe and the Soviet Union, but 1975). For economies carrying out reforms failed miserably.41 Those failures led to a aimed at transforming a centrally planned discrediting of the experimental approach economy into a market economy, this is par- in reforms and to the adoption of the big ticularly true since markets there have yet to bang approach. Ironically, to a large extent, be developed. In his Nobel Lecture, Coase China followed many of Eastern European- (1992) argued that the function of manage- style gradual reforms with experiment as an ment in a firm “was to co-ordinate” beyond essential ingredient in the earlier stages of the markets. He asked: “Why was it needed its reforms. A fundamental question is: what if the pricing system provided all the co- are the conditions that make China special in ordination necessary?” His answer was that deploying regional experiments successfully? “[t]o have an efficient economic system it is And, what makes the experimental approach necessary not only to have markets but also work in China but not in Eastern Europe? areas of planning within organizations of the The key potential benefit of experiment- appropriate size.” When an organization is ing is to reduce the uncertainties of reforms. large, such as a multinational company or a national government, a related key issue is “the appropriate size” of the suborganization 41 An interesting example is Khrushchev’s “Sovnarkhoz” reform (decentralization reform) launched in 1957 and that coordinates, or who should coordinate 1958 through a trial-and-error process, which eventually what within an organization. In the spirit of established 105 “Sovnarkhozes” in the territory of the Coase, to some extent different ways of allo- USSR (Howard R. Swearer 1959). The reform delegates full authority to regional party secretaries over appoint- cating authorities within a government, or ing SOE directors in their jurisdictions (William B. Ballis different ways of decentralization, is an insti- 1961). Regional leaders were encouraged to try reform tutional design issue that addresses the ques- measures and strong incentives are linked to their per- formance (Swearer 1962). But this “Sovnarkhoz” reform tion: what is the boundary of different levels failed due to serious cross-region coordination failures of government? (Paul R. Gregory and Robert C. Stuart 1998), which leads In reality, the success or failure of coor- to the removal of Khrushchev in 1964. Andrei Markevich and Ekaterina Zhuravskaya (2011) document this failed dinating reform experiments is deeply reform. entangled with the political economy of

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reforms. To make the analysis tractable, in thirty years of reform, most reform ideas did the following subsection I simplify important not come from the central government. political economy issues into a reduced form A closely related disadvantage of cen- as parameters of a model. This allows me to tralized experimentation is the incentive focus on analyzing coordination problems. problem. Without autonomous power, Then, in subsection 4.2, I bring political unmotivated local officials would be passive economy issues back to real cases of regional at the best and would not take initiatives to experimentation. observe and to resolve potential problems. Delegating the power to conduct reform 4.1 The Institutional Foundation for experiments to local governments converts Regional Experiments local officials into entrepreneurs. A major fea- Appropriately devised and implemented ture of China’s economic reforms is that local reform experiments may reduce uncertain- officials make efforts to find market niches, ties substantially. However, a reform experi- initiate inventive ideas, try new approaches, ment often involves several complementary etc. Without this widespread entrepreneur- subprograms, so a reform experiment will ship and their institutional innovations, most fail if its related subprograms are not coor- of China’s successful reforms would not have dinated satisfactorily.42 The role of the gov- been attempted. ernment, particularly local governments, in However, not all governance structures are initiating and coordinating local experiments conducive to regional reform experiments. A is particularly vital in cases where many mar- challenging question to be addressed here kets are missing or ill functioning. is the institutional foundation for coordi- There are many reasons why it is important nating regional experiments. As discussed to let local governments initiate and coordi- previously, a typical Chinese region is rela- nate local experiments. These are best seen tively self-contained and a subnational gov- by exploring an alternative approach, which ernment is responsible for most economic would be to let the central government ini- activities within its jurisdiction. That is, tiate and coordinate reforms. “Local knowl- subnational governments are assigned with edge” and “local information” (Hayek) are the power and the resources to initiate and the basic reasons why decentralized experi- to coordinate regional reform experiments. mentation is superior to centralized experi- Moreover, given that interregional depen- mentation. The central government does dence is relatively weak in China, when a not know every thing; without information regional experiment fails, its impact on the on local preferences, local technology, and rest of the national economy is minimal local institutional conditions, it is hard for a (Qian and Xu 1993).43 centralized regime to come up with a con- Qian, Roland, and Xu (2006; also 1999, crete, implementable idea that satisfies local 2007) developed a theory to explain how the demand (preferences). Moreover, imple- Chinese RDA regime creates conditions that menting a reform requires detailed local alleviate coordination problems in reforms knowledge. As a matter of fact, in China’s

43 Provincial officials of Anhui and Guangdong argued that a failed experiment in an isolated locality would not 42 Here, the central importance of complementarity affect the province’s performance when they initiated among different reform dimensions is in odds with the regional experiments related to land reform and special simplistic view that a single factor determines economic zone reform in the late 1970s (for more details, see sec- development. tion 4.2).

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and that allows for flexible experimentation.44 If some attributes of the two tasks are not In this theory, a reform program is consisted matched, many laid-off workers may not of some complementary subprograms. Each be compensated appropriately, so they may subprogram of the reform is characterized by strike and the ensuing social disorder will its own individual attributes, and these com- make the reform a failure. plementary subprograms must ultimately fit Therefore, a successful reform requires together in order to be integrated properly. A both a good reform blueprint and proper reform is completed successfully only if the implementation (i.e., coordination). The characteristics of each attribute of the vari- uncertainty of the quality of a reform pro- ous subprograms are matched successfully. A gram can be reduced to form an expression failure in the matching of attributes implies of two factors: (a) the political support for, a breakdown of economic order, i.e., a dras- or resistance to, a reform and (b) the tech- tic failure. To simplify the matter, suppose a nical quality of the proposed reform. A pro- reform program is ex ante well designed in gram with many political challenges is more the sense that all the attributes are matched uncertain, and a reform program that incites by those in the blueprint of the program. strong political opposition will fail in spite However, some of the attributes may not suit of how “good” the program looks from an local conditions ex post, and adjusting these outsider’s perspective. Therefore, a program attributes may lead to mismatches with the without political support will be regarded as attributes of other tasks, which will then bad regardless of how good the program is require further adjustments. in theory or in practice in another country. To illustrate the basic idea, let us look at In addition, a program can be technically the following example. Suppose a reform has uncertain. For example, a mechanical trans- two subprograms: an enterprise restructur- plantation of the case law from the United ing program (involving a lay-off of excess States to China would be highly technically workers) and the creation of a social safety uncertain given the linguistic, historical, and net (involving unemployment benefits). cultural differences between the two coun- The attributes of the enterprise restructur- tries. In a simplified theory, a bad reform ing program include the number of laid-off program always leads to a failure, however workers and their individual characteristics, well coordinated in the implementation. Yet, such as: age, seniority, family composition, without a test it is not known for sure ex ante length of residence, sex, type of contract, whether a reform program is good or not. current wage, and history of employment. On the other hand, a good reform pro- The attributes of the unemployment ben- gram needs to be implemented or coordi- efits in the social safety net include the rules nated correctly. The quality of coordination of eligibility, such as length of employment, depends on the quality of the information special circumstances (i.e., veterans), the sta- available to decisionmakers in the organiza- tus of enterprises, the rules of the benefits tion. Regional officials enjoy a local informa- (such as size and length), the types of ben- tion advantage (a la F. A. Hayek 1945), in efits (monetary or not), the technical support that they have firsthand observations on the of computers, administration, and budget. site; whereas for others, any onsite informa- tion would require communication, which is subject to imperfect transmission. The 44 In the Qian, Roland, and Xu papers, Chinese econ- Qian, Roland, and Xu framework assumes omy is modeled as an M-form organization. All the political economy interpretations associated with the RDA regime that information transmission is imperfect. discussed here may or may not be shared by my coauthors. To capture the reality fully, this assumption

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should be interpreted as a reduced-form a small-scale experiment, the central gov- expression of two noises: (a) political noise ernment has to carry it out in multiple steps and (b) technical noise. Political noise occurs involving all relevant ministries. These com- when information is transmitted through plications in coordinating regional experi- political skeptics or opponents, while techni- ments not only incur deadweight losses (as cal noise arises from the fact that two officials shown rigorously in Qian, Roland, and Xu), can have different knowledge and different but also make it easy to sabotage an experi- interpretations of the same message, or for ment in the process. some other technical reasons. In general, when there are more political In China’s RDA regime, where each suspicions surrounding a reform program region is self-contained and regional officials and when political opposition within the are assigned the power to coordinate, reform government is stronger, therefore causing experiments can be coordinated locally. coordination failure to occur more often, Relying on firsthand local knowledge directly, the advantage of the RDA regime becomes without involving upper-level officials, local more apparent. These points are illustrated coordination will not be subject to political by case studies in the following subsection. interference and technical noises, and will be 4.2 Regional Experiments on Land Reform easier to accommodate. Most importantly, and Special Economic Zones (SEZs) flexibility in reform experiments makes it possible to try a reform in one region (or a China’s land reform and SEZ reform few regions) first and extend the experiment were both made possible by the efforts of to other regions later if the first experiment reform-oriented subnational governments is a success. In the case of a failure, although facing stiff political resistance at national the failed experimenting region’s payoff will level. Successful regional reform experiment be reduced, the payoff for the nonexperi- outcomes created bases for forging consen- menting regions will remain constant. This sus among the central leaders, which made flexibility weakens resistance to reform pro- large-scale diffusion of the reform programs posals and encourages attempts of many dif- possible at a later date. Ex ante the reduced ferent reforms, which may otherwise not be uncertainties of regional experiments gave tried at all. reformers better chances to try controver- In contrast, in an economy where spe- sial programs. Ex post successful experiment cialized ministries are responsible for outcomes—even those that were only par- implementing tasks, because ministries are tially successful—could be used as evidence complementary, reform experiments have to convince undecided politicians and to to be coordinated by the central officials. accumulate momentum and political sup- This inevitably involves both political and port for the reforms. technical noise, thereby making coordina- Chinese land reform started in the tion failure more likely. One of the worst late 1970s and is officially known as the features of this economy is its rigidity, which household responsibility system (HRS). It prevents a regional experiment or a small- is regarded as “a major social experiment scale experiment from being beneficial. A in the design of institutions in which a fundamental institutional problem here system emphasizing social values has been is that, because complementary tasks are replaced by a system relying on economic grouped separately into specialized minis- incentives” (McMillan, Whalley, and Lijing tries, coordination across ministries must Zhu 1989, p. 782). During the period of be provided by the center. In coordinating the HRS reform between 1978 and 1984,

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output in the Chinese agricultural sector was in Xiaogang village in Fengyang county increased by over 61 percent. Seventy-eight of Anhui. In those localities, land and output percent of the increase in productivity in quotas were contracted out from local govern- Chinese agriculture in this period of time ments (communes) to individual households. was due to the changes brought about by the The experiments were carried out under high HRS reform (McMillan, Whalley, and Zhu risks, given that people who were involved in 1989). By examining many other factors, the 1960s’ land reform were heavily penal- Lin (1992) disentangled the contribution ized not long ago.45 At that time, land reform to output growth of the HRS reform from was unconstitutional (as stated in the 1978 those of other reforms, as well as from that Constitution of China), and was officially of increased input availability. He confirms banned by the Communiqué of the Third that the dominant source of agriculture Plenum of the 11th Central Committee of the output growth during 1978–1984 was the CCP, which is often quoted officially and in change from the production-team system the literature as the first milestone of the post- to HRS, which was directly responsible for Mao reform (Daniel Kelliher 1992; Naughton 49 percent of the output growth. Moreover, 1995). The State Council and the Party’s the change in crop patterns, from grain to newspaper, the People’s Daily, issued decrees nongrain crops, also had a positive impact. and commentaries on behalf of the central Although it may be a bit of an exaggera- government to stop any land reform attempts tion to call the introduction of the HRS “the with political threats based on the ban of design of institutions,” it is pretty accurate to the Communiqué (Wu 2009). The supreme regard this process as “a major social experi- leader Deng was quiet until some obviously ment.” A key point I want to highlight here successful experimental results came out. is that this major social experiment was initi- Facing the daunting challenges of car- ated and carried out by subnational govern- rying out the land reform, in 1979 Zhao ments without a design at the national level; Ziyang and Wan Li, then the governors of this is the way to overcome the political resis- Sichuan and Anhui respectively, decided tances and risks associated with land reform. to experiment with different land contract- Similar to what happened in Central- ing schemes in a few counties within their Eastern Europe before the 1989 reforms, jurisdictions. According to Tian Jiyun, a or in the former Soviet Union during pere­ Vice-Premier of the State Council between stroika, political/ideological resistance to 1983 and 1993, Dangtu county was one of land reform were strong in China. Any the counties picked up by Wan in 1979 and change that could lead to decollectiviza- about 17 percent of rural households there tion was seriously challenged, and any fail- participated in the land contracting experi- ure associated with land reform would be ment.46 All of the land reform experiments utilized by the conservatives for political were coordinated locally. reasons. Thus, minimizing the political and technical uncertainties of land reform was critically important for the survival of the 45 Land reform was tried in many Chinese regions dur- reform, as well as the reformers themselves. ing the early 1960s but reforms were banned, and officials and peasants involved in the experiments were punished In the late 1970s, “proto-types” of the severely during the CR. HRS were tried by a handful of local officials 46 Similar experiments were also carried out in in a few provinces such as Anhui, Sichuan, Guangdong in 1978 under the leadership of governor Xi Zhongxun at that time but were stopped due to political and Guangdong. One of the best-known pressure from the conservatives in the central government examples of initiative by local government (Dongshi Cai et al. 2008).

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In 1980, validated by the successful allocated to separate agencies over which regional experiment results, Wan and Zhao neither collective farms nor regional gov- reported to the central government and ernments had any control, and thus it would rallied for expanding reform experiments have been extremely difficult to experiment into more regions throughout the nation. without support from all relevant ministries. Supported by their successful experiment In 1989, Gorbachev launched his compre- results, in late 1980 the central government hensive agriculture reform in a manner such decided to allow for regional land reform that all relevant ministries were included. In experiments spread-out nationwide. Zhao the reform, peasants could lease land with and Wan were promoted to be the Premier long-term contracts. Although the goal seems and Vice-Premier of the State Council, similar to the Chinese reform, the farmers respectively, in order to carry out the nation- encountered grave coordination problems. wide reform experiments (Tian 2008). After As a result, there were serious problems in this, the nationwide land reform experiment implementation, such as waste during the propagated quickly, so that in 1981 about storage, transport, and processing stages 45 percent of rural households participated due to failures in coordination between pro- in the reform. Subsequently participation duction units, transport, and storage (Karl- increased to 80 percent in the next year, Eugen Wädekin 1992). and finally, reached 99 percent in 1984 (Lin Another famous Chinese reform is the 1992). Thereafter, agricultural reforms in special economic zone (SEZ) develop- general and land reform in particular were ment and the subsequent meteoric rise in consolidated through numerous further foreign direct investment (FDI). Thanks reform measures. Similarly, most of those to this reform, even though China started are based on successful regional experiment with virtually zero FDI and almost negli- results.47 gible trade and foreign reserves in 1978, in In sharp contrast, at the onset of Soviet/ a quarter of a century China has become Russian reforms, all Soviet farming tasks one of the largest FDI recipient coun- were coordinated by the central govern- tries in the world, with the world’s largest ment through specialized ministries (e.g., foreign reserves, and also one of the larg- Ministries of Agriculture, Trade, Cereal est trading countries in the world. Table and Grain Production, Tractors and 4 clearly shows that FDI in China and Farm Machinery, Food Industry, Rural Chinese exports are essentially driven by Construction, Fertilizer, Land Reclamation the SEZs. When China first opened up and and Water Resources, and Fruit and began attracting FDI and trade, 37 percent Vegetable Farming, etc.). The tasks of pro- of FDI was located in SEZs in 1985, and 89 viding inputs to the farmers, of manag- percent of the national exports came from ing their operations, storage, processing, the SEZs in 1985. In 2005, when China transport, and road infrastructure were all became the largest FDI recipient country in the world, 93 percent of FDI was located in SEZs, and 93 percent of China’s exports 47 Although rural households enjoy the residual income came from the SEZs. It is not an exaggera- and residual control rights over what they do with the land, under the HRS the control rights of allocation and man- tion to claim that it is the SEZ that made agement of land resources are kept with the local officials. China the country with the largest foreign Thus, most cultivated land in rural China remains partially reserves in the world, as well as the coun- collectively owned. Hanan G. Jacoby, Guo Li, and Scott Rozelle (2002) show the existence of inefficiencies caused try with the largest trade surplus with the by this partial privatization. United States and the European Union.

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Table 4 The Impacts of SEZs on National FDI and Exporting

Number Nat’l exports SEZ exports SEZ share Nat’l FDI SEZ FDI SEZ share Year of SEZs (mil US$) (mil US$) of exports (mil US$) (mil US$) of FDI 1980 4 18,119 278 1.5% 145 51 34.9% 1985 77 27,350 24,327 89.0% 1,956 728 37.2% 1990 290 62,091 44,602 71.8% 3,487 2,551 73.2% 1995 341 148,780 124,692 83.8% 37,521 33,694 89.8% 2000 341 249,203 228,779 91.8% 40,715 38,796 95.3% 2005 342 761,953 709,373 93.1% 60,325 56,397 93.5%

Sources: China statistical yearbooks 1986-2006; China Urban Statistical yearbook 1986–2006; China Urban Forty years; Provincial Statistical yearbooks 1996–2006; State Council documents.

Therefore, among all the Chinese reform and regional—how could China accommo- measures, the SEZ has had the greatest date foreign and domestic firms to develop direct impact on the global economy. trade-intensive businesses? Although by conventional wisdom it Facing these tough constraints, the central seems obvious to suggest SEZ reform poli- leadership was, at best, not able to build a cies in order to improve trade and attract consensus to move forward (Cai et al. 2008; FDI, initiating and carrying out these Zhao 2009). The idea of setting up SEZs to reforms was a great challenge at the begin- attract FDI and to develop export-oriented ning of the reform era. There was strong industries was initiated and experimented political opposition to the idea of renting by subnational governments. The strategy of land to foreign firms or multinational firms, regional experimentation played a vital role as these kinds of practices were regarded in dealing with the ensuing difficulties and as “selling the nation.” Indeed this kind of uncertainties. According to the archives (Cai reform was unconstitutional at that time. et al. 2008), the idea of conducting municipal The political risk would be too high for a experiments to attract FDI was proposed by reformer to bear if one had to confront the officials of Guangdong province in 1979. The convention of the planning apparatus at a proposal suggested to authorize Shenzhen national level or to confront the constitu- and Zhuhai as experimenting municipalities, tion head-to-head. Thus, those concerned and required that conditional on the success with how to attract FDI to China faced tre- of the first experiment other cities will follow mendous political and economical difficul- similar experiments in the next step. A major ties and uncertainties. Moreover, when the part of the experiment involved trying new constitution (including the Party’s constitu- sets of institutions, legislation, and rules for tion) did not protect private property rights, the purpose of attracting FDI, and further- how would one convince foreign investors more municipality governments were made to invest? When imports/exports were all responsible for implementation. Moreover, controlled by government agents—national the proposal asked for greater regional

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autonomy, particularly for decision-making the SEZs is subdued and encouraging SEZ power in regional experiments. development becomes a national policy. In The skepticism toward the SEZs was 1992, SEZs comprised all the capital cities strong at the top level of the central govern- of inland provinces and autonomous regions, ment (Jianhui Zeng 1984). There had been fifteen free trade zones, thirty-two state-level fierce debates in the central government and economic and technological development within the party apparatus on the desirabil- zones, and fifty-three new- and high-tech ity and the nature of SEZs, and on the paths industrial development zones. Currently, of development the SEZs should take.48 As SEZs encompass more than one hundred a compromise, approval was given by the national economic and technological devel- State Council for small-scale experiments opment zones, fifteen national bonded areas, in four remote cities in 1979 (The Central and fourteen border trade and cooperation Government Circular No. 50, 1979, Zhongfa regions in the broadest sense. (1979) 50, cited by Zeng 1984). One of the major features of the small- Together with authorizing the experi- scale regional experiments, such as the ments for SEZs, the central government also HRS and SEZ reforms, is that for a cer- granted the Guangdong government, and tain period of time the nonexperimenting particularly the experimenting municipal regions remain unchanged until diffusion governments, more autonomy in regional commences. The coexistence of two sys- planning, in enterprise management, and tems, experimenting versus nonexperiment- in policies related to FDI. In August 1980, ing or reforming versus nonreforming, in the People’s Congress approved the State the reform process is sometimes called “the Council’s proposal of setting up four SEZs in dual track system.” The dual track system has Guangdong and Fujian and passed the first been used to describe both small-scale and legal rule on the SEZs: “the Regulation for full-scale reform experiments in which all Guangdong SEZs.” This was the first kind of regions implement a reform experiment at regional law tested, which was drafted with the same time, while keeping the nonexperi- the help of legal experts sent from the cen- menting system for a certain period of time. tral government (Cai et al. 2008). When the A major example of a full-scale experiment experiment was expanded into other prov- is the dual track price system. The most inces, they also adopted and modified this important benefit of the dual track system is law accordingly. to reduce resistance to a reform by substan- Supported by the initial achievements of tially reducing the number of losers through the first group of SEZs in 1984, the central keeping the nonreforming system at earlier government endorsed another fourteen cit- stages of the reform (Lawrence J. Lau, Qian, ies to experiment with SEZs, and the experi- and Roland 2000). However, there are essen- ment was further expanded to more cities tial conditions to be satisfied to make the in 1985. In the early 1990s, the extremely dual track approach beneficial in reforms. fast growth of export and FDI validated If the state is weak in enforcement and, as the success of the SEZs. The opposition to a result, parties are able to siphon resources away from low-priced existing transactions to 48 Chen Yun, a top leader of the CCP, cast deep doubts high-priced new transactions, the dual track on the SEZs. The idea of setting up the SEZs was regarded approach may fail to function (Jiahua Che as equivalent to a “rented territory” or “the selling of the and Giovanni Facchini 2007). Thus, the sub- nation,” which would be a revival of the semi-colonial era. The other objection charged that the SEZs would exacer- national governments’ enforcement capa- bate inequalities (Zhao 2009). bility to regulate firms’ strategies is vital in

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order for the dual approach to be efficiency setting up proper incentives is essential for improving. inducing subnational officials to conduct In addition to locally initiated reform experiments.49 experiments, almost all important reforms It is relatively straightforward to design sponsored by the central government in incentives for central government-sponsored the past three decades were also tried and local experiments. Often, the central govern- implemented through regional experiments, ment provides generous compensation to such as the state sector reforms (Sebastian experimenting local governments (Heilmann Heilmann 2008). The bankruptcy reform in 2008). However, for locally initiated experi- the mid 1990s illustrates this phenomenon. ments, the incentive mechanism is subtler. Although there was collective support from It turns out that the regional competition- the top leaders for restructuring the state sec- based promotion system is one of the mecha- tor drastically through enforcing the bank- nisms that create motivations for regions to ruptcy law, there was no consensus on how be entrepreneurial in experimenting. In the to do it. After it issued general guidelines on RDA regime, regional officials are appointed, the basic priorities and general approaches and initiating or implementing successful in 1994, the central government encour- regional experiments can lead to substantial aged local governments to experiment with promotions. Thus, although experimenting innovative solutions for debt restructuring, involves risks and externalities, experiment- mergers, closures, and employee resettle- ing also creates chances not only to outper- ment. Eighteen municipalities were picked form others, but also more importantly, to up by the central government “to test new lead others, which implies getting unusual methods for dealing with the resettlement promotion opportunities. That is, the ben- of employees in insolvent industrial enter- efits associated with promotions will correct prises.” Each experimenting municipality disincentives from positive externalities. was responsible for coordinating all the rel- In addition to the costs of experiments, evant aspects within its jurisdiction, such as another critically important issue is who land-use rights and using the proceeds for decides what to experiment and who con- resettling the laid-off workers (Heilmann ducts the experiment. By being granted a 2008). This reform finished in the mid 2000s. broad range of control rights over regional economic affairs, the regionally decen- 4.3 Incentives of Experimenting tralized structure converts many regional Regional experimentation is a major strat- bureaucrats into entrepreneurial officials. egy for moving a reform forward before Regional officials are active in identifying central decisionmakers are able to build reform experiment opportunities. If, after consensus for the reform. Experimenting someone’s initiative, other regions follow involves high risks for regional officials who an experiment, it implies that this reform conduct the experiments, and it also creates experiment was a success, and therefore the large positive externalities at the costs of chance of getting a substantial promotion is experimenting regions. Moreover, conduct- higher. Perceiving this, officials with greater ing reform experiments often requires offi- cials take initiatives and make extra efforts to deal with unexpected contingencies. 49 In a Tiebout federal system, where officials are Without the initiative to solve problems, elected from their constituencies, the value dilution due to the positive externalities will disincentivize regional offi- experiments would easily fail. Therefore, in cials and lead to too few experiments (Gordon 1983; Cai addition to previously discussed conditions, and Treisman 2005).

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career ambitions would initiate reform rate was significant for the period of 1990 experiments on their own, sometimes even to 2004. taking high risks. That is, the centralized personnel control may internalize some of 5. Regional Competition and Regional the externality problems of regional experi- Experiments in Some Major Reforms ments. The HRS and SEZ experiments dis- cussed in the previous subsection are the This section discusses some major eco- most visible examples of this process. In nomic reforms that have had substantial those examples, the pioneers of the HRS impacts on China’s economic growth over and SEZ reforms were promoted substan- the past three decades. This discussion tially when the experiments were recognized serves two purposes: first, it is important to by the central government as models for the understand the mechanisms by which these nation to follow. reforms operate for their own sake and, sec- Moreover, it is observed that a common ond, these reforms act as concrete examples practice in reform era is to promote officials of the conceptual discussions above about from more developed municipalities, where the mechanisms of regional competition and many reform experiments were tried out ear- regional experimentation. lier, to leading provincial posts, particularly 5.1 The Township–Village Enterprises in less developed regions. Chien and Zhao (TVEs) and the Nonstate Sector (2007) document that, from the late 1990s to the early 2000s, there were three former Large-scale entry and fast development of heads of Suzhou city who were promoted to the nonstate sector is a distinctive feature of become governors of Jiangsu, Shaanxi, and China’s reforms.50 The pace of growth of the Jilin respectively; a former Shenzhen mayor nonstate sector is so quick that the state sec- was appointed as the governor of Hunan, tor is unable to compete. Without a conven- and a mayor of Wenzhou became the gover- tional form of privatization of the state sector, nor of Sichuan. These three cities pioneered i.e., privatizing existing SOEs, the market many reform experiments on their own and share of China’s state sector in the national are among the best reforming municipalities economy shrunk from 78 percent in 1978 in China. to 53 percent in 1991. The most important By using a panel data consisting of thirty nonstate sector until the mid-1990s was the provincial regions between 1978 and 2005, TVE. By the early 1990s, TVEs accounted through a diff-in-diff approach to control for for about four-fifths of the output of the groups with and without transfer of gover- nonstate sector. Between 1981 and 1990, nors and before and after transfer of gover- the total industrial output of TVEs grew at nors, Xu, Wang, and Shu (2007) found that, an average annual rate of 28.1 percent, while everything else being equal, cross-regional the rate for the state sector was 7.7 percent. governor transfer increased regional GDP As a comparison, China’s average annual growth rate by 1 percent. In the more GDP growth rate was 8.7 percent between recent period of 1992 to 2005, the effect 1979 and 1991. Moreover, TVEs had sub- was enlarged to 2 percent. By construct- ing a panel data consisting of thirty provin- cial regions between 1978 and 2004, with a similar approach, Jun Zhang and Yuan Gao 50 To some extent, Hungary, Poland, and Vietnam are the other transition economies that shared this feature and (2007) find that the effect of cross regional they all enjoyed better performances than other transition governor transfer on regional GDP growth economies.

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stantially higher TFP growth rates than the community citizens did not. Moreover, when state sector in those years (Xu 1995). the firm is owned by the community govern- More importantly, the TVE actually served ment, the community government faces less as a major stepping-stone in changing China’s state expropriation because part of the rev- institutions. A typical TVE is a collectively enue is used to finance the local provision owned enterprise located in a township/vil- of public goods, which addresses the state’s lage. All the people in the township/village concerns and also enhances the firm’s future that “sets up” the TVE own the firm collec- earning potential (Che and Qian 1998). tively. The community government of the These arguments are supported by empiri- township/village “represents” the communal cal evidence collected from villages (Hongyi collective owners and is the de facto execu- Chen and Rozelle 1999). tive owner of the TVE (William A. Byrd and Another major feature of the TVEs is the Qingsong Lin 1990). The property rights of prevailing of the informal institutions, such the TVE are vaguely defined. From a view- as implicit contractual relationships between point based on “conventional wisdom,” the community governments and TVEs, governance of these firms appears deficient between TVE employees, and between and should result in unproductive firms. TVEs. Weitzman and Xu (1994) conjectured Therefore, the spectacular performance of that local cultural or social norms may be the TVE sector poses major challenges to an important factor behind informal institu- economics (Weitzman and Xu 1994). This is tions. This conjecture shares the same spirit particularly true before the mid-1990s. of the evolutionary repeated game theory of Several complementary explanations are social norms (Robert Axelrod 1984; Drew proposed in the literature, and most focus on Fudenberg and Maskin 2008) and is closely the role of the community government. The related to the literature on the evolution of strong incentives created by regional compe- social norms, culture, and human behavior. tition are one of the institutional reasons for Empirically, it sheds light on substantial the rapid development of TVEs. Moreover, regional differences in TVE development, the relatively self-contained nature of including powerful informal institutions in regional economies gave TVEs opportunities post-TVE developments (Xu and Xiaobo to grow. There are broad ranges of products Zhang forthcoming), which reflect the that the TVEs can produce to meet local diverse history of China’s regional economic demand, and there are often sufficient local development.51 semiproducts to supply to TVEs as inputs. As protection of private property rights Close links between TVEs and local SOEs improved (Donald Clarke, Peter Murrell, often facilitated the transfer of technology and Whiting 2006) and asset markets devel- and management know-how (Xu and Zhuang oped, many benefits of TVEs are dimin- 1998). ished. Moreover, associated with large-scale Concerning the relatively effective gov- ernance of the community government 51 Most TVE employees and managers lived in the over TVEs, most conceptual discussions same community for generations when there was almost emphasize the second-best nature of TVEs no migration before the early 1990s. Under certain con- ditions, close long-term interactions among community when there is weak or no legal protection members (virtually infinitely repeated overlapping-gener- of private property rights (Chun Chang and ation relationships) might foster a social norm within the Yijiang Wang 1994; David D. Li 1996; Oi community that may facilitate informal institutions. In contrast, SOEs are not organized based on natural com- 1999). That is because township–village gov- munities, such as villages; therefore, many of the informal ernments had access to resources, whereas mechanisms found in TVEs would not function in SOEs.

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migration since the mid-1990s, an increasing networks of informal arrangements, such as number of TVE employees, including TVE implicit contracts, so that every final prod- top managers, have become migrant work- uct is jointly produced by a collection of ers. This also contributes to changes in the many firms. Repeated interactions among governance of TVEs.52 A large percentage of the workshops and among the agents help TVEs were privatized since the mid-1990s reduce the monitoring and enforcement (James Kai-Sing Kung and Yi-Min Lin 2007; costs. The township government affects the Albert Park and Minggao Shen 2003; Li and overall and long-run strategic direction of Rozelle 2004). the cluster without direct involvement in the Although TVEs have declined, the insti- daily operations of the thousands of small tutional legacy of TVEs in China’s economic workshops.54 To a large extent, some impor- development and corporate governance is tant features of TVE institutions, particu- extensive. Important mechanisms that pre- larly the importance of entrepreneurial local vailed in TVEs, e.g., the intimate involve- governments to local business development, ment of community governments in business remain in this post-TVE development. The and informal institutional arrangements, are clusters are strategically managed by town- still at work today, and their impacts on the ship governments, although they have no rise of entrepreneurship in China are far- ownership of the assets of the workshops and reaching, such as on the fast growth of clus- are not involved in their financing, except for ters of large numbers of small private firms most of the land and some of the buildings. in coastal provinces. They provide infrastructure, secure property With clustering of a vast number of small rights, regulate quality, train laborers, and specialized firms, many Chinese townships provide favorable policies. have become national or world “factories” All of these make the township govern- for certain products. It is these townships ment similar to the headquarters of a con- that made China “the world’s factory.”53 In a glomerate. Moreover, to a large extent, due typical industrial cluster, thousands of highly to the way that they coordinate with each specialized family-owned entrepreneurial other, the behavior of those privately owned firms are worked together with infrastruc- specialized workshops are more like work- tural and regulatory support of township shops within an integrated large firm than governments. The small firms in a cluster independent small firms in a market (Xu and are closely coordinated, similar to workshops Zhang forthcoming). within an integrated firm, whereas they are The evolution of TVEs and the subse- also highly competitive, as in markets. These quent clustering of modes of production are specialized small firms are linked together by institutional responses created by entrepre- neurs, including local entrepreneurial offi- cials, to overcome constraints such as weak 52 In the terminology of evolutionary game theory, there legal protections for property rights, weak were lots of mutants that invaded the repeated games and that would change the equilibrium strategy of the game contract enforcement, and credit and techni- (Fudenberg and Maskin 2008). cal constraints. When the political, legal, and 53 For example, Datang township makes one-third of the world’s socks; 40 percent of the world’s neckties are made in Shengzhou township; more than 70 percent of 54 Take Puyuan Township (Zhejiang province), the larg- the buttons for clothes made in China come from Qiaotou est cashmere sweater production center in the world, as township; Songxia township produces 350 million umbrel- an example. There were six thousand family-owned highly las every year; and Puyuan township produced 60 percent specialized workshops and three thousand private trading of China’s cashmere sweaters, of which China is the world’s shops in the cluster coordinated strategically by the town- largest producer (Xu and Zhang forthcoming). ship government (Xu and Zhang forthcoming).

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economic conditions improve, a firm’s orga- conglomerate in which subnational govern- nization and organizational structure may ments functioned like the headquarters of change as well. Less viable forms of organi- regional conglomerates (Oi 1999). This is zational structures are eliminated through particularly true for municipalities and coun- competitive pressures in a decentralized set- ties. The regional governments, functioning ting, whereas it will be hard to prescribe the like the personnel department of a regional optimal path of firm evolution beforehand. conglomerate, selected managers, made This makes regional experiment-based deci- decisions on promotions and demotions, sion making important. Overall, the success maintained dossiers, and tracked managerial of TVEs and post-TVE developments is due records, etc. In response to regional com- to the regional decentralization that allows petition, also under the encouragement of for the full use of individual talents through the central government’s reform guidelines, introducing various institutional and organi- subnational governments experimented with zational innovations to cope with constrain- various “managerial responsibility systems” ing factors. in which managers were delegated power to make many decisions, and employees were 5.2 State Sector Reform: Centrally given financial incentives tied to enterprise Sponsored Local Experiments performance. Similar to other transition economies, the By using firm-level panel data, Groves et Chinese economy was dominated by the al. (1994, 1995) and Li (1997) evaluated the state sector at the onset of the reform and, outcomes of some major SOE reform experi- therefore, state sector reform was the most ments in the 1980s. In their sample, over 80 important. Yet, as opposed to other transi- percent of the managers were appointed by tion economies, most of the SOEs in China subnational governments, and their careers were “owned” by subnational governments. were determined by the evaluations of China’s state sector reforms have been very their bureaucratic superiors; the majority of much driven by regional competition and SOEs were in the regional experiments del- regional experiments. Two major aspects egating more authority to SOE managers, of early SOE reforms have been discussed which allowed SOEs to keep a large propor- in the literature. The first aspect concerns tion of their profits and to use the retained appointment or selection of SOE managers. funds for worker bonuses, worker welfare Before privatization (to be discussed later), facilities, and enterprise investment, etc. subnational governments were responsible Moreover, performance responsibility con- for selecting SOE managers within their tracts for SOE managers were experimented jurisdictions. Under the pressure of regional with in many regions. The contracts speci- competition and the importance of local fied performance indicators, such as profit, SOEs to regional economies, subnational reinvestment, and compensation structure. officials became very performance conscious Most of the SOEs’ managers in the Groves when considering the appointment of SOE et al. sample signed the contracts. Groves et managers (Theodore Groves et al. 1995). al. (1994) investigated how SOE managers The second aspect of the early reforms responded to their increased autonomy and involved managerial incentives (Groves et al. how firm productivity was affected. They 1994; Zhuang and Xu 1996). found that with more autonomy in output As regional SOEs were owned by regional decisions and with higher marginal profit- governments, to a certain extent, a region’s retention rates, SOEs increased their use of state sector is like a state-run regional bonuses and hired more fixed-term contract

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workers. Moreover, the strengthened incen- 1997), which is confirmed by researches tives were positively correlated with higher based on national census data (Gary H. productivity. Jefferson, Rawski, and Yuxin Zheng 1996). Another important experimental SOE Nevertheless, the early SOE reforms failed reform was the system of management selec- to solve some basic problems of the state sec- tion by competitive auctions. About 14 per- tor. While productivity was increased, facing cent of the managers in the Groves et al. fierce competition from the nonstate sec- sample were selected through competitive tor and losing monopolistic position in most auction. The usage of this reform peaked in product markets, the financial performance the late 1980s—1987 and 1988 accounted of the state sector worsened rapidly. The for 57.4 percent of the competitive auctions total losses in the state sector kept worsen- in the Groves et al. sample. Auction proce- ing between 1993 and their peak in 1998, dures varied among regional experiments. In when the state sector made a net loss of 285 general, a typical SOE was put up for auction billion RMB (table 4) and the government by its superior municipal government. The kept pumping financial aid into this sector most important part of a bid was the prom- for bailouts.55 The record-breaking losses ise of profit to the municipal authority in the of the state sector led to an unprecedented near future. In most cases, bidders also made number of nonperforming loans (NPLs) in promises to reinvest, etc. The municipal gov- China’s banking sector. These were mani- ernment as the owner of the SOE then chose festations of a serious soft budget constraint the winning bidder on the basis of promised syndrome (SBC), a major moral hazard profit delivery and the management plan, problem prevalent in all centralized econo- etc. The top manager often signed a manage- mies and transition economies.56 The severe ment contract and frequently was required SBC problem and the well-known conse- to put up a security deposit, which could be quences of SBC created deep worries about forfeited if the manager failed to meet the promised performance. Based on their firm level data, Groves et al. 55 Groves et al. (1994, 1995) reported no evidence that indicated that the managerial labor market budget constraints for state-owned firms were hardened in the 1980s. In studying the “fiscal contracting system” was functioning in China’s state sector such operating between the central and provincial governments that SOE managers changed jobs frequently. from 1980–93, Jin, Qian, and Weingast also found that the They found both demotion/promotion of the central government was not able to keep its commitment to restrain from offering ex post subsidies to subnational previous manager and the conditions of the governments. new manager’s appointment can be partially 56 Yet, the TVEs did not suffer much from the SBC syn- explained by the corresponding firm’s per- drome, as millions of them went bankrupt in 1989, even though they were supported by community governments formance. Moreover, they found that SOE and many of them also had policy burdens for community managers’ total compensation is positively employment and social security. This is because at the bot- related to firm profits. In their sample, over- tom level of the hierarchy, community governments, as well as local branches of rural credit cooperatives, have all, SOE per worker output rose 67 percent limited financial resources available in their disposal. (in constant prices) for the decade of the Moreover, their access to subsidies and credits from the 1980s. As a result, in that period of time TFP central government is restricted by law. These limitations have prevented community governments from bailing out growth contributed to 73 percent of output loss-making TVEs (Qian and Xu 1993). Moreover, given growth; moreover, over 87 percent of the local governments’ limited financial resources, they face TFP growth was attributable to improved high opportunity costs for bailing out failing firms. When regional competition is tougher, the opportunity cost incentives, intensified product market com- becomes higher and local governments would be less will- petition, and improved factor allocation (Li ing to bailout their failing firms (Qian and Roland 1998).

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Table 5 Losses and Layoffs in the State Sector, 1991 to 2005

Losses (bil) Profits (bil) Layoffs (mil) Net profits (bil) 1991 92.6 167.1 74.5 1992 75.7 171.2 95.5 1993 47.9 214.6 166.7 1994 62.5 223.3 160.8 1995 80.2 227.2 147.0 1996 112.7 200.4 5.42 87.7 1997 142.1 196.1 6.34 54.0 1998 306.7 328.0 5.95 21.3 1999 214.5 329.1 6.53 114.6 2000 184.6 468.0 6.57 283.4 2001 199.4 480.5 5.15 281.1 2002 180.3 558.9 4.10 378.6 2003 282.0 758.9 2.60 476.9 2004 306.1 1,042.9 1.53 736.8 2005 242.6 1,200.6 0.61 958.0

Note: Losses: the total losses in the state sector; Profits: the total profits from the profitable SOEs; Layoffs: the accumulated number of employees laid-off by the state sector. Sources: Finance Yearbook of China, 1996–2006; China Accounting Yearbook, 1995–2006; China Labor and Social Security Yearbook, 2006; China Labor Economic Yearbook, 1997–98.

the sustainability or even the survivability of a budget constraint is to make bankruptcy the Chinese regime. The SBC syndrome is threats to SOEs credible. caused by the lack of a credible commitment To a large extent, since the late-1990s, the from the government to allow loss-making state sector bankruptcy reforms and privati- SOEs to fail (Kornai 1980, 1992; for surveys zation (to be discussed in section 5.3) have see Maskin and Xu 2001; Kornai, Maskin, hardened budget constraints, which turned and Roland 2003).57 The key to hardening the state sector to profitability since the year 2000 (table 5). The effectiveness of these reforms constitutes a big surprise for many experts.58 Indeed, as it is for other transition 57 Concurrent with increased state sector losses, between 1993 and 1995, inflation also worsened. A loss economies, hardening budget constraints of control over monetary policy due to decentralization in and bankruptcy reform were some of the credit control was blamed as the cause (Wang 1991; Huang 1996b). Sharing a similar perspective, Loren Brandt and Xiaodong Zhu (2000) argue that facing competition from the nonstate sector, the central government was forced to 58 Around that time, some authoritative China experts, rely on money creation to finance the state sector, since the such as Nicolas R. Lardy (1998), worried that with a con- central government supports the employment and invest- tinued increase of the number and value of NPLs, the ment of the state sector. This not only softened budget Chinese financial system would collapse soon, which would constraints of the state sector but also caused inflation. lead to economic disaster.

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most difficult reforms in China. Given the creditor-friendly. Instead of being a law to close interrelation between SOE debt and be enforced nationwide, however, this law the state banking system, and between SOEs only served as a guideline for central-gov- and social safety nets, radical bankruptcy ernment-sponsored local experiments. Very reform or SOE restructuring could lead importantly, in experiments, local govern- to massive social unrest and bankruptcy of ments deviated from the law substantially. To state banks (Charles Booth 2004; Heilmann prevent local social problems, the administra- 2008). Moreover, state firms carry many tive practice of local governments in dealing types of policy burdens, such as employment with insolvent enterprises favored employ- and social security, etc. (Shleifer and Robert ees (Heilmann 2008). The early reform pro- W. Vishny 1994; Lin, Fang Cai, and Zhou gressed fairly slowly, so that between 1989 Li 1997). With the policy burdens, the state and 1993, among tens of thousands of chron- is accountable for the losses incurred from icle loss-making SOEs, there were only 1,150 policy burdens, and thus it has to bailout bankruptcy cases nationwide. insolvent SOEs (Lin and Guofu Tan 1999).59 Pressured by rapidly growing SOE debts There were intense political controver- and mounting state-bank-held NPLs, bank- sies in drafting, updating, and finalizing the ruptcy reform emerged as a top-priority bankruptcy law from the 1986 version to the issue in the 1990s. The central government final 2006 version (Booth 2004).60 Facing sponsored new waves of local bankruptcy vast difficulties and political risks, China’s experiments.61 In the peak years of restruc- bankruptcy reform was carried out through turing and bankruptcy reforms from 1996 to local experiments to deal with the social 2001, every year there were more than 5 or and fiscal consequences of SOE insolven- 6 million SOE employees laid off nationwide cies, and was used by central policymakers relatively peacefully (table 5). Summarizing in their debates, decisions, lawmaking, etc. local experiment practices, the 2002 and (Heilmann 2008). 2004 versions of the bankruptcy law gave One of the most contested political and workers first priority over the rights of legal issues in China’s bankruptcy reform was secured creditors; and the burden of pro- about who should be assigned with priority viding compensation to the employees of protection in the liquidation of assets. Should insolvent enterprises was put on local gov- that be given to creditors (state banks, i.e., gov- ernments. As a result, the state sector was ernment assets) or to employees (the source significantly transformed, total loses were of potential social unrest) (Heilmann 2008)? reduced from 306.7 billion RMB in 1998 to The first bankruptcy law, the “Experimental 184.6 billion RMB in 2000, net profits were Bankruptcy Law” passed in 1986, was more increased from 21.3 billion RMB in 1998 to 958 billion RMB in 2005, when bankruptcy and layoffs became negligible (table 5). SOE 59 In this logic, Lin and Zhiyun Li (2008) argue that productivity in the corresponding period also even privatization will not necessarily harden budget con- straints. This is because bearing policy burdens, to provide the same policy service a private enterprise will demand more ex post subsidies from the government than an SOE 61 In 1994, the State Council issued a circular on trial due to more agency problems between the state and pri- implementation of new insolvency procedures and spon- vate firms. sored experiments in eighteen cities. Two years later, trial 60 Controversies revolved around safeguarding state implementations of new merger and insolvency proce- assets in liquidations; containing the social and financial con- dures were tested in 56 cities. In the next year the State sequences of SOE insolvencies; dealing with unemployment Council sponsored experiments in 117 cities for trial and rearranging the social safety net function of the SOEs implementation of merger, bankruptcy, and reemployment (pensions, health care, housing, etc.) (Heilmann 2008). procedures.

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improved significantly (Brandt, Chang-tai was pushed through by the central govern- Hsieh, and Zhu 2008; Jefferson, Rawski, and ments as a high priority at the beginning Yifan Zhang 2008).62 of the transition, privatization was and is a Experimental bankruptcy reform pro- highly controversial subject in China due to cesses helped “to conceal and manage fun- ideological and political reasons. As a result, damental political-ideological controversies privatization has been postponed by the that were at the heart of the delayed law Chinese government as much as possible. making. Policy experimentation over twenty- Moreover, the Chinese privatization scheme three years allowed recurrent adaptations in is not based on a rational design; instead, it the application of the basic priority scheme is a result of political games given existing and thereby helped to avoid open policy institutions. Due to this delay, at the time of conflicts” (Heilmann 2008). When the bank- privatization, even though the state sector ruptcy reform was carried out by local exper- was loss making and was deeply in debt, the iments, the law was only “provisionary” and national economy was in a better shape and formal bankruptcy proceedings in courts conditions for privatization were more ready played a minor role. Generally, corporate than all other transition economies when rescue measures were undertaken through they launched privatization. The nonstate a variety of flexible, inconsistent, but less sector had already surpassed the state sector painful policies that were experimented with in the national economy, while the market locally (Heilmann 2008). The final version of had already replaced most of the planning the Bankruptcy Law (2006) was not passed related to resource allocation, including the until the reform experiments were over and product, capital, labor, and managerial labor the number of bankruptcy cases dropped markets. Moreover, the improved productiv- drastically. However, the final version of the ity of the state sector through earlier reforms, law goes back to the protection of creditors as discussed in section 5.2, might also have and did not retain those policies in favor of played an important role in making the tran- protecting workers vis-à-vis creditors. sition smooth. Furthermore, the Chinese privatization has been carried out by munici- 5.3 Privatization: Locally Initiated pal governments at their discretion under Experiments regional competition for economic growth. Although there is no empirical work that That is, they have opted not to privatize if decomposes factors contributing to the turn- doing so would hurt their regional growth. As around of the state sector from chronicle a result, China is an exceptional case among loss-making to a profitable sector, perhaps all transition economies that did not suffer the most effective reform was privatization, from recessions as CEE–FSU economies did which sold most of the loss-making firms to during their privatizations (Saul Estrin et al. private owners. In sharp contrast to other 2009). Instead, China’s privatization is asso- transition economies, where privatization ciated with a high growth rate. Privatization was officially banned and, in practice, it was not encouraged by the 62 Of course, given that many reform measures were central government until the late 1990s. taking place in the same period of time, such as privatiza- tion, layoffs, change of corporate governance, market com- However, given the local “ownership” of petition, large scale FDI, and lower interest rates, it is a most of the Chinese SOEs and pressures challenge for researchers to find out what specific reform faced by local governments, de facto privati- measure has exactly contributed by how much to the improvements of productivity and profitability of Chinese zation was tried quietly without official per- firms. mission from the central government in the

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process of restructuring local SOEs before contain the risks of privatization, a prevailing the mid-1990s. Even in the late 1990s, it is privatization strategy chosen by most Chinese still a city government’s decision whether or city governments is to sell the ownership of not to privatize and how to privatize within SOEs and COEs to their employees. This is their jurisdictions (Ross Garnaut et al. 2001, because employee ownership is the least con- 2005; Jie Gan, Yan Guo, and Xu 2010). troversial politically and ideologically. Moreover, even by then, due to political Similar to the situation of the bankruptcy and ideological constraints, privatization has reform, the most important impetus for occurred in a camouflaged form such that privatizing SOEs was the large amount of the term “privatization” is officially disguised debt built up by the state sector in the 1990s. as “transforming the system” or “gaizhi” Distinctively different from the central gov- in Chinese (Garnaut et al. 2001, 2005). ernment’s sponsorship of the bankruptcy Nevertheless, in 2005, about two-thirds of reform, however, privatization was initiated the Chinese SOEs and COEs with annual by city governments. The central govern- turnover of more than 5 million RMB Yuan ment tolerated this by turning a blind eye (about $620,000) have been privatized and to the actions of city governments. One of the total asset value involved in the process the first regional privatization experiments was about 11.4 trillion RMB (or 1.63 trillion was in Zhucheng, a city in Shandong prov- USD) in 2005 (Guo, Gan, and Xu 2008). 63 ince. In that city, more than two thirds of the Due to its recentness and the lack of data, SOEs were loss-making in 1992, with losses the research on China’s privatization is still amounting to the city government’s total very limited (Estrin et al.). fiscal revenue over eighteen months. The One of the early major reforms attempted city government sold many SOEs to their by many cities in the late 1980s, and which employees. Another representative example lead to privatization later, was the leasing of is the municipal government of Shunde in SOEs. The top managers of small- or medium- Guangdong. The Shunde city government sized SOEs leased the firms by paying the sub- also encountered a serious debt problem national government a fixed proportion of the when it privatized most of its state and col- firms’ profits. This reform gradually led to de lective firms in 1992 (Garnaut et al. 2005). facto privatization, since after some years of As a result of successful local experi- leasing the share value of a manager would out- ments with privatization and the severity of weigh that of the city government, the “state SBC problems in the state sector, privati- owner.” The other major reform initiative, zation was gradually accepted by the cen- which facilitated privatization later, was incor- tral government through several steps, poration. Although officially incorporation was from an explicit “tolerance” policy to some restricted to the exchange of shares among the proactive guidelines on privatization.64 SOEs, private shareholding was allowed in some cities. The first reported cases were in 64 In 1993, the Third Plenum of the 14th CCP Congress Guangzhou in the late 1980s, when employees endorsed the creation of a modern enterprise system, of some SOEs bought a substantial amount of which approved the development of diversified forms of shares of the firms where they worked. Under ownership including private ownership. Although much of the political constraints on privatization were still in severe political and ideological constraints, to place, this created a more tolerable environment for local privatization experiments. In 1995, the central govern- ment announced the policy of “retain the large, release 63 Based on the data collected from a nationwide ran- the small” (zhuada fangxiao), i.e., the state was to keep dom survey of all Chinese industrial firms conducted in the largest few hundred SOEs in strategic industries and 2006. to give local governments full control rights to local SOEs.

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Finally, a green light was given by the improving firm performance.65 In contrast, CCP’s 15th Congress, 1997 (see Research governments still kept substantial controls Center of the CCP History 2009), which over those firms privatized through other granted de jure ownership of local SOEs to methods, and these privatization strate- local governments. By default, this implies gies failed to improve performance (Gan, that the center has authorized the ‘owners,’ Guo, and Xu 2010). mostly city governments, of smaller SOEs It is the decision of a given municipal gov- to try everything on their own, including ernments whether to privatize and, if so, privatization, although this has never been how to privatize. According to a nationwide explicit. With this major change, the scale random survey, MBO was chosen mostly of privatization gradually enlarged after by those cities that had stronger fiscal dis- 1997. cipline and/or were less concerned about China’s regional experiments on privati- shedding labor, such as fast growing coastal zation have adopted multiple approaches. cities like Ningbo, Wenzhou, Hangzhou, These approaches include share issue priva- Changzhou, and Wuxi. Meanwhile, non- tization (SIP), joint ventures with foreign MBO approaches were chosen mainly by firms, management buyouts (MBO), and those city governments that had weak fiscal sales to outsiders. Privatization in China discipline and a concentration of the state has created concentrated private ownership sector, such as heavy industrial cities like and about half of privatized firms in China Changchun, Jinzhou, Handan, and Xian were sold to managers, i.e., through MBO, (Gan, Guo, and Xu 2010). which has greatly changed corporate gov- The process of privatization illustrates ernance and corporate performance (Gan, the importance of regional experiments in Guo, and Xu 2010). advancing China’s reforms. To make this pic- Not every privatization approach was ture sharper, it is important to point out that effective. Based on their nationwide ran- MBO was never favored by the central gov- dom sampling survey data, by controlling ernment. In fact, the mass media, which has for privatized and not privatized firms; been tightly controlled by the central gov- before privatization and after privatiza- ernment, was hostile to MBO. In contrast, tion, based on a nationwide random sur- the central government-sponsored major vey, Gan, Guo, and Xu (2010) found that, ownership reforms, such as share issuing among all privatization methods, only privatization, failed to improve the perfor- MBO had statistically significant positive mance of SOEs.66 impacts to the restructuring, corporate governance and performance. One of the most important changes associated with 65 Without differentiating between MBO and non- MBO is that the state has retreated from MBO privatization, by examining formerly state-owned firms after privatization. That is, after buy- large and medium-size enterprises for the period from 1994 to 1999 nationwide, Jefferson and Jian Su (2006) ing out the firm, owner-managers became found that privatization increased productivity and invest- the decisionmakers of their own firms on ments in research and development. Similarly, based on issues like hiring, layoffs, wages, compen- firm level data collected from one city, Xiao-yuan Dong, Louis Putterman, and Bulent Unel (2006) found that pri- sation, production, marketing, and invest- vatization has significantly improved productivity and prof- ments. Moreover, MBO firms substantially itability for urban firms. restructured in a deeper way than other 66 It has been shown that China’s share issue privatiza- tion has failed to contain costs and improve profitability privatized firms. As a result, MBO had a (Qian Sun and Wilson H. S. Tong 2003; Jianping Deng, statistically significant positive impact on Gan, and Jia He 2008).

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5.4 The Impacts of Regional decentralization. The major focus of the Decentralization on Growth paper is fiscal decentralization. In addition, other reforms included in the regression It is a major challenge to study the impact model are the HRS reform; and the share of regional decentralization on economic of non-SOEs’ output in the total industrial growth empirically. One of the most difficult output. As discussed in previous sections, the issues is how to measure regional decentral- HRS reform and nonstate sector develop- ization. The Chinese regional decentraliza- ment are all consequences of regional decen- tion involves much more than simply fiscal tralization. Therefore, together with fiscal decentralization. But how to measure statis- decentralization these variables capture a tically nonfiscal elements of regional decen- large part of regional decentralization. At the tralization is an unsettled subject. Moreover, same time, their regression models also con- regional decentralization captures only part trol for the growth rate of per capita invest- of the operations of China’s RDA regime. ment, the financial strength of a region, the The effectiveness of regional experiments impacts of urbanization and the size of the and regional competition is often conditioned population on economic growth, and price on effectiveness of central control. That is, liberalization. All of these control variables centralization is an essential part of the pic- have insignificant impacts to regional growth. ture. In addition to the conceptual and theo- Lin and Liu discovered that, everything retical problems in the literature, the lack of else being equal, the growth rate of per statistics on broadly defined decentralization capita provincial GDP would increase by is another major problem yet to be resolved. 3.62 percent in response to an increase of Given the difficulties, most of the empirical the marginal retention rate of regional fiscal literature concerning the impacts of regional revenue from 0 to 100 percent. Moreover, decentralization on growth is restricted to the impact of the HRS on regional growth fiscal decentralization. rates was similar to that of the fiscal decen- Lin and Zhiqiang Liu (2000) and Jin, tralization. Furthermore, among all regional Qian, and Weingast (2005) found that fis- decentralization variables, the one with the cal decentralization contributed to regional largest impact was the nonstate sector devel- growth in general, and to the development opment. Everything else being equal, the of the regional nonstate sector in particular. regional GDP growth rate would increase by Tao Zhang and Zou (1998) found a negative 14.2 percent if the share of the nonstate sec- relationship between fiscal decentralization tor increased from 0 to 100 percent. and regional economic growth in China, but Consistent with Lin and Liu, by using Lin and Liu and Jin, Qian, and Weingast provincial data from 1980 to 1993, Jin, suggested potential data and methodological Qian, and Weingast found that stronger problems in Zhang and Zou. fiscal incentives are associated with faster Lin and Liu use provincial data from 1970 development of nonstate enterprises and with to 1993 to study the impact of fiscal decen- greater reforms in state-owned enterprises. tralization on regional economic growth. Furthermore, Jin, Qian, and Weingast found Their regressions are based on a Solow provincial governments in China faced type of growth model. Economic growth stronger ex post fiscal incentives after the is decomposed into growth of per capita reform. Specifically, they found a strong investment and growth of total factor pro- correlation between the current provincial ductivity. All the major reforms included in budgetary revenue and its expenditure the regression models are related to regional for the period of 1982–91 when the “fiscal

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contracting system” was implemented. The governments’ de facto ownership over Jin, Qian, and Weingast discovery is echoed regional SOEs has been transformed into de by a literature that argues that the different jure or nearly de jure ownership.67 Together fiscal federalist approaches used by China and with other major changes, this endorsement the FSU are related to well/poorly defined paved the road for subnational governments tax rights for subnational governments and to privatize SOEs and COEs (Garnaut et strong/weak fiscal incentives for subnational al. 2005). Moreover, subnational govern- governments. Some of this literature claims ments were authorized to sell land within that these shed light on the performance gap their jurisdictions. Secondly, these changes between China and Russia (Shleifer 1997; in turn have had impacts on fiscal matters, Daniel Berkowitz and Li 2000; Zhuravskaya so that the revenues of subnational govern- 2000). ments in more developed regions created However, the results of both Lin and Liu through privatization and selling land in the and Jin, Qian, and Weingast are based on past years could sufficiently offset losses data up to 1993. As discussed previously, of their tax revenue. Control rights over fiscal policy was substantially recentralized land give subnational government impor- after 1994. This makes these results vulner- tant leverage over regional development, able to challenges (Tsui and Wang 2004; regional industrial policy, and macro control Mertha 2005). of the region (to be further discussed in sec- Nevertheless, the Lin and Liu–Jian, Qian, tion 6.1). To summarize, although the share and Weingast evidence constitutes a valu- of subnational governments’ tax revenue in able step in understanding the impacts of national tax revenue was reduced substan- regional decentralization on regional growth. tially, subnational governments’ importance After all, fiscal decentralization is an impor- in regional governance and in national eco- tant part of regional decentralization, which nomic development remains essential. The includes land reform, SEZs, and nonstate central government still relies on subna- sector development. The period before 1994 tional governments to govern the bulk of is one in which fiscal decentralization is fully the Chinese economy and subnational gov- consistent with regional decentralization in ernments still dominate regional economic general. Thus, fiscal decentralization may be affairs, including fiscal and nonfiscal matters, a good proxy for regional decentralization in such as allocating critical resources to firms, that period of time. However, the contribu- dealing with contract enforcement, and tion of nonfiscal reforms to economic growth property rights protection. is pooled together with fiscal decentraliza- tion so that the contribution of each remains 6. Trade-Offs of Regional Decentralization entangled. That is, the identification prob- lem has yet to be resolved in this literature. Rent-seeking behavior and general conser- Last but not least, it should be pointed out vatism are inherent features of an authoritar- that although taxation has been recentral- ian regime, therefore making them difficult ized since the mid-1990s, it is not clear that to reform. However, under the RDA regime, regional decentralization has been reversed completely in general. Firstly, in the same 67 In 2005, subnational governments owned about period of “fiscal recentralization” subna- thirty-one thousand SOEs plus control of a huge number tional governments gained more power in of COEs (NSB 2006b) whereas the central government owned 166 firms (the State-Owned Assets Supervision and some nonfiscal spheres. Endorsed by the Administration Commission, or SASAC: http://www.sasac. 15th Party’s Congress in 1997, subnational gov.cn/gzwgk/gzwgk_jj.htm).

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rents could be eliminated if subnational gov- SEZs, were less intrusive to rural stakehold- ernments face fierce regional competition: ers’ interests, such as land. given the importance of winning the compe- However, after a quarter century’s fast tition, if losing a competition implies losing economic growth, the multitask nature of a position, which is the necessary condition subnational governments’ duties has become for enjoying rents. Moreover, as discussed more pronounced and the general consen- in section 2, regional experimentation and sus on the importance of economic growth regional competition can alleviate the prob- has broken down. Many major growth- lem of conservatism, enabling reforms to enhancing reforms implemented since the move forward. mid-1990s generated immediate conflicts However, regional competition and among stakeholders. A prominent example regional experimentation are effective only is firm restructuring and privatization, which when subnational governments’ tasks can be started in the 1990s. In those reforms, a summarized by a single indicator, e.g., eco- large number of SOE employees were laid nomic growth. If subnational governments off, whereas new private owners obtained face multiple tasks that cannot be encom- huge amounts of wealth through manage- passed under a single objective, regional ment buy-outs. Another example is associ- competition and regional experiments may ated with large-scale rapid urbanization, become focused on tasks, which are more which converts arable land for nonagricul- measurable, while less measurable tasks are tural developments and creates a great num- ignored. In that case, high-powered incen- ber of landless peasants. This often leads to tives created through regional competition sharp conflicts between those who lost land may lead to undesirable consequences. Even without receiving proper compensation, and worse than this, subnational governments property developers who profited immensely may be induced to race to the bottom, i.e., from the transactions, and are usually closely regions may compete in or may experiment associated with subnational governments. on some policies that may benefit regional 6.1 Law and Regulation officials but damage most other citizens, or may benefit the region but damage other Under the RDA regime, Chinese subna- regions. tional governments play significant roles in At earlier stages of the reform, it was both law enforcement and law making. The commonly agreed by the central govern- aforementioned provincial law on SEZs, “the ment, subnational governments, and citizens Regulation for Guangdong SEZs,” illustrates that economic growth was the most impor- that subnational legislation can also serve tant objective of China’s economic reform. as the experimental basis for new national Under that consensus, other objectives can legislation. Subnational governments were be overlooked so long as the economy grows endowed with law-making power since the rapidly. Thus, regional competition and PRC’s founding in 1949. Although most of regional experiments faced easier tradeoffs. their de jure law-making power was taken Moreover, at earlier stages of the reforms, away during the centralization movement most growth-enhancing policies and institu- of the 1950s, subnational governments kept tional changes avoided immediate conflicts some de facto law-making powers. At the among stakeholders. The land reform (HRS onset of the reform, subnational governments reform) distributed land equally among rural regained much of their law-making power households. The TVE development and other (http://www.china.com.cn/zhuanti2005/ nonstate sector developments, including txt/2003-02/27/content_5283965.htm), and

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these gains were institutionalized by the 1982 helped avoid governance ­vacuums, as pri- constitutional amendment. In addition, the vate businesses were at times disguised by central government from time to time exper- subnational governments. Indeed, many of imented with giving additional law-making the initiatives and protections provided by powers to subnational governments, such as subnational governments to private firms “authorized law-making power” (shouquan flew in the face of the constitution. Thus, lifa) or “beforehand law-making power” strong incentives given to subnational gov- (xianxing lifa). As a result, more than six thou- ernments played essential roles for them to sands laws have enacted by subnational gov- take the risks associated with their unconsti- ernments nationwide since 1978. Conflicts tutional actions. that arise between regional laws and national The roles of the municipal governments of laws are one of the major concerns of this sys- Taizhou and Wenzhou of Zhejiang province tem, although, in principle, whenever there in developing private sectors ahead of rele- are conflicts the national law overrules. vant legal developments illustrate this point. However, the starting point of China’s The municipal governments offered “red legal reform is among the weakest of all heads” to private firms within their jurisdic- transition economies, since during the CR tion to conceal their vulnerable legal status, China dismantled its formal legal system. thereby giving the outsiders the illusion of As a result, China has had to build its legal official government sanction. Thanks to this system virtually from scratch during the kind of development in many regions where reform era. Moreover, ideological and politi- subnational governments provided similar cal constraints delayed major legal reforms, protections, the private sector in China expe- such as the protection of private property rienced double-digit growth for more than a rights. Together with the lack of judiciary decade without full legal protection. To some independence, China was in a weaker posi- extent it is this spectacular development of tion than average transition economies in the private sector that catalyzed the legal- terms of legal reforms. It is not surprising ization of private property rights. When the that a lack of proper law and law enforce- constitutional protection of private property ment can lead to serious problems, and I will rights was enacted in 2004, the private sector discuss some of the most serious problems was already the dominant sector in Zhejiang related to Chinese law later in this subsec- and one of the largest sectors in China. tion. However, the coexistence of very fast- Concerning regulation, given its weakness growing businesses, including the private in legal institutions, under the RDA regime, sector, and a very weak formal legal sector China introduced an administration-based is puzzling. The solution to this puzzle lies in regulatory decentralization scheme. In this the fact that regionally decentralized admin- scheme, the central regulatory authorities istrative measures step in as substitutes for break down the regulatory tasks and delegate law and law enforcement (Pistor and Xu them to subnational governments. Together 2005).68 In the past, this has ­sometimes with regional competition, this system some- times is able to implement some national

68 It is worthwhile to note that there are many cases in which business practice preceded relevant laws in laws, such as contract law and tort law, on new business European and American history. For example, important practices (Xu and Pistor 2006). But in Chinese reforms, a securities laws (US 1933/34 Acts) were developed decades basic functioning legal system itself is under construction. behind major developments in U.S. securities markets. Thus, subnational governments are essential as substitut- However, in Europe and the United States, there were ing mechanisms to fill in the governance gap (Pistor and functioning legal systems that effectively enforced general Xu 2005).

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regulatory goals, but sometimes fails to do governments in turn would allocate quotas so. The regulatory scheme that evolved dur- to selected SOEs for going public through ing the last twenty years relies essentially IPOs or to listed companies seeking SEOs. on subnational governments’ assistance and The subnational governments would collect cooperation for enforcement of its regula- information on these firms and submit it to tions (Julan Du and Xu 2008). In this sys- the China Securities Regulatory Commission tem, one of the major instruments that are (CSRC), the national regulatory agent. After deployed is the quota system. reviewing the company information, the The bank credit quota system, which CSRC would give its approval to companies was utilized by the People’s Bank of China to issue shares in the public equity markets. (PBC) to control the aggregate money sup- The quota system was officially in place from ply until 1998, is an example of one such 1993 to 2000; however, it actually governed quota (Du and Xu 2008). The PBC formu- financial markets up until around 2003 lated the national credit plan and allocated (Pistor and Xu 2005). credit quotas to the headquarters of all major Although the quota system was not state banks, which in turn reallocated these designed for dealing with informational or to their regional branches and subsidiar- incentive problems, several bodies of evi- ies. The regional allocation of bank credit dence indicate that it has played a signifi- quotas depends largely on regional banking cant role in creating incentives for regional performance, measured in ways such as the competition and decentralized information amount of deposits taken by regional banks collection in stock issuance. Based on the in the previous year; regional economic per- data of all listed firms from 1993 to 2004, formance; and a variety of other metrics. The after controlling for political factors, macro bank credit quota system was a major instru- variables, etc., Du and Xu (2008) find that ment for implementing macroeconomic firms located in regions with better perfor- policies in general and monetary policy in mance obtained more quotas in subsequent particular until market-based credit alloca- periods. In explaining firm-level quotas by tion mechanisms were somewhat deployed provincial performance, this result essen- in the late 1990s. tially rules out the possibility of reverse cau- Another major example is the evolu- sality, since none of the firms in the sample tion of Chinese financial market regulation. were large enough to affect provincial per- China’s securities markets, the Shanghai and formance. In addition, the data demonstrate Shenzhen stock exchanges, initially emerged that everything else being equal, listed firms as self-regulated regional markets with from provinces that disclosed information supervision from the corresponding munici- better were rewarded with more stock quo- pal governments (Stephen Green 2003). tas in the ensuing periods. Moreover, the The quota system of equity share issuance quality of regional information disclosure was introduced to the Chinese equity mar- was substantially more important than other ket in 1993, and was designed to control the factors, such as regional corporate or macro size of financial markets to maintain balance performances, in determining how quotas among the regions and to preserve the domi- were allocated. These findings suggest that nant position of public ownership. The cen- provinces that performed better in various tral government would determine the total aspects previously would be given a higher number of shares to be issued in the nation stock issuance quota later from the central and then would allocate stock issuance quo- government. That is, the quota allocation tas to regions and ministries. Subnational functioned as a de facto incentive device

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that induced subnational governments to use quota for each year and regions violating select better-performing firms for initial the land-use quota would face a deduction in public offerings (IPOs) or seasoned equity future quota allocation, together with other offerings (SEOs). Finally, detailed evidence penalties. Moreover, an official’s compliance from twenty-three provincial-level regions with quotas is taken as part of the criteria for suggests that the majority of IPO firms evaluating his work. However, because this selected by subnational governments had quota system violates all the three aforemen- been better-performing state-owned enter- tioned conditions, the land quota system fails prises before they went public (Julan Du and to work. Chenggang Xu 2009). This further indicates In fact, the land problem is one of the that the Chinese regulatory decentralization most serious social problems in China and it is somewhat effective at the IPO stage. can be used as an illustration of how China’s However, administration-based regulatory RDA system makes trouble for the economy. decentralization is not always effective, and it Deeply-flawed laws governing land owner- is not a long-term substitute for law enforce- ship and fiscal recentralization “collectively” ment. There are several conditions that must incentivize local governments to ignore the be met for decentralized admin measures to quota system (Kung, Xu, and Feizhou Zhou function well as a substitute for conventional forthcoming). Arable land in China is de jure legal institutions. Firstly, subnational govern- collectively owned and, in this system, the ments must have substantial control rights commune authorities before the reform, and over the regulatory subjects; otherwise, sub- the village authorities afterwards, represent national governments would not play a major the collectives. Although rights of use and regulatory role (e.g., the quota system does income over land have been reassigned to not work effectively for non-state-owned the farm households since the land reform firms and cannot ensure adequate corporate of the early 1980s, the farmers have no right governance of listed companies). Secondly, to alter the land’s usage or to transfer it to subnational governments must have strong another party. The crucial right to transfer vested interests in the subjects of regulation; these rights has remained in the hands of the otherwise, subnational governments would state and, in part, of the village authorities. not be motivated to participate. Finally, the Yet, the collective owners have no right to central government must have direct control convert arable land into nonarable usages. over the resources to be allocated by a quota Nationalization has been the only legal system; otherwise information problems will mechanism by which farmland can be con- disable the system. For example, the quotas verted into nonarable usages since any non- systems used for bank credit control and for arable usage of collective farmland requires environment protection did not work well a change from collective to state ownership since these quotas are nominal, the financial (Articles 63 and 43 of the Land Management resources of local banks or local branches of Law of 1999). Moreover, the law confines national banks and pollutant emissions are farmers’ rights in land to basically an “agrar- directly controlled by local governments, and ian” usage when land use is changed to they can easily manipulate the information. nonagrarian and ownership converted (from In order to prevent excessive conversion collective to state). In other words, farmers of arable land for nonagricultural uses, the would only be compensated according to the Chinese government has applied a land quota value of crop production after conversion, system to regulate local governments’ land even though the land postconversion may be conversion. Each region is allocated a land- far more valuable. Apart from the minimal

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compensation that is legally protected, the bundle of rights assigned to them at the China’s farmers are subject to the whims of outset of the reform. Opposite to the harmo- local authorities in the process of land con- nious atmosphere at the era of land reform, version (Kung, Xu, and Zhou forthcoming). i.e., the early 1980s, land expropriation by As discussed previously, the fiscal recentral- local governments now becomes one of the ization of 1994 reduced the share of local gov- worst sources of social conflicts in China ernments’ entitlement to most tax sources. To (Xiaolin Guo 2001; Lianjiang Li and Kevin compensate local governments for the losses, J. O’Brien 2008). This illustrates that, with- local governments were assigned greater con- out a properly developed legal system, many trol rights over revenues generated by land problems cannot be resolved by regional sales within their jurisdictions. From 2002 competition, regional experimentation, per- onwards, the central government further pro- sonnel control, and other methods deployed posed to appropriate 50 percent of the enter- by the RDA regime. prise profit tax, which greatly disincentivizes 6.2 Regional Protections local governments’ efforts to improve enter- prise efficiency. The fiscal recentralization, Regional decentralization alone may not together with the monopoly right assigned automatically guarantee growth-enhancing to local governments over the conversion regional competition. Without checks of the of farmland to nonarable uses, has induced central government, subnational officials local governments to switch from a passion may restrict cross-regional trade to protect for industrialization to “urbanization” frenzy firms within their jurisdiction. Indeed, it is (Kung, Xu, and Zhou forthcoming). oft-cited that subnational governments opt Blessed with escalating land prices (espe- to put up barriers to shield local firms and cially for commercial and real estate devel- industries from competition. It was docu- opments in premium locations) on the one mented that, in the mid-1980s, many subna- hand and artificially low compensations on tional governments tried to retain low priced the other, many local governments, particu- raw materials, such as wool or silk, within larly those in the rapidly developing coastal their jurisdictions in order to favor local man- areas, have pocketed “windfall profits” from ufacturers (Andrew Watson, Christopher this urbanization process. Attracted by the Findlay, and Yintang Du 1989; Thomas P. huge “windfall profits,” land conversion has Bernstein and Xiaobo Lu 2000), and this was accelerated after 1999. In 2003, the state also widely reported by both domestic and became worried that China would soon international mass media coverage.69 deplete its arable land below its thresh- If there are no effective central-govern- old required for food self-sufficiency. In ment policies to keep barriers in check, in an attempt to slow down the conversion of addition to making factors immobile as most farmland, since 2001 the central government often emphasized in the literature, regional has set land conversion quotas for all prov- inces for each year. But with seriously dis- torted incentives, the land quota assignment 69 For example, a New York Times report illustrated did not work. Much worse, in the process of trade barriers among Chinese regions. To protect their local made car manufacturers, “Tianjin local officials land conversion, local authorities have trig- barred taxi companies in the city from buying Geelys,” gered serious conflicts with the farmers, as which are produced by a Zhejiang-based car manufacturer a large number of farmers lost their primary (New York Times, November 17, 2006). Casual observa- tions confirm this as a general phenomenon that most taxi source of livelihood with minimal compensa- cabs in many major cities, e.g., Beijing, Tianjin, Shanghai, tion. They feel that they have been robbed of Changchun, and Guangzhou, are made locally.

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protection could destroy regional compe- debated intensively in the literature. There tition itself, one of the basic mechanisms is abundant literature about, statistical evi- that drive China’s reform and development. dence of, and mass media coverage of the Moreover, interregional trade barriers and fast growing interregional trade (Holz 2009). regional protectionism can eventually lead Indeed, one of the most important early to serious political problems, such as disinte- reforms in the early 1980s was the legal- gration of the country. ization of cross-region trade carried out by Recognizing the seriousness of the prob- state and nonstate merchants, including pri- lem, the Chinese central government has vate traders. Lau, Qian, and Roland (2000) battled against regional protectionism contend that the “dual-track system,” intro- repeatedly during the whole reform period. duced during the reforms, promotes interre- The central government has issued decrees gional trade because, under this system, local in 1982, 1990, and 2001 to curb regional pro- officials can “sell” the rights to purchase a tectionism (Carsten A. Holz 2009). A State certain percentage of raw materials and final Council circular of 10 April 1982 states: products at lowered planned prices. Since “regional or departmental (trade) block- opening up the market to other regions may ages . . . are extremely harmful to China’s significantly increase the market price, this economy in total.” The State Council clari- system is beneficial for local officials. fied that enterprises had the authority to In an ideal situation with perfect national sell their above-plan output anywhere in markets, all factors would be mobile, and the country they wanted, and subnational therefore their productivities across regions governments were not to interfere in the would be equalized; regional economies distribution of the above-plan output. In would utilize their comparative advantages, 1990, the State Council issued a circular on their production would be specialized, breaking interregional blockades. It requires and regional prices for the same products that all regional trade checkpoints must be would converge. Based on this idea, taking rectified, and differential tax rates based on the first best case as the benchmark, it has product origin were prohibited. The State been argued that the Chinese economy has Council issued another regulation in 2001 become fragmented regionally and that the to deal with issues of the malfunctioning of situation was getting worse. Young (2000) the “market order,” including regional trade reported widespread convergence in the barriers. It contains detailed stipulations for regional structure of production during the eliminating specific kinds of regional trade reform period, and a rise in the interre- barriers (Holz 2009). The great efforts of the gional variation of prices during the 1980s. central government in containing regional Moreover, there was a divergence of regional protectionism demonstrate the stubbornness relative factor allocations and labor produc- of the problem and the determination of the tivities. These findings were interpreted central government to contain the problem. as evidence of industrial duplication across It also underscores the “checks-and-bal- regions caused by regional barriers. Based ances” between the central government and on this, he claimed that regional protection subnational governments in the context of in China was worsening and that Chinese regional competition. reforms resulted in a fragmented internal Whether or not the central government’s market with fiefdoms controlled by local offi- efforts in confining regional protectionism cials. To some extent, similarly, by studying and whether or not regional fragmentation capital mobility across provinces, Genevieve has worsened during the reform have been Boyreau-Debray and Shang-Jin Wei (2005)

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found great discrepancies in regional mar- specialization. Echoing this finding, Fan and ginal capital productivities and from this Wei (2006) also find the convergence trend concluded that the Chinese financial system in China is similar to those discovered in the was regionally fragmented. United States and Canada. In these three However, by using more diverse and economies, many prices follow relative price recent data than that of Young (2000), Bai convergence rather than absolute price con- et al. (2004) found that regional specializa- vergence. Obviously, it will not be convincing tion has increased and has become domi- to claim that market development in China is nant over the forces of regional protection at a similar level of the United States given in recent years. Moreover, with a data set this evidence. However, it would be even that consists of 93 products in thirty-six cities harder to claim, based on this methodology, over more than ten years, C. Simon Fan and that Chinese economic reforms have moved Xiangdong Wei (2006) provided evidence the economy further away from markets. of market integration during the reform In fact, it is quite likely that applying a period. They found an overall price conver- similar approach, regional specialization in gence in China that indicates that markets Russia, or more generally in the CIS and across different cities are indeed integrated. Central–Eastern European countries, is Furthermore, they found that the products much higher than that in China before 1990. for which interregional trade was more likely But it would be misleading to interpret this to be restricted by local officials for rent- as evidence for more-developed markets in seeking purposes tended to converge to a these locations. Indeed, based on the theo- greater degree of absolute price parity. This ries discussed in sections 3 and 4, an econ- finding suggests that local protectionism omy with overly specialized regions would might be a less important obstacle to inter- hamper regional competition and experi- regional trade in China than some other fac- mentation. Of course, in those theories, the tors, such as transportation costs. composition of regional economies is exog- Yet, there are serious concerns regard- enous. A more complete theory has yet to be ing the methodologies used to study trade developed to analyze dynamics of regional barriers. Specifically, focusing on measur- competitions when both the composition of ing regional specialization alone may not be regional economies and scale economies are most helpful in understanding regional pro- endogenously chosen by players. tection since it does not have the warrant of a 6.3 Regional Disparity theoretical foundation. As Naughton (2003) points out, without an underlying theory and In light of record-breaking rapid and without a cross-country comparison, i.e., prolonged growth, the quickly increasing without knowing proper benchmarks, look- disparity of wealth in China has become ing at one country’s regional specialization a major concern. It is commonly agreed in alone might be misleading. Indeed, state the literature that inequality in China has manufacturing sectors in the United States, substantially worsened since the reforms, an integrated national economy, became mainly in the past two decades. Based on less specialized than before 1987, and they household data from nine provinces, Dwayne became more similar than they were in Benjamin et al. (2008) find that the overall the past (Sukkoo Kim 1995). Moreover, (combined urban–rural) Gini coefficient by using a similar approach, Holz (2009) of China probably exceeds 0.50, which finds that Chinese provinces are similar to is approaching that of some of the most American states in their degree of regional unequal countries in the world, e.g., South

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America. Based on provincial level aggregate inequality can even lead to the disintegration data, Ravi Kanbur and Zhang (2005) found of a nation (Patrick Bolton and Roland 1997). that, associated with the increase of GDP and Concerning China’s growing inequality, it trade, the Gini coefficient has increased from has been warned that increased regional 0.29 in 1978 to 0.37 in 2000. To what degree inequality in China may threaten economic regional decentralization has contributed to and political stability, and national unity this increased inequality is a hotly contested (Hu, Wang, and Xiaoguang Kang 1995). subject in the literature. Is the Chinese duo of high growth and The relationship between growth and increasing disparity a “normal” development inequality is a subject of debate in the litera- path prescribed by the well-known Kuznets ture (for a survey sees Philippe Aghion, Eve curve? Will worsening inequality hurt Caroli, and Cecilia Garcia-Penalosa 1999). China’s economic growth? To what extent In the classical view, inequality is regarded as is the widening disparity related to regional necessary and transitional in the process of decentralization? These are issues still under industrialization or growth (Simon Kuznets debate in the literature. 1955). Moreover, an increase of inequality Although empirical findings unequivo- may not be so bad even for the poor when an cally show rapidly increasing inequality, economy grows quickly, since the poor ben- particularly during the recent twenty years efit more from increasing aggregate growth of reforms, findings on the relationship than from reducing inequality through between inequality and reforms, includ- redistribution (David Dollar and Aart Kraay ing decentralization, are divided. Based on 2001). China’s rapidly increasing per capita a Chinese household survey dataset with income came together with rises in inequal- about one million households in the period ity and is used as a major example to illustrate between 1980 and 2002, Martin Ravallion the above point (Danny Quah 2003). This and Shaohua Chen (2007) found that line of thought would argue that the reform inequality was not always related to growth- policy in the first two decades of Chinese enhancing reforms, and that there was no reforms enabled some people to become overall evidence of an aggregate growth- rich first. Driven by this policy and imple- equity tradeoff in China. They found that mented within the framework of regional higher growth in rural areas, which cor- decentralization, arguably, in the last quarter responds well with HRS reform and TVE century, China has experienced the largest development, brought inequality down. scale of poverty reduction in human history. It reduced inequality within both urban The Chinese population in absolute poverty and rural areas, as well as between them. (defined as $1/day income) has dropped Moreover, provinces with worse dispari- from 50 percent to 7 percent in twenty years, ties, both within rural areas and between while the number of individuals in absolute urban and rural areas, were less able to poverty was reduced by almost 400 million. speed up rural economic growth. However, This number is nearly three-quarters of pov- urban economic growth was positively cor- erty reduction in the whole developing world related with inequality. Moreover, they (World Bank 2003). found that the increases in public spending On the other hand, however, it is argued reduced poverty but not inequality. And, that inequality has impacts on politics, the increases in public spending tended to investment, etc., which in turn can harm come from subnational governments, not stability and growth in general (e.g., Alberto the central government. Finally, they found Alesina and Rodrik 1994); and high levels of substantial regional variations such that

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provinces with a more rapid rise in inequal- Tsui 1993; Jian Chen and Belton M. Fleisher ity usually made less progress in poverty 1996; Zhang and Kanbur 2001), they contend reduction. that regional disparity in general, and inland– Based on rural household-level data col- coastal disparity in particular, is a key dimen- lected in nine provinces during 1986 to 1999, sion of increased inequality in the reform Benjamin, Brandt, and John Giles (2005) era. From 1978 to 2000, the inland–coastal made qualitatively similar conclusions. They GE component increased by nine times, found that initial inequality affects growth, from 0.4 percent in 1978 to 3.8 percent in whereas rising inequality is not related to the 2000. They argue that this rapid widening of growth trajectory. Specifically, they found the gap between coastal and inland regions that villages with higher inequality initially— is mainly due to FDI and trade since the two i.e., in 1986—in their sample, grew more regions have different opportunities. On the slowly over the next thirteen years. However, other hand, the rural–urban GE coefficient in village fixed-effects specifications, there is component increased from 11 percent in no statistical relationship between inequality 1978 to 13.9 percent in 2000. Although this and growth. They believe this suggests that raise looks marginal, there was an inverse the mechanism linking growth to inequality trend, as the number had bottomed out at operates “in the long run.” They also found 6.4 percent in 1984 when the HRS reform that more unequal villages had the slow- was completed.70 They argue that the wors- est nonagricultural development. Part of ening of the rural–urban disparity was also the explanations for the long-run impacts related to FDI and exporting. of inequality on growth may be related to Based on provincial-level data, Lin and their other findings. That is, low inequality Peilin Liu (2005) and Fleisher and Chen is related to the effect of village education, (1997) also claimed that widened regional which leads to higher income growth, espe- disparities were related to regional decen- cially of nonfarm incomes. tralization. Lin and Liu (2005) emphasize Yet, worries over ever-increasing inequal- different subnational governments’ strate- ity are increasing, and the impact of regional gies and their effectiveness in economic decentralization on inequality has been hotly development, whereas Chen and Fleisher debated. Some scholars even argue that the (1996) attribute the widened disparity to rapid widening of regional disparity caused the central government’s policies of favoring by regional decentralization can lead to the the development of coastal regions, as most disintegration of China (Hu, Wang, and important reform policies favoring coastal Kang 1995). Kanbur and Zhang (2005) claim regions are FDI- and export-related poli- that fiscal decentralization is responsible for cies. Similarly, Shujie Yao and Zongyi Zhang the rise of nationwide inequality. (2001), Sylvie Demurger (2001) and Xiaolan Based on provincial level aggregate data, Fu (2004) all claim that these reforms con- Kanbur and Zhang (2005) use the GE (the tribute to regional inequality. They report generalized entropy index) inequality coef- that both exports and FDI have significant ficient, which increased from 0.14 in 1978 and positive impacts on growth in coastal to 0.25 in 2000, and decompose Chinese regions, but not in inland regions. inequality into three components: inland– Fiscal recentralization was proposed as a coastal and rural–urban. They suggest that policy remedy to ease regional disparities. regional decentralization has contributed to about one-third of Chinese inequality. 70 Ravallion and Chen (2007) report a similar trend of Consistent with some earlier literature (e.g., rural–urban disparity over this period of time.

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However, based on county-level data, Tsui that, during the 1990s, the difference in (2005) and Zhang (2006) find that the average incomes between the two regions regional fiscal disparities have worsened widened considerably. However, much of since the 1994 fiscal recentralization. the increase in the gap appears to be the Regional disparities in per capita fiscal result of a growing difference in incomes expenditures (and by implication, the between rural households in the coastal and provision of services) are extraordinarily interior provinces. By 2000, rural incomes in large across rural governments, and they the coastal provinces were about 50 percent were persistent since the peak reached in higher than they are in the interior, whereas the late 1990s. Among the 2,800 county- the urban income gap between the two level jurisdictions, in 2003 the richest spent regions did not widen much. Consistently, forty-eight times as much as the poorest—a inequality in the coastal provinces increases gap that is unusually large compared to that only slightly (from 0.35 to 0.39), whereas of other countries (Wong 2007). increases are larger in the interior (from 0.39 Yet, one has to be careful about real to 0.48). The significantly larger increase mechanisms behind the so-called fiscal in the interior is attributed to the increase decentralization or fiscal centralization as in inequality in rural areas in the interior most of the empirical work in the literature (increases from 0.40 to 0.49) compared to is based on aggregate data and is carried out the coastal provinces, which remains under in a reduced form. As we discussed previ- 0.40; and a widening rural–urban income ously, at certain times fiscal decentralization gap in the interior (which widened from 1.58 is concurrent with regional decentralization to 1.85) compared to the coastal areas (which such that a correlation with fiscal decentral- fell from 1.60 to 1.32). ization in such a period could capture some Benjamin et al.’s findings suggest a strong things other than fiscal decentralization. link between inequality and regional decen- On the other hand, since the mid-1990s, in tralization, but due to a different mecha- addition to fiscal recentralization there have nism than many others proposed. Instead of been many changes in regional decentral- regional disparity, they argue that economic ization. Thus, further research should be opportunity for citizens varies across regions, done to study the impacts of regional decen- and this affects the development of rural tralization and various specific reforms on areas. Thus, local institutions and differences inequality. in the opportunities for people living in the Based on household data from nine prov- same community explain most of the rising inces, Benjamin et al. found that the contri- inequalities. Concretely, they contend that at bution of regional disparities to household the outset of the reforms, the role of the state inequality was increasing and peaked in the sector was significantly more important in the mid-1990s, when fiscal policy was recentral- interior than in the coastal provinces. During ized, and since then it has declined. They the reform, the growth of the nonstate sec- find that, after the mid-1990s, most of the tor in the interior provinces has been much inequality in China is within the villages and slower. This has handicapped the growth in cities in which Chinese households live and rural incomes in both the urban and rural work; that is, most of the inequality was due sectors. In contrast, growth in the nonstate to differences of income among households sector in coastal provinces has provided in the same province. opportunities to rural households, which Concerning the disparity between coastal has prevented a sharp deterioration in rural and interior regions, Benjamin et al. found inequality like that observed in the interior.

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6.4 Resolving China’s Institutional However, most provincial governments who Problems initially joined this “Green GDP” project have withdrawn from it due to a conflict of The lack of an independent judiciary, interests (between growth and other objec- rent-seeking behavior, and unresponsive- tives) and disagreements on technical issues ness to citizens’ preferences are some of related to its measurement. Indeed, this idea the intrinsic deficiencies of an authoritar- is fundamentally flawed and the problem can ian regime, and China’s RDA regime is no be traced back to the Lange versus Hayek exception. As discussed previously, some of debate on the feasibility/infeasibility of cen- those problems might be mitigated under tralized information collection. The GDP the RDA regime when economic growth measurement is market-based and, there- is an overwhelming objective because the fore, market transactions have already solved multiple tasks of a regional government can a large share of the associated incentive and be effectively converted into a single task, information problems. The difficulties in achieving a high GDP growth rate. Under measuring nonmarket activities, i.e., beyond this condition, regional competition can alle- GDP measurement, are notoriously difficult viate many problems. due to incentive and technical problems. If However, when there are many tasks that there existed a general way to measure eco- are not well defined by quantitative targets, nomic activities without using markets or to regional competition may lead to problems, measure nonmarket activities accurately and such as regional protection and ignoring tasks efficiently, a centralized economy would be that are not directly growth enhancing. It has able to resolve all incentive and informa- been widely reported that there has been a tion problems at least as well as a market severe deterioration of China’s environment economy. as a result of its rapid economic growth. SO2 It is known that assigning high-powered emissions increased from 19.9 million tons incentives, through methods such as tour- in 2000 to 25.5 million tons in 2005, mak- nament competition, to subnational officials ing China the largest emitter of SO2 (World can be harmful when they are responsible for Bank 2007). Moreover, this deterioration multiple tasks (Bengt Holmstrom and Paul was closely related with a lack of interest Milgrom 1991). However, without regional from subnational government officials, who competition, subnational officials under the found that enforcing environmental regula- RDA regime would not make efforts to initi- tions detracted from their ability to provide ate reforms or undertake growth-enhancing regional economic growth (Wanxi Li 2006). activities, which would deeply affect China’s Theoretically, if all tasks and their outcomes future development. In the following, I could be well measured, then by assigning a briefly discuss some principles to handle this policy weight for each task it might be pos- dilemma. sible to construct a comprehensive index to First, the multitask problem can be miti- summarize an official’s achievement of all gated by redefining tasks assigned to minis- tasks. In this way, a multitask problem could tries and provincial governments. The scope be reduced into a single-task problem, and of tasks to be carried out by subnational regional competition and experimentation governments should be narrowed down. over the comprehensive index would func- For example, responsibilities for activities tion well. The “Green GDP” proposal of with strong cross-region externalities should the Chinese government is an endeavor in be centralized and regulated by ministries. this direction (Elizabeth Economy 2007). Moreover, to reduce the multitask problem

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at the central level, tasks to be handled by elected officials provide better public ser- the central government should be handled vices and are more harmonious with their by specialized ministries, special courts, and constituencies than appointed ones (Brandt specialized regulatory bodies. Second, many and Matthew Turner 2006; Renfu Luo et al. monitoring and law enforcement functions, 2010). If China is unable to meet the seri- including regulation, should be separated ous challenges of managing the institutional from subnational governments, i.e., should transformation into a democratic federal sys- be carried out by an independent press and tem, China’s political stability and long run an independent judiciary. This will not only development could be put in jeopardy. reduce the multitask problem of subnational Another closely related, fundamental, governments effectively, but also greatly and challenging problem China has faced is enhance neutrality, objectiveness, justice, law and law enforcement. To some extent, and thus effectiveness in monitoring and law by deploying a regulatory decentralization enforcement. Third—and this would further regime as a substitute, China has mitigated entrench reforms—most market activities or postponed serious problems associated should be carried out by firms and should with the absence of the rule of law, and has be separated from subnational governments. therefore won itself some time to reform its This will not only narrow the tasks of sub- law and legal institutions. However, argu- national governments, but it would also ably, reform in this area is among the slowest preserve strong incentives for firms for eco- and weakest, and this slow pace has caused nomic development even when incentives of and will continue to cause severe socioeco- subnational governments are weakened. nomic problems. As the private sector and I must make it clear that some of the most markets become fundamentally important serious and fundamental problems intrin- to the economy, the negative impacts of bad sic to the RDA regime cannot possibly be laws and the absence of the rule of law will resolved without a fundamental institutional become even more manifest. The lack of an change. The multitask problem faced by independent judiciary is one of the most seri- subnational governments is fundamentally ous problems; additionally, this is an intrinsic associated with the fact that officials are problem of the RDA regime and, therefore, accountable to their bosses, who face inher- an ultimate resolution depends on institu- ent and difficult informational problems in tional transformation. Following success- performance evaluation, not to mention the ful experiences in previous reforms, China legitimacy problems of the central leader- should start to establish an independent judi- ship (section 2). The ultimate solution to ciary system at the county level—the bottom those problems lies in transforming the RDA subnational level—and expand the reform regime into a democratic federal system in upwards. Without substantial legal reforms, which subnational officials are elected and the absence of the rule of law could lead are accountable to their constituencies, so entrenched interest groups, particularly cor- that their multitask problem will be con- rupt officials, to block the reform, obstruct verted into a single-task election problem. development, and even threaten the political Arguably, to some extent this transformation stability of the nation. is on its way, but very slowly, in a bottom- up fashion. In the past decade, most village 7. Concluding Remarks heads (O’Brien and Li 2000, 2006) and some township heads (Li 2002) in China were In this paper, I argue that the regional elected; and systematic evidence shows that competition and experimentation governed

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by China’s regionally decentralized authori- that fit with this regime could not be eas- tarian (RDA) regime have effectively allevi- ily transplanted as a package to other coun- ated potential incentive and informational tries. However, there are still some general problems. By linking regional performance lessons that can be drawn from China’s to officials’ promotion, tournament-like reforms and development for other devel- regional competition provides high-pow- oping countries. ered incentives to subnational officials to The first general lesson is our understand- initiate and to implement market-oriented ing of “institutions” and their relationship reforms, while simultaneously limiting cor- with development. During its process of tran- ruption (section 3).71 Therefore, to some sition and development, China has changed extent, competition among subnational its institutions at a large scale and has cre- governments encouraged or forced them ated market-supporting institutions in an to create implicitly the institutions essen- evolutionary way, i.e., new institutions have tial for a well-functioning market (section gradually replaced old institutions when the 5). Furthermore, by incorporating regional new is ready. It would be mistaken to advise experimentation into the central govern- transition economies or developing coun- ment’s decision-making process, reforms are tries to abandon their existing institutions in less likely to be blocked, and the political and a rush by copying stylized “best practice” or technical risks of reforms are greatly reduced “good” institutions without a careful under- (section 4). standing of the operation of both inherited Nevertheless, the very same institution, and new institutions. As a matter of fact, the the RDA regime, and the solutions created sophisticated market-supporting institutions and implemented by the RDA regime—as observed in today’s developed world were highly imperfect substitutes for “standard” not created overnight; instead, they histori- solutions—also have created serious prob- cally coevolved with markets.72 Thus, for a lems (section 6). Yet, given the political and country with many missing “good institu- economic context of China’s reforms (section tions” like China, it is inevitable to use exist- 2), many “standard” approaches were and are ing institutions, such as the government, as politically and institutionally infeasible, and a starting point to pave the road for institu- it could be even worse for China’s reforms tional evolution. if a reform fails as a result of implementing Overly simplistic, black-and-white views an infeasible approach. In this sense, the of government are detrimental to reforms regional competition and regional experi- and economic development. There is a ments implemented by the RDA regime are popular view that reforms in transition and second-best solutions. developing economies should focus on con- To highlight the major features of the fining the government, such that the role of RDA regime, the following table 6 compares the government should be restricted to the the characteristics of China’s RDA regime protection of property rights and contract with the federal state and the Soviet system. As it evolved from a unique history, China’s RDA regime is itself somewhat 72 Ironically, the ongoing catastrophic financial crisis makes it crystal clear how problematic the legal (regula- unique. Therefore, many reform policies tory) and financial institutions are in the most advanced market economies. If we economists had a standard uni- versal recipe on the shelf for institutional building, as 71 My prediction is if there was no fierce regional offered to transition and developing economies, why do competition, corruption would lead to the collapse of the we not apply the recipe to fix these problems in advanced Chinese government and Chinese economy. market economies?

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Table 6 Characteristics of China’s RDA Regime Compared with Other Regimes

China’s RDA regime Soviet system Federal State

Composition of Central, regional and Central and Federal legislature national decision- ministerial officials ministerial officials representing regional making body constituencies Decision-making Central-regional bargain- Top-down; SOE-Ministry Voting in legislation; process ing; consensus building; local bargaining federal-state bargaining ­experiments as a strategy Subnational Promotion: absolute and Promotion: absolute To be elected; independent officials’ incentives relative performance; performance; accountable from the federal government; accountable to superiors; to superiors; personnel accountable to local personnel control control constituencies

Regional Tournament-like competition; Not important Fiscal (Tiebout) competition; competition competition affects governor’s competition affects promotion governor’s re-election Regional Local experiments as part of Not important States are “laboratories” for experiment central decision-making; policy; voluntary adoption of experimental results may experiments by states become national policy

enforcement. However, it has been well The second general lesson is to use argued that reform and economic develop- regional decentralization as an approach ment involves complementary institutional to solve incentive problems imbedded in changes to be carried out by the govern- reforms. China’s reforms illustrate that the ment. China’s reforms in particular, and ability to reform institutions is endogenized the experience of East Asian development as a result of the incentives of the stake- in general (Japan, South Korea, Taiwan, holders of existing institutions; while exist- Singapore, Hong Kong) illustrate this (Lin ing institutions are endogenized as a result 2007); the history of market development in of a country’s history, social norms, culture, pre–Industrial Revolution Britain also illus- endowment, technology, etc. These facts trates this (Smith 1763). The government is make institutional reform and policy design the most important institution in any country fundamentally different from engineer- (Stiglitz 1989) and its involvement is essen- ing design. The primary reason why many tial for market development (Smith 1776), reforms with comprehensive plans failed was and this has been borne out yet again dur- a lack of understanding of details of existing ing the market reforms in China. In addi- institutions, and of stakeholders’ incentive tion to macro and political stability, national problems with newly designed institutions, reform strategies, a functioning national particularly when those were designed by government also determines effectiveness outside “experts,” who are not informed on of decentralization, which is the next point I those incentive problems. A thorough under- want to make. standing of the details of existing institution

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in general, and the incentive problems of the and regional experiments facilitate this stakeholders of a reform program in particu- approach, thus making reform easier. A lar, is the foremost factor in determining the large number of reforms in China were fate of a given reform. locally initiated responses to local problems. Although there may exist commonly The greatest benefit of this decentralized agreed-on goals for reforms or economic approach is that it evolves within the existing development at an abstract level, it is often institutional framework. Therefore, it is eas- not very helpful to prescribe a universal pol- ier for a reform to be incentive-compatible, icy recipe in detail. This is because any effec- the reform will fit better with local condi- tive policy recipe must take into account the tions, and when new problems arise, officials interests of stakeholders in the existing insti- will have better incentives and information tution, which varies from country to country to find solutions. and from context to context. When China However, what is the limitation of decen- “ignored” standard advice, what they ignored tralization? Or what is the boundary of a was mainly the details, particularly when national government? Pushing decentraliza- these were not incentive-compatible with tion to the limit, if every city is completely Chinese stakeholders and thus would not decentralized and becomes an independent work. Sometimes they have also “ignored” country, each city-state will have substan- basic principles of standard advice due to tial powers and responsibilities and each political considerations, which is another will be subject to a hard budget constraint. type of incentive compatibility problem. Is this optimal? Applying the analytical Most of the details of Chinese reform poli- framework of this paper (sections 2, 3, and cies were not designed ex ante, but instead 4), I would argue that, in addition to social evolved during the process of the reforms costs of breaking up of a nation (depend- when incentive problems were resolved. ing on the procedure these costs may vary The importance of decentralization is not from extremely high, e.g., anarchy or a civil only due to heterogeneous local preferences, war, to almost zero, e.g., a peaceful refer- (Oates 1999) but also due to heterogeneous endum and an orderly change), there are local incentive problems and local institu- “pure” economic reasons that, under cer- tional arrangements that can be handled tain conditions, an integrated nation with more properly locally. Economic reforms and regional decentralization can dominate a economic development are path-dependent, nation’s breaking up. This is because the and this is true not only at the national level central government in an integrated nation but also at the subnational level. A local his- is in a good position to address externali- tory determines what interests stakeholders ties among regions, such as strong positive have nested into the existing institution there externalities created by a few local experi- and how those affect institutional reforms in ments in a nation. the locality. The typical approaches deployed The last, but not the least, general lesson in Chinese reforms evolved as a result of from China’s reform is the importance of dealing with local incentive-compatible subnational governments. Decentralization problems explicitly.73 Regional competition is important for reforms and economic development in all countries except city- states. To make decentralization work, 73 The Pareto-improving requirement (a la Lau, Qian, subnational governments should not only and Roland 2000) is the strongest criterion, whereas the incentive-compatible requirement is weaker and more be empowered but also enabled. The lit- general. erature on decentralization and federalism

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