The economics of shortage and problems of reform in Chinese industry

JOURNAL OF COMPARATIVE

ECONOMICS lo,

363-387 (1986)

The Economics of Shortage and Problems of Reform in Chinese Industry’ CHRISTINE

P. W. W O N G

Crown College, University of California, Santa Cruz, California 95064 Received May 31, 1985; revised April 15, 1986 Wang, Christine P. W.-The Chinese Industry

Economics of Shortage and Problems of Reform in

This paper employs the economics of shortage framework to examine post-Mao reforms in Chinese state-ownedindustry. Performance has been disappointing because reforms through 1985 failed to fundamentally alter economic agent behavior. The “soft” budget constraints at the enterprise and local government levels continue to generate“quantity” and “expansion” drives. The resultant intlationary pressureshave necessitatedadministrative interventions and thwarted reform progress. The Maoist legacy of active participation by local governments in economic management is highlighted as a major obstacleto the elimination of paternalism in state-enterpriserelations. 0 1986 Academic Press,Inc.

Journal of Economic Literature Classification Numbers: 027,052, 124.

1. INTRODUCTION Economic reform in China began in December 1978, with a program of “readjustment and reform” that was intended to redresssector-alimbalances, alter the economic management system, and improve efficiency. Through 1985, a number of far-reaching measureshad been gradually implemented, including the decollectivization of agriculture. These measuresbrought a significant reduction in the scope of central planning and material allocations, gave greater decision-making powers to enterprises and local governments, ’ Researchfor this paper was financed by grants from the Committee for Scholarly Communications with the People’s Republic of China, National Academy of Sciences;and the Center for Chinese Studies, University of California, Berkeley. Field work was arranged by the Institute of Economics, Chinese Academy of Social Sciences.I am grateful to the many people who read or heard presentations of earlier drafts of this paper in Cambridge (Mass.), Toronto, New York, Seattle, Los Angeles, Berkeley (Calif.), and Santa Cruz (Calif.), whose critical comments helped to shape this final product. Special thanks are due to Bill Byrd, Terry Sicular, and anonymous refereesof the Journal of Comparative Economics for detailed and extremely helpful suggestions. The usual disclaimer applies regarding responsibility for remaining errors. 363

0147-5967186 $3.00 Copyright Q 1986 by Academic Pms. Inc. All r&s of i-eproductionin any form rcscrved.

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CHRISTINE P. W. WONG

and offered better incentives to guide economic agentstoward more efficient resource use. Together, these measures went far beyond previous efforts at reforming the Chinese economy; if fully implemented, measuresannounced in October 1984 could take decentralization of economic management in China beyond even the Hungarian reforms. Many successeshave been achieved in the reform period, most notably in the rural sector. Gross value of agricultural output grew at a rate of 7.9% per year during 1979- 1983, under a set of policies that, besidesdecollectivization, included price increases,reapportionment of procurement quotas, and elimination of restrictions on trading and on other nonagricultural activities (Zhao, 1985, p. V). The across-the-board increasesin grain and key cash crop production gave a big boost to light industry and helped to effect the structural shift that saw agriculture and light industry’s sharesof gross material product rise from 27.8 and 31.1% in 1978 to 33.9 and 32.1% in 1983, respectively (Tongii Nianjian, 1984, p. 27). Increases in raw cotton production enabled the government to end rationing of cotton products in 1984, and Premier Zhao Ziyang expressedhope that continued growth in grain production would also allow the gradual elimination of procurement quotas, freeing grain production to “market regulation” (Beijing Review, 1985, 5:4). Standards of living have risen markedly, with substantial income increases in both rural and urban areas, and with significantly improved supplies of foodstuffs and other consumer goods.* In the urban sector, while the operation of collective enterprises has also shown improvement under liberalization policies, progress has been more elusive in state-owned industry. According to Lu Dong, M inister in charge of the State Economic Commission, a survey of 5800 key enterprises in early 1985 found that after 6 years of reform, only 15% “[are] beginning to use their newfound powers to improve production and management. . . . Some 65% of the key enterprises[are] still implementing the reforms and no obvious effectscan be seenas yet. And the other 20% [are] having economic difficulties” (Beijing Review, 1985, 9:lO). In spite of the near-universal implementation of profit-sharing schemes,Zhao Ziyang reported in m id- 1984 that it remained as the central task in urban reform “to eliminate the practice of making no distinction between well-run and badly run enterprises . . . and to see to it that enterprises will not eat from ‘the big pot’ of the state . . .” (1984, p. IV). This paper looks at the problems of reform in Chinesestate-ownedindustry, a sector that includes over 87,000 enterprises and produces more than threequarters of the gross value of industrial output. First it shows that reforms through 1985 have failed to alter fundamentally the behavior of economic agents. Because of the consistent bias toward leniency in the treatment of enterprises in the reform period, the measures have been largely ineffective ’ For a brief survey of economic performance through 1984, see Wong (1985b).

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in forcing enterprises to adjust to competitive pressure. A central task of the paper is to explain why reforms have thus far failed to achieve their primary objective of “breaking the habit of enterprises eating from the ‘big rice pot’ (chi dug~ofan).” Employing the economics of shortage framework developed by Janos Kornai, the paper arguesthat this lack of financial discipline, or the existence of a “soft” budget constraint, at both enterprises and local governments is the root cause of the current problem of slow progress in reducing costs and improving efficiency.’ Finally, the Maoist legacy of active participation by local governments in economic management is highlighted as a major factor in exacerbating the difficulties of eliminating paternalism in state-enterprise relations. The reform period is divided roughly into two phases,demarcated by the introduction of a new set of policies in 1983-1984. A brief discussion of the Cultural Revolution period provides the background to reform. During the Cultural Revolution period (1966-1976), the Maoist disdain for financial restraint and extremely growth-oriented policies greatly exacerbated the “quantity” and “expansion” drives. The dismantling of the planning apparatus and attacks on bureaucracy and “economism” also weakened central planning, so that administrative controls normally applied to curb excesses were often nonexistent.4 In addition, the regional self-reliance policy transferred many resourcesto local governments and made exercising central control increasingly difficult.’ At the end of the Cultural Revolution decade,China displayed all the symptoms of a classic shortageeconomy: an investment rate that was over 30% of national income,6 chronic and pervasive shortages of producer, investment, and consumer goods; declining product quality; low efficiency; and a heavy industry-dominated development pattern that left few resources for agriculture, in spite of repeated calls to “put agriculture first”.’ Aside from their well-known effects of reducing allocative and productive efficiency, the pervasive shortagesduring the Cultural Revolution period left 3 This is an analytical framework developed by Janos Komai (1979, 1980). ’ The disruption of planning work was extremely seriousduring the Cultural Revolution. Because of political struggles in the State Planning Commission, annual plans were not fommlated for 1967 and 1968. In June 1970, nine central government control agencieswere merged, including the State Planning Commission, State Economic Commission, State Statistical Bureau, State Price Bureau, Industry-Transport Office, Labor Bureau, Material Allocation Bureau, Geological Bureau, and Central Relief and ResettlementOffice. The combined “State Planning Revolutionary Committee” had 610 statI members, only 11.6% of the original staffing level of the separate agencies(Deng Liqun et d, 1984, p. 131). J This is an argument made both in Naughton (1985) and Wong (1985a). 6 The World Bank estimatesthat the accumulation rate of 34.6% of national income by Chinese definitions converts to the conventional investment rate of about 3 1% of gross material product. (World Bank, 1983, p. 78.) ’ For more details of the problems faced by the economy at the end of the Cultural Revolution, seeMaandSun(l981).

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a lasting impact on economic behavior in China. In the reform period, there is much evidencethat widespreadexpectationsof shortagecontinued to govern decision-making among plant managersand government officials, where concern over availability predominated over price and cost considerations in project evaluation.* As ex ante behavioral constraints, these shortage expectations have the effect of muting adjustment to market signalsand perpetuating shortages,and the active participation of local governments greatly magnified the difficulty of altering this behavioral pattern. 2. READJUSTMENT AND REFORM: THE FIRST PHASE (1979-1983) The impetus for reform stemmed from the seculardeterioration in economic performanceduring the Cultural Reform decade,which gaverise to widespread dissatisfaction with the economic management system. The problems of low efficiency, inability to match production to demand, and severeinfiastructural bottlenecks of the past decade were generally attributed to the rigid and ineffectual command economy. Blame was also placed on the excessive rates of growth and investment, overemphasis on heavy industry, and the lack of incentives for producers. In responseto these criticisms, measuresintroduced during the first phase of reform contained two interdependent components. Of first priority were readjustment measures aimed at slowing the rate of growth and redressingthe severesectoral imbalances.At the sametime, reform measures would gradually remove rigidities in the system by reducing the scopeof administrative control, devolving decision-making authority to lowerlevel units and improving incentives. The centerpiece of efforts to improve incentives in the state sector is profitretention schemes that link bonuses and workers’ welfare expenditures to enterprise profitability. Since their inception in 1978- 1979, the schemeshave gone through a number of metamorphosesin responseto changing conditions. Experimentation with profit-sharing had begun cautiously in October 1978, with six pilot firms in Sichuan province. In the Sichuan Experiment, firms were allowed to retain 1525% of above-plan profits for use as workers’ bonuses, collective welfare, and enterprise development funds if they fulfilled all eight of their annual economic and technical plan targets (for physical output, output-mix, quality, input consumption, labor productivity, production costs, profits, and working capital) plus their contracts to supply goods to other enterprises. In addition, enterprises were allowed to retain 100% of profits generatedin the first 2 years by small investment projects undertaken with their own funds. By 1979,100 firms were enrolled. For theseexperimental firms, remittances to the state accounted for 92% of total profits in 1979. * Information from field work conducted in 1981- 1982.

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367

Enterprises retained 6.5% as development funds, and workers received 1.5% as bonuses. Of the increased profits, enterprises retained 28% and 7% went to workers’ bonuses.’ On the basis of the Sichuan experience, the State Council in July 1979 promulgated the National Pilot Program, which introduced profit-sharing on a nationwide basis. By June 1980, 6600 of the largest and most profitable enterprises were enrolled. In the initial version, enterprises were allowed to retain a fixed portion of total profits for use in workers’welfare, bonuses, and production development funds. The retention rate was to be fixed for 3 years, using 1978 figures as the base for total funds retained by enterprises under previous programs, with adjustments only to offset changesin external conditions. These rates were modified in January 1980, when a new version of the program was introduced to allow for two rates to be applied, one for profits up to last year’s level and a higher rate for increased profits. Retention rates for increased profits were to be 10% for high-profit industries, 30% for low-profit industries, and 20% for most industries (Sun, 1982,p. 28). A separate schemewas devised for loss-making enterprisesin 1979,whereby loss subsidies were to remain fixed, with enterprises absorbing the difference whether losses were increased or reduced. In April 1981, the pace of enrollment of enterprises in profit-sharing accelerated further with the introduction of “economic responsibility systems,” which quickly turned into a profit contract system that subsumed all previous forms of profit sharing. Under this system, enterprises negotiated for annual profit remittance quotas with their supervisory agencies,with enterprises retaining 40- 100% of above-quota profits. By year-end, 80% of all state-owned enterprises were under profit contracts. Through this phase, the evolution of profit-sharing schemes was characterized by a progressive simplification of performance indicators, from comprehensive plan fulfillment under the Sichuan Experiment to an exclusive focus on profit targets. The trend was also toward rapidly rising enterpriseretention of profits, which rose from 2.1 billion yuan in 1978 to 17 billion by 1982, at a rate far exceeding the growth of industrial output or total profits. lo In spite of these incentives, however, there was little evidence of improved efficiency in state-owned industry. In addition to the State Economic Comm ission survey cited earlier, aggregatecapital-efficiency indicators also showed little or no improvement. For the 1978-l 982 period, gross value of industrial output per 100 yuan fixed assetsfell by 8%, although output per 100 yuan working capital rose 8%” (Ton@ Niunjian, 1984, p. 263). However, since 9 These estimates are.made by Byrd (unpublished). lo These estimates are from Naughton (1985). ” One caveat to note is that the Chinese practice of evaluating fixed assets at original value may to some extent mask real improvements in efficiency. But this may be offset by the failure to revalue assetsas replacement costs rise..

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CHRISTINE P. W. WONG

light industry is less capital-intensive and has shorter production cycles than heavy industry, the structural shift of production toward light industry during the period should in fact have improved both indices. Indeed, when adjustment is made to account for the increasedportion of light industrial output, Robert M ichael Field estimates output per 100 yuan fixed assetsto have declined by a total of 14.5%in the 5 years from 1978 to 1982 (Field, 1984, pp. 751-756). What were the causesof these continuing problems? Some enterprise managersblamed shortagesthat continue to interfere with production. Lu Shouquan, manager of the Beijing Machinery Company, reported that supplies of raw materials, fuel, and other inputs in 1984 were sufficient to meet only an average of 60-70s of production requirements for the 11 enterprises in the company. In a description reminiscent of the “three-eights system” practiced during the Cultural Revolution, ‘* Lu said that for some enterprises, the situation continued to be one where “[alllocations fall short of needs, orders fall short of allocations, and deliveries fall short of orders” (Jingji Guanli, 1984, 12:6). In his analysis of the reform period, Xue Muqiao, director of the Institute of Economics in the State Planning Commission, attributed these shortages to the difficulties of curtailing investment. According to Xue, the government was unable to reduce budgetary investment in 1979 becauseof the large number of projects already under construction. In 1980, the reduction of planned investment was more than offset by the growth in investment financed by enterprise-retained funds and local fiscal revenues. A combination of more stringent controls and deep cuts in budgetary investment finally brought total investment down in 1981 (see Table l), and shortageswere temporarily alleviated. By 1982, however, because the government again lost control of investment, shortagesof some producers’goods reemergedby the second half of the year. “In addition, since heavy industrial growth once again significantly exceeded light industrial growth, supplies of consumer goods also became tense. . . . In 1983 we were forced to call emergency meetings to deal with the suppressionof extra-plan investment and to ensure keypoint construction projects and continued priority for light industrial growth. At present, these problems have not yet been fundamentally solved”(Xue, 1984,p. 11). Growth rates of heavy and light industry in Table 2 show the growing momentum of heavy industry and the “suction” effects that are fueled by the high levels of investment. The effects of readjustment policies were apparently short-lived. After a brief spurt in 1979 and 1980, light industrial growth began to decline, and the trend was reversed only when administrative intervention once again I2 A three-eightssystem was reportedly applied to the allocation of key materials where allocations covered eight-tenths of requested quantities, orders were accepted for eight-tenths of allocated amounts, and deliveries were eight-tenths of amounts ordered.

369

REFORM IN CHINESE INDUSTRY TABLE 1 SOURCESOF INVESTMENT IN FIXED A&VETS(BILLIONS YUAN)

1978 1979 1980 1981 1982 1983 1984

Total”

Budgetary b

ExtrabudgetaryC

66.87 69.94 74.59 66.75 84.53 95.20 118.52

48.35 (72.3) 55.07 (78.7) 45.97 (61.6) 36.33 (54.4) 34.37 (40.7) 42.22 (44.3)

18.52 (27.7) 14.87 (21.3) 28.62 (38.4) 30.42 (45.6) 50.16 (59.3) 52.98 (55.7)

’ Tongji Nianjian. 1984, p. 301; Tongji Zaiyao, 1985, p. 4. ’ Estimated from budget allocations for basic capital construction plus half of “technical renovation and new product development” funds (Tongi Nianjian, 1984, p. 420). f Total of enterprise-retained funds, local government revenues, and bank loans. Calculated as a residual. Nofe. Figures in parenthesesrepresent percentageof total investment.

diverted supplies to the sector in m id-1983.13At the same time, investment demands were stimulating heavy industrial growth, which has exceeded planned levels each year since 1982. In the next section, it is shown that these problems were symptoms of expansion and quantity drives which can be traced to the persistence of the soft budget constraint. In spite of their stated objective of “breaking the habit of enterpriseseating from the ‘big rice pot’,” profit-sharing schemeshad failed to fundamentally alter enterprise behavior. Through the first phase of reform, profit remittance targetsand even taxes remained negotiable,so that enterprises were rarely forced to adjust to competitive pressure. 3. THE UNBREAKABLE “BIG RICE POT”: PERSISTENCE OF THE SOFT BUDGET CONSTRAINT The postreform budget constraint remains soft for Chinese enterprises in numerous ways. The first and most important is that despite the many govI3 Light industrial growth had slowed to an annual rate of only 2.5% during the first quarter of 1983. Alarmed by this trend, the State Council reassertedthe “six priorities” principle to direct supplies to light industry (Zhongguo Jingji Nianjian, 1984, p. IV-2). There is a caveat that should be borne in mind in interpreting relative growth rates of heavy and light industry: Chinesereporting methods include consumer goods produced in heavy industrial plants under heavy industrial output. For example, refrigerators and washing machines produced by many machine-building enterprises may be included in heavy industrial output, which would introduce an upward bias in the heavy industrial growth rate.

370

CHRISTINE P. W. WONG TABLE 2 INDUSTRIALGROWTHRATESAT CURRENTPRICES(o/o) All industry 1953-1979 average

Heavy industry

Light industry

11.1

13.4

9.1

1979

8.8

1.7

9.6

1980

8.7

1.4

18.4

1981

4.1

1982 (Planned)

7.1 (4.0)

9.8 (5.7)

5.7 (7.0)

1983 (Planned)

10.6 (4.0)

14.4 (3.9)

6.8 (4.1)

1984 (Planned)

14.0 (5.0)

14.2

13.9

-4.7

14.1

Sources. Ton& Nianjian, 1981, p. VI-4; 1983, pp. 215, 217; Tongii Zaiyao, 1984, p. 5; 1985, p. 5; Planned growth rates: Renmin Ribao, June 3, 1984, p. 2; Song Ping, 1984, p. 19; State Statistical Bureau, 1985, p. II.

ernment statementsurging closure of inefficient enterprisesin order to redirect scarce resources to more efficient ones, relatively few have been shut down for purely economic reasons.The exceptionsare the highly publicized closures of egregiouslycostly plants during 1978-1979 in the “five small industries,” which included several hundred small-scaleenterprises (out of a total of over 10,000 such plants at or above the county level).14In the collective sector, there have been closures and mergers of money-losing enterprises, but again they were small-scale. Moreover, the rural collective sector operates under relatively hard budget constraints. I5 The prevailing view in the 1980s is that “[n]o matter what the circumstances, it is virtually inconceivable that the ChineseGovernment would allow [large, state-owned] enterprisesto go bankrupt” (Byrd and Tidrick, 1984, p. 62). The indulgence of financially ailing enterprisesgoesbeyond allowing them to survive. Through the successionof profit-retention schemes,profit remittance targets remained highly negotiable. This was culminated in the profitcontracting system, where “contracts” were set for each enterprise through annual negotiations. The expectation that firm-specific incentive schemesare I4 For details, see Wong (1982). ” Altogether, only some 20,000 of a total 400,000 enterprises were closed during the 4 years of 1979-1982, while over 60,000 were added, many in the collective sector (Li Yue, 1983, p. 259).

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prone to softening is borne out by the upward drift in retained profits. Starting from the modest levels of the Sichuan Experiment, retention rates rose to over 85% of increased profits in 1983 for enterprises under profit-contracting (Caizheng, 1984,7:4,8:2-6). In addition, while they were generouslyrewarded for overfulfilling profit quotas, enterprises were rarely punished for underfulfillment. In Yantai Prefecture in Shandong province, for example, only two enterprises were penalized by having their enterprise funds reduced in 1981, even though 46 profit-making enterpriseshad failed to meet their profit quotas and several money-losing enterprises showed lossesgreater than their contracted amounts (Gu, 1982). The leniency with which enterprises were treated led many to complain that the schemesmade enterprises “responsible for profits but not for losses,”which greatly weakened the incentive effect of the reform’s “carrot and stick” approach. The budget constraint is also softened by the negotiability of prices and taxes, two important determinants of enterprise profitability. With partial market reforms that liberalized trade outside state channels, a multitiered price structure has developedin the reform period, with often-substantial gaps between the different levels of plan and market prices.16The proportion of output that an enterprise sells at each price is negotiable to some extent. This is especially true at the local level, where officials can manipulate the price structure to provide disguised subsidies for money-losing factories. In order to improve the financial status of a local chemical fertilizer plant, for example, officials in one rural county allowed the plant to sell a portion of output directly to users, bypassing the distribution organs and enabling the plant to capture the 20-30s differential between retail and wholesale prices. In the cement industry, factories allowed to sell at the market price were able to get more than twice as much as the state price.” The arbitrary power of local governments to set the m ix of prices was reflected in one writer’s complaint that in Shanxi province, local officials discriminated against commune and brigade coal m ines by saddling them with assignments to sell to local users at the low price of 7-8 yuan per ton, while state m ines were allowed to sell outside the province at much higher prices of over 27 yuan per ton (Hao, 1982, p. 42). The tax system is equally subject to softening, as officials often help financially ailing enterprises by offering tax exemptions or reductions. Even for highly profitable, large-scaleenterprises, one study found that “[tlax exemptions were freely given . . . on various pretexts” (Byrd and Tidrick, 1984, p. 61). When manipulating prices and taxes is not enough, loans can be rolled I6 For details of the distinctions among state and local prices, and among plan and market prices, see Wong (1986). ” Field work information, June 1982.

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CHRISTINE P. W. WONG TABLE 3 EXTRABUDGETARY FLJNDS(BILLIONSYUAN)

1978 1979 1980 1981 1982 1983 1984

(1)

(2)

(3)

State budget revenues’

Extrabudgetary fimd.sb

(2) f (1)

112.1 110.3 108.5 109.0 112.4 124.9 146.5

36.1 39.0 45.0 51.0c 86.6 89.3 100.+d

32.2 35.4 41.5 46.8 77.0 71.5 68.3+

(%)

’ Tot@ Nianjian, 1984, p. 417; Tongji Zaiyai, 1985, p. 4. b Derived from Tongji Nianjian, 1984, p. IV-43; 1983, p. 111-90. ‘Interview in Beijing, August 1982. d Caimao Jingii. 1985,8: 1.

over, and as last resorts, state grants are still given to enterprises in serious financial trouble. I8 To explore why reforms failed to achieve their primary objective of hardening enterprise budget constraints, we examine three overlapping sets of factors: (1) the poor design of reform measures,(2) the difficulties of applying a consistent set of performance measurement criteria to a large and diverse group of enterprises, and (3) “behavioral inertia” rooted in shortage expectations and bureaucratic reluctance to give up control. Thesefactors are closely correlated and interdependent, and their mutually reinforcing nature is made clear in the following discussion. Overdecentralization of financial resourceswas arguably the most egregious design problem through the first phase of reform, which greatly exacerbated the expansion drive. Since 1979, profit-retention schemesand fiscal reforms that introduced revenue-sharing with local governments have left large and growing funds in the hands of enterprises, local governments, and administrative organizations (see Table 3), reaching over 100 billion yuan by 1984. The existence of so much money outside the state budget obviously posed enormous problems for the government’s task of reducing investment. These problems were greatly exacerbatedwhen downside risks to investors continued to be absorbed by the soft budget constraint. As important as the availability of funds outside state control was the fact that stipulations for the use of decentralized funds often ensured continuation ” In the CCWC case, an 850,000 yuan loan was turned into a free grant when the company faced marketing difficulties (Byrd and Tidrick, 1984, p. 61).

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of the “expansion” drive. First, the wish to control the growth of bonuses led early reform measuresto require that 30-401 of retained profits be used for expanding production, and that another 30% be used for collective welfare (in most casesconstruction of workers’ housing or other collective facilities, which add to demand for construction materials). The marginal investment rate stipulated for retained funds was 0.6-0.7, compared to the average investment rate of 0.3-0.4 from state budget revenues.” The provision allowing firms to keep 100% of the first 2 years’profits from self-financed investment projects was a significant inducement to invest. The further stipulation that these profits be used for reinvestment again ensured a high marginal investment rate. Second, given that revenue-sharing arrangements had divided enterprise incomes between different levels of government by ownership, local govemments were eager to use their newly acquired funds to invest in expanding their revenue bases.With continuing negotiations over revenue-sharingratios through the first phase of reform, local government budget constraints also remained somewhat ~oft.*~Furthermore, recurrent budget deficits forced the state to introduce new levies, such as the repeated bond sales forced upon local governments and the new transport and energy fund created in 1983 with a tax on extrabudgetary revenues.*l These actions clearly reinforced the local expansion drive: the marginal cost of local funds approached zero as long as unspent monies were subjected to various forms of expropriation. Third, bank loans were granted on such soft terms that the objective of reducing demand for investment funds by raising their cost to users was effectively sabotaged.At least through 1984, loans were to be repaid primarily from benefits accruing to the loan-financed project, namely, the before-tax incremental profits generatedby the project. If these were insufficient to meet repayment schedules,funds could be diverted from (1) depreciation charges on fixed assetscreated by the loan, (2) turnover (“industrial-commercial”) taxes on incremental output from the project, and (3) turnover taxes on the enterprise’s other output. ** Since profits and depreciation chargesare partially destined for state coffers, their diversion to meet loan repayment shifted the I9 This is calculated by taking budgetary allocations for “basic capital construction,” “enterprise renovation,” and “new product development” as a percentage of total budgetary expenditures (Tongii Nianjian, 1983, p. 449). ” These revenue-sharing ratios were set in 1980 and changed in 1982. For details, see Xing (1983) and Han and Zhao (1982). *’ The new tax on extrabudgetary funds collected 10.26 billion yuan in 1983 (To@ Nianjian, 1984,p. IV43), and bond saleshave run around 4 biion yuan/year. In addition, local governments are sometimes asked to “lend” excess funds to the state, which netted 7.4 billion yuan in 1981 (interview, August 1982). ** For more details on loan repayment terms, see Byrd and Tidrick ( 1984).

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CHRISTINE P. W. WONG

burden partially to the state budget. More than that, in practice, the short repayment periods, usually under 3 years, meant that even very profitable projects were seldom able to service the loans from incremental profits and depreciation charges alone, so that repayment came largely from diverting tax revenues and the burden actually borne by enterprises was quite small. Two explanations for the poor design of reform measuresare the inexperience of reformers and their inability to control the reform process. The interaction of these two factors is clearly illustrated in the evolution of profitsharing schemesinto profit contracting. Initially, concern with stabilizing state revenues had led the M inistry of Finance to push for lim iting enrollment of enterprisesin profit-sharing programs, as well as to try to keep retention rates at low levels.Once begun, however, the program gained momentum, especially with the active support of local governments. The central government’s attempt to control retention rates collapsed in 1981, when efforts to reduce the budget deficit produced sharp deflationary pressures.As a result of cutbacks in budgetary investment, many enterprisesfound their production plans drastically reduced.23At the sametime, the decentralization of material allocations freed many prices to float, resulting in windfall losses or profits for many enterprises. In this extremely unstable environment, the practice of basing profit targets on the past year’s figures had to give way to a more flexible approach, based on the particular circumstances faced by the enterprises. Since the tailoring of incentive schemesto individual enterprisesenlarged the scopefor bargaining,the designof profit contracting was fundamentally flawed for the purpose of cutting enterprises loose from the “big rice pot.” Closely related to the poor design of reform measuresand the inability of reformers to control the process is the second set of factors behind the soft budget constraint: the difficulties of applying a consistent set of performance measurement criteria to all state-owned enterprises, which face substantially different production coditions. (1) As as result of the Maoist strategy of technological dualism (“walking on two legs”), in many industries there are enterprises using a diverse range of production technologiesto produce the same product. In industries such as cement, chemical fertilizer, paper, iron and steel,and sugar refining, enterprisesuse technologiesof different vintages with different capital intensities and requiring inputs of differing quality, and they face costs that differ by as much as two- to threefold (see Wong, 1982). (2) The Maoist policy of dispersing industrial production led to substantial investments in the inland provinces in the 1960s and 1970s. For a variety of reasonsassociatedwith inexperience and inadequate infrastructure, productivity in inland factories lags behind that of factories located in coastal prov23For example, in the hardest-hit First Ministry of Machine Building, production plans amounted to only onequarter of productive capacity.

REFORM IN CHINESE INDUSTRY

315

inces, so that today there are substantial regional disparities in productivity and co~ts.*~(3) Also as a result of developmentsand policies during the Maoist period, state-owned enterprises are divided into state (central) and local enterprises, separated by a complex web of distinctions in terms of ownership and control. While there is a great deal of overlap between state and local enterprises in production, the two sectors are treated differentially by the central plan. State enterprises are given privileged accessto allocated inputs at state prices, whereaslocal enterprises must purchase a large portion of their suppliesat market prices.25For all thesereasons,costs vary substantially across enterprises in the same product line, requiring differentiated treatment. To accommodate these diverse enterprises,profit remittance targets had to be set at low levels of the state hierarchy, often requiring active participation by local officials. Since the inexperienceof officials at low levels of administration often gave enterprises an enormous advantage in profit negotiations, it also contributed to the upward drift in profit retention rates and the leniency in dealing with enterprises. The third and most important factor behind the persistence of the soft budget constraint may be called the “behavioral inertia” of decision makers in the reform period. Accustomed to facing pervasive shortages and sellers’ markets throughout the Cultural Revolution decade,government officials and enterprise managerswere typically unable to anticipate the effects of growing competition. Their expectation was simply that all additional output could be sold at current prices.26 The immediate impact was that when decisionmaking was decentralizedto local governments and enterprises,allowing them to respond to market signals, there was a rush of investment to industries where either shortages or high profits had prevailed, without adequate consideration of the effects of competition or price changes. The experience of the Chongqing Clock and Watch Company (CCWC) provides an illustrative example. Initially faced with an environment with excess demand and high profit margins, CCWC responded to its increased autonomy by expanding output rapidly, with little attention to cutting costs, improving quality, or developingnew products. During 1980- 1982,it invested of InnerMongolia, Guangxi,Guizhou,Yunnan,Xinjiang,Ni24The eight interiorprovinces ngxia,Tibet,andQinghai have labor productivities in state enterprises that are 20-4096 below the national average. In Quinghai, taxes and profits generated per 100 yuan fixed assetsis only one-sixth the national average (Jingji Yanjiu, 1984, 10~70). *’ See Wong (1986) for a detailed discussion. 26For example, a county in rural Guangdong was in the process of building a synthetic fiber factory with a designed capacity that was close to one-fourth existing capacity in the province, yet questions about the market saturation that would soon occur if several other counties were undertaking similar investments were not seriously entertained (field work information, June 1982).

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a total of 38.5 m illion yuan to expand production, an amount that was more than double the total investment undertaken during the previous 8 years. CCWC made these investments based on an overly optimistic assessmentof long-term market demand that did not take into account the competition posed by other producers, especially the larger and more reputable manufacturers in Shanghai and Tianjin. By 1981, the market for clocks had become saturated, and beginning in 1982 CCWC faced growing competition in selling watches as well. As a result, clock production fell by 55% in 1982, and output of watches grew only lo%, compared to growth of 79 and 60%, respectively, in the previous 2 years (Byrd and Tidrick, 1984, p. 42). Due to similar decisions, by 1981- 1982 there were widespread problems of excesscapacity in industries such as textiles, cigarette rolling, distilleries, and consumer durables such as electric fans, sewing machines, and bicycles. Rather than attributing these suboptimal investment decisions entirely to inexperience and to the rigid and irrational prices that generate high profits which attract entry and restrain demand, it is important to note the asymmetry in this decentralized decision-making. While eager to invest in profitable industries to expand their revenue base, local officials were reluctant to close down unprofitable ventures. Perhaps the most extreme example was the fertilizer plant cited earlier, where state allocations of coal had been reduced as a penalty for the plant’s failure to meet technical standards. To enable the plant to continue operation, the county Economic Committee had authorized subsidiesto help the plant buy coal through market channels. By 1982, with the market price of coal rising to twice the state price, the county was paying out over 1 m illion yuan per year in coal subsidies, in addition to routinely absorbing operating losses of the plant. When asked why they kept the obviously inefficient plant in operation, county officials replied that this was the only way they could ensure sufficient fertilizer supplies for the county’s agricultural production.27 There is also a deep-rooted reluctance to “punish” enterprises for factors beyond their control. In another rural county, officials continued to pour money into expanding and upgrading a chronically unprofitable cement plant, even as construction was under way to build a larger and more efficient plant near the county’s coal m ine. Officials explained that the existing plant’s problems were mainly locational; located far from raw materials and lacking access to cheap modes of transport, the plant had to absorb extremely high f@ht costs. Though it is unlikely to reach break-even costs even with technical improvements, officials explained that the plant’s manager and workers were *’ It may be that benefits to the county of incremental farm output from the fertilizers outweigh their high production costs, but it was not obvious that these calculations were part of the decision process.

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working very hard to improve efficiency and deserved support. Resides,the county badly needed the cement produced.28 Continuing shortagesand shortageexpectationsare clearly hindering efforts to instill cost consciousnessand to improve efficiency in the reform period. There are also the fear of market-generatedinstability, a bureaucratic resistance to giving up control, and a powerful urge to redistribute income “fairly” across enterprises. All of these work against efforts to make enterprises more accountable by fostering an environment where enterprises continue to be shielded from competitive pressures.29Many of the design problems discussed earlier stemmed in part from the urge to retain control and to ensure fairness in the treatment of enterprises.This paternalistic attitude is especiallyprevalent at the local level, where officials often have close ties to personnel in the enterprises.Again, the active participation of local governments in the reform process greatly magnifies the problem of behavioral inertia in China. To sum up, the primary force driving the shortagemechanism in the reform period was the uncontrollable expansion drive, which can be traced to the soft budget constraint. In the reform process, shortage expectations have a self-fulfilling quality. They slow down the market adjustment process and perpetuatethe quantity and expansiondrives, which in turn generateshortages. The persistence of shortage makes monitoring enterprise performance more difficult and reinforces officials’reluctance to punish enterprises unfairly. So, through the first period of reform, the Chinese economy remained trapped in the vicious circle of shortage: so long as shortages persisted, exercise of financial discipline was unlikely, and so long as enterprises operated in the absenceof a hard budget constraint, autonomous mechanisms were in gear to drive the economy toward shortagesand bottlenecks. 4. THE SECOND PHASE: 1984Reforms in Chinese state-owned industry can be judged a failure through the first 5 years: resources were transferred to lower-level units without a commensurateincreasein their accountability, with the result that state control was eroded without any significant improvement in resource use. In 19831984, reforms began to move into the second phase, with the introduction of a number of measures aimed at redressing earlier problems. The first step was to recapture some of the decentralized financial resources and curtail extrabudgetaryinvestment. A 10%tax on extrabudgetaryfunds was introduced on January 1, 1983; in m id-year this was raised to 15%. A new tax was also *’ Field work information, June 1982. 29These traits are common to reformed, socialist market economies. For example, see Komai (1980) and Tyson (1977).

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levied on extra-plan construction projects, along with the imposition of more stringent administrative controls to curb extrabudgetary investment. Altogether, these measuresreduced decentralized funds by some 30% and allowed the state to increase budgetary allocations to the development of the energy and transport sectors3 The most important reform in the second period is the introduction of “substituting taxes for profits” (ligaishui), the latest metamorphosis of profitsharing. Under this scheme, all large and medium-sized state enterprises will gradually be shifted from the system of remitting profits to paying taxes on profits, with enterprises given greater autonomy in disposing of the residual income. The scheme was introduced nationwide in two phases,with phase 1 beginning in July 1983 and phase 2 scheduled to begin on January 1, 1985. The first phase brought little sustantive change in state-enterprise financial relations. A new income tax on profits of 55% was introduced for large and medium enterprises, which continued to remit profits under contracts that were recalculated to leave them with the same retained after-tax profits as in 1982. More substantive changeswere to come during the second phase of implementation, whose introduction was moved up to October 1984, amidst great fanfare, with the announcement of a program for further reform focused on the urban sector. According to Premier Zhao Ziyang, phase 2 will include a “gradual rationalization of the price structure.” By the completion of phase 2, profit remittances will be completely replaced by a series of taxes designed to tax away all benefits accruing from factors “external” to enterprises, so that enterprises are rewarded only for profits due to their performance. In addition to the income tax on profits, charges are to be levied on fixed and working capital. The present industrial-commercial (turnover) tax will be broken down into four parts: the product tax, value-added tax, business tax, and salt tax, which will tax away differential profitability across products. For enterprises in the m ining and extractive industries, a resource tax will be levied to tax away differential rents. Finally, an adjustment tax is to be applied to absorb undeserved profits not covered by the other taxes. Interestingly, even though the scheme originated at the county levek3’its final implementation will exclude most county-level enterprises from participation. It was announced that ah small state-owned enterprises with fixed assetsunder 1.5 m illion yuan and annual profits of 200,000 yuan or less will be contracted or leasedto collectives or individuals over a 3-year period, with the contractors responsible for paying capital chargesand income taxes on profits (Cuizheng, M For a more detailed treatment of financial reforms in the second phase,seeNaughton ( 1986). 3’The tax-for-profit experiment first began in Hua Xian, Hubei province, in 1979.

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1983, 2:23-24; Zhao, 1984). This program will affect approximately half of the 8 1,000 state enterprises presently classified as “small-scale.“32 According to Zhao, the rationale for the tax-for-profit schemeis to formalize the financial relationship between the state and enterprises and reduce the negotiability of profit remittances. As an interim measure until price reform is completed, this scheme also enablesthe government to use taxes as a lever to moderate problems of “bad” prices. In addition, it is hoped that the scheme will alleviate the problems of regionalism and local government intervention in enterprise operations by separatingthe revenuesof local governments from the ownership and profitability of specific enterprises.33An important objective of the tax-for-profit scheme is also to stem the tide of rapidly eroding state revenue incomes, with the new taxes recapturing a greater share of enterprise incomes for the state budget.34 By taking aim at the two main obstaclesto reform during the earlier periodthe problems of enterprise accountability and excessive local control-the tax-for-profit scheme clearly takes reform in China in the right direction. However, there are a number of problems that can be readily identified in each of the three key components of tax reform, contracting out small enterprises, and price reform. In theory, the series of taxes to be levied under the scheme will help to sort out profitability due to enterprise performance from that due to external factors, so that enterprises can be rewarded or punished accordingly. With the different layers of taxes separating out the effects of prices, technology, capital intensity, location, etc., it should be possible to compare performance of enterprises across sectors and industries and apply objective standards to the division of revenues between the state and enterprises. In practice, however, determining the proper levels of these various taxes will be an extremely difficult task, and their redistributive impact on enterprise and regional incomes is likely to invoke the same opposition that has stymied price reform to date. Furthermore, even if tax reform is successfully implemented, a major weakness remains in the key role that is to be played 32The 1983 profile of these enterprises is as follows: they had average output of 3.1 million yuan, fixed assets of 2 million yuan, and remitted taxes and profits of 430,000 yuan (Tongji Nianjian, 1984, and Beijing Review, 1985,9:10). 33Under the then-current fiscal system, profits of central and local enterprises were divided between the central and local treasuries by ownership of the enterprises. See Wong (1986). 34Reports on the results of implementation in 1983 point to what this is to entail. For the 28,110 industrial enterprises under tax-for-profit, which accounted for 83% of the total profits earned by money-making enterprises in state industry, the division of increased profits was as follows: 6 1.8%was remitted as profits and taxes to the state, 18% was retained for use in developing production in the enterprises, 13.3% was distributed as workers’ bonuses, and 6.7% went into collective welfare funds for workers. This compared with enterprises still under profit contracts, which remitted only 14.5% to the state (Caizheng, 1984, 74; 8:2-6).

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by the adjustment tax. In its design, the product tax is to be differentiated across products but applied uniformly nationwide, whereas the adjustment tax is to be firm-specific, designedto offset the different conditions faced by enterprises in the same line of production. The need to set adjustment taxes at the firmlevel posesthe same problems of bargaining faced by earlier profitsharing schemes, though the range of negotiation should be considerably narrower. The decision to contract out small-scaleenterprisesto private or cooperative operation seemsto be a rational extension of the effort to reduce negotiability in state-enterprise financial relations. By excluding small-scale enterprises from the scheme, the range of diversity in technology and costs can be narrowed considerably, reducing the size of adjustments necessary. While the contract system looks like a straightforward mechanism for hardening the budget constraint of local enterprises by stipulating a simple contractual obligation, there is still plenty of room for softening. In fact, functionally this is little different from the earlier profit contracts, though in practice significant differencescan be expectedin the way these contracts are enforced, given that the beneficiaries of official largessewill be individuals or small groups rather than “all the people.” The true test will come only when enterprises fail to generate sufficient profits to make rental payments. Given that contractual terms are set by local officials, concern with social issues such as unemployment, regional development, and tax revenues may lead to accommodations in casesof failure, once again softening the budget constraint.35 A far graver threat to the contracting program is the opposition of local governments, whose economic role will be reduced from active agents in production and investment to that of rent collectors if the program is carried out. Curtailing local influence is undoubtedly an important objective of the program, given the harmful role played by local governments in the reform process to date. However, by taking direct aim at undercutting local power, this measure may well sow the seedsof its own demise. Price reform is the third major component of the package announced in October 1984. Even before its formal announcement, the Chinesegovernment had begun in 1983 to make a series of adjustments in prices, especially for light industrial products, that began with the adjustment of relative prices for 35So far we have only anecdotal information on how this contracting is supposed to work. By the end of 1984, over 11,000 industrial enterprises and 58,000 enterprises in the service sector had been rented out, with rental agreements running up to 5 years. In one case, a man named Ling Fangyou won a public bid to run the Shenyang Oil Pump Factory in June 1984. Based on realized profits of 30,000 yuan for the first half of 1984, the contract terms were set at a rent of 60,000 yuan for the first year, 80,000 in the second, and 120,000 in the third. Under the contract terms, Ling will get 30% of the factory’s profits after paying the rent and taxes, presumably with the other 70% distributed as bonuses to the workers (British Broadcasting Corp., W 1326/A/2).

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cotton and synthetic textiles (Zhongguo Jingii Nianjian, 1984, pp. IV-49IV-5 1). For light industry, the combination of growing competition and price reductions has already reduced excess profits; one report from Shanghai claimed that the situation of “high prices and high profits has virtually disappeared”for enterprisesin the second light industrial system (Caimao Jingji, 1984,10,54). If this is true, the problem of duplicative and wasteful investment attracted by distorted price signals may have been largely corrected in the consumer goods sector. In the producer goods sector, however, price reform had not been implemented through 1985, largely due to concern with inflationary pressuresamid worsening shortages.In the meantime, de facto price drift is occurring, with growing portions of producers’goods moving through market channels. De facto price drifl cannot be a substitute for price reform, which is necessary to eliminate three extremely harmful effects produced by the present muhitiered price structure. In attempting to retain control over key sectors of the economy in the reform period, the government has inadvertently produced a “perverse” situation where small-scalelocal enterprisesare allowed to charge market prices, while large-scaleenterprises must observe plan prices. Given the prevalent shortages in producer and investment goods, this practice is encouraging the proliferation of small-scale enterprises in industries often characterized by significant economies of scale, with extremely adverse longterm implications for efficiency.36Secondly, the existence of multiple prices introduces a degree of unpredictability on the cost side and allows output prices to be negotiable, thus increasing the difficulty of hardening enterprise budget constraints. Finally, multiple prices are responsible for the growing problem of corruption, where the very substantial financial rewards for diverting resources from state channels into market channels pose temptations for managersand workers as well as for government officials. What the price reform will not do is eliminate shortagesin the presenceof soft budget constraints. In his study of Hungarian reforms, Komai argues that as long as the growth and survival of enterprises do not depend on their financial health, enterprises’responsivenessto changesin input prices is weak. There is a good deal of evidence in China to indicate that enterprises have inelastic demands for inputs. One example is the fertilizer plant cited earlier, where the reduction of coal allocations at state prices was simply replaced by purchases at market prices without too much concern being expressed by managers or local officials. In recent years, wage and bonus payments have grown much faster than planned, largely becauseenterprise managers have not been very resistant to such cost increases,leading government officials to M The most notable examples are in the building materials industries, where small plants are selling cement and plate glass at two to three times the state price. See Wong (1986).

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accuse plant managers of colluding with workers (Xue, 1982, p. 7). Finally, available data on some transaction prices for producer goods during 1980 and 1981 show surprisingly large variations betweenhigh and low prices within each 3-month period. 37Plausible explanations include extremely poor information about availabilities and prices, and perhaps differences in quality or product characteristics. Equally plausible is that buyers were not much concerned about price, or that they were conditioned to buy whatever was available at the going price before it disappeared. More empirical studies are needed to establish the price elasticities of demand for enterprises, but it Seemsreasonable to expect that the easewith which cost increasescan be passedalong to the buyer or to the state budget determines how much effort enterprises will devote to the search for cheaper substitutes. After 6 years of what looked like ad hoc experiments, the Chinese government in late 1984 introduced a package of reform intended to correct the major designproblems of earlier measuresand stem the erosion of state control over macroeconomic balance. Despite some weaknesses,the package represented a significant improvement over measuresintroduced during the first phase of reform. Unfortunately, it may have come too late. Implementation of severalkey measuresappearedto have stalled in 1985,and efforts to partially recentralize financial resourceswere neutralized by a rapid expansion in bank credit. Through 1985, only the product and adjustment taxes had been added to the tax-for-profit package. Widespread opposition forced postponement of the introduction of the tax on fixed and working capital. In fact, 1984-1985 saw a retrogression in the effort to price capital more realistically. In at least some localities which had already instituted capital charges as part of their reform package,these chargeswere repealedpending nationwide implementation which turned out not to be forthcoming.38 Even more ominous was the fact that liberalization measuresintroduced in 1984 fueled another explosive growth in investment, which jumped by nearly 25% during the year. This was followed by a 45% increase in capital construction spending39during the first 7 months of 1985,with extrabudgetary r’ These are data from the Shanghai Means of Production Service Company, which is one of the new markets set up to handle “surplus” producer goods outside of plan channels (Shanghai Means of Production Service Company, “Shanghai ShengchanZiliao Jiaoyi Shichang Qingkuang Huibao” (A Report on Conditions at the Shanghai Market for Means of Production). In China Enterprise Management Association, ed., Shanghai Gongye Qiye Jingyan (The Experience of Shanghai’s Industrial Enterprises). 1:56, 1981; cited in Byrd, 1985). The average range for transactions prices at the market was I5-49%, but went all the way up to 2 15%, within each 3-month period. 38Information collected by the American Economists Study Trip to China, December 1984. This information came from Barry Naughton. 39There is a slight difference in the coverage of the 1984 and 1985 figures: the former refer to total investment in fixed assets,while the 1985 figures include only investment in capital construction.

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investment jumping by 90% over the 1984 level (Beijing Review, 1985,37: 7). Intense inflationary pressurescreated by the uncontrollable growth of investment as well as of consumer incomes led to repeated calls to slow down the economy, so as to create a favorable environment for reform. In the meantime, price reform appearsto have been lim ited to decontrol of selected foodstuffs and small consumer goods prices, which set off panic buying in some cities. The program to contract out small enterprises to private and collective management may also have stalled due to opposition from local governments.40 5. CONCLUSION

Despite the different policies pursued during the Maoist and post-Mao periods, there has been an essential continuity in the Chinese economy: the persistenceof shortages,albeit with varying intensity. This continuity is due to the fact that reforms have thus far failed to eliminate the root cause of shortage: the lack of enterprise accountability. Findings in this paper tend to support Kornai’s observation that “. . . the explanation of chronic shortage, of suction, and of the functioning of a resource-constrained system is to be found not in the financial sphere, or in special features of price information, but at a deeperlevel, in institutional relationshipsand in behavioral regularities which the institutional relations foster in decision-makers” (1980, p. 559). By demonstrating the existence of the same shortage-generatingmechanisms in China, where central planning was never effectively implemented, this paper helps to illustrate the general applicability of the Komai model. The problems encountered by the Chinese reforms in 1985 serve as rem inders that shortages hold the key to successful management of macroeconomic policies. In the short run, the intensity of shortage will determine whether and how quickly price reform can be implemented, as well as the pace of continued reduction of administrative control over the economy. In the longer run, it will determine whether the government can fundamentally alter the “Stalinist” pattern of development and restructure the economy to be more responsive to consumer wants. Since shortagesand the nature of the budget constraint determine how enterprises respond to cost pressures,they also hold the key to whether the Chinese economy can ultimately shift to an “intensive” path of development, where industrial growth will be based on productivity increasesrather than on continuing massive investments. The primary lesson from the first period of reform in post-Mao China is that partial reforms are extremely problematic. What is remarkable is that in spite of the fairly severeproblems to date, the Chinese leadership seemsfirmly u) This is inferred from the absence of progress reports in the Chinese press during 1985.

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committed to pushing forward with measures to reduce the scope of central planning. In the second phase of reform, if they are to realize the announced intent of confining the government’s role to managing a few key sectors while relying on the indirect instruments of prices and taxes to control the overall pace and orientation of development, enterprise budget constraints must be hardened. It is not enough to send the right signals to economic agents; the agents must be forced to adjust to these signals. Given the importance of the nature of enterprise budget constraints and the enormous difficulties involved in hardening them, reforms in Chinese industry still face many obstacles. What the Hungarian experience shows is that a decentralized system using some combination of economic and bureaucratic incentives can work far better than a centrally planned one, so that the failure to achieve in China a pure socialist market economy in which economic agentsrespond completely to market signals should not necessarily be a cause for pessimism regarding its prospects for improving efficiency. The real problem facing Chinese reformers is how to find a workable combination of economic incentives and administrative control. The Hungarian system of informal bargaining between officials and enterprises is unlikely to work in China, with over 87,000 industrial enterprises in the state sector and a large and fragmented bureaucracy. During the Maoist periods, the Chinese government had sought to alleviate the difficulties of managing a large, underdeveloped economy through administrative decentralization. Planning was partially decentralized to the local level, and Party control was relied upon as a key instrument for keeping local decisions in conformance with central policy. As local governments gained increasing autonomy in resource allocation, however, state control declined correspondingly. Rather than functioning as an ideal-type “indirectly centralized” economy tightly controlled by Beijing, the system gradually degenerated into an unwieldy mass characterized by fragmented and compartmentalized control over resources and enterprises (see Wong, 1986). One important objective of the present reforms is to sever the particularistic ties that bound enterprises to administrative units and to break down the barriers to resource flows. During the past 7 years, however, decentralizing reforms have had the paradoxical effect of strengthening the ties between enterprises and local authorities. Just as Maoist leaders found it difficult to manage a planned economy by transmitting central commands through the vast middle layers of the bureaucracy, reformers are finding it difficult to motivate them to implement reform measures. The prospects for finding a workable combination of economic and administrative incentives are dim. As long as implementation of reform depends on the faithful compliance of local officials, it is subject to distortion or even outright sabotagewhen reform

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objectives are so clearly seen to be against the allied interests of enterprises and localities. At present, continuation of the reform program faces two hurdles: the opposition of local governments and inflationary pressures. Through the first phase, local governments saw decentralizing reforms as a way to further extend their control over resources, and their enthusiastic support was a key factor behind the reform momentum. In the second period, however, the reforms are aimed at reversing the trend of growing local influence over industrial production that had characterized the past two decades.Given the dramatic impact these reforms may have on the alignment of power, it is unlikely that local governments will go along willingly. Inflationary pressures have been very intense though unmeasured in the reform period, since official indices capture on a small portion of price increases.In the producer goods sector, these pressuresare exacerbatedboth by the demand-pull effect of shortages and the cost-push effect that is worsened by the weakness of buyers’resistance. The rapid increases in wage and bonus payments have in turn generatedburgeoning consumer demands that are also contributing to inflationary pressures.Inflation and shortageshave traditionally been the foci for rallying antireform forces in socialist economies, as they create pressures for reasserting control and reinstituting administrative allocation. So industrial reforms are now in the proverbial phase ofjintui liangnan: it is difficult either to advance or to retreat. To advance requires some hardnosed handling of inefficient enterprises and laggard workers, steps that are certain to exacerbate social and regional tensions. To retreat is to accept the microeconomic inefficiencies of the command economy, now exacerbatedby the erosion of central control. It is not surprising that the difficulty of reform increaseswith progress.The first problems faced by reformers are mechanical in nature: those of design and implementation. As reforms progress, mechanical problems give way to ones of political economy: those of reconciling the conflicting interests of various affected parties. Finally, as resource allocation is increasingly turned over to market forces, reforms begin to threaten the core values of the socialist system, and ideology will provide the rallying point for divergent interest groups. The next 2-3 years may be decisive for the post-Mao reforms. With local governments now swung to the other side, the prospects for maintaining reform momentum are much diminished. The emergence of significant economic problems may well turn the tide. REFERENCES Byrd, William, China’s Financial System: The Changing RoleofBanks. Boulder, Cola.: Westview Press. 1983a.

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Byrd, William, “Enterprise Level Reforms in Chinese State-Owned Industry”, Amer. Econom. Rev. 73,2:329-332, May 1983b. Byrd, William, “The Shanghai Market for the Means of Production: A Case Study in the Reform of China’s Material Supply System.” Comp. Econom. Studies 27,4: l-30, Winter 1985. Byrd, William, “Financial Incentive Schemesfor State-Owned Enterprises” (unpublished). Byrd, William, and Tidrick, Gene, “Adjustment and Reform in the Chongqing Watch and Clock Company.” World Bank Staff Working Paper no. 652, 1984. Deng Liqun et al., Dangdai Zhonogguo di Jingji Tizhi Gaige (Systemic Reforms of the Contemporary Chinese Economy). Beijing: Chinese Acad. Social Sci. Press, 1984. Field, Robert Michael, “Changes in Chinese Industry since 1978.” China Quart. 100:742-76 1, Dec. 1984. Gu Fuwen, Caizheng 8~26-27, 1982. Han Guocun and Zhao Bokun, “A Brief Primer on the ‘Dividing Up Revenues and Expenditures, Contracting by Levels’Fiscal Management System”. Caizheng 78-9, 1982. Hao Shengde,“From the Changing Production Costs in Commune and Brigade Coal Mines to a Discussion of the Need to Adjust Prices and Taxes.” Jingji Wenti (Issues in Economics) 542, 1982. Kornai, Janos, The Economics ofShortage. Amsterdam: North-Holland, 1980. Komai, Janos, “Resource-Constrained Versus Demand-Constrained systems.”Econometrica 47, 4:801-819, July 1979. Li Yue, ed., Zhongguo Gongye Bumen Jiegou (The Structure of Chinese Industrial Ministries). Beijing: Chinese People’s Univ. Press, 1983. Ma Hong and Sun Shangqing, eds., Zhongguo Jingji Jiegou Wenti Yanjiu (Research on the Problems of China’s Economic Structure). Beijing: People’s Press, 1981. Naughton, Barry, “Finance and Planning Reforms in Industry.” In U.S. Congress,Joint Economic Committee, China in the 1980s. Washington, DC.: US. Govt. Printing Office, 1986. Naughton, Barry, “False Starts and SecondWind: Financial Reforms in China’s Industrial System.” In E. J. Perry and C. Wong, eds., The Political Economy of Reform in Post-Mao China, pp. 223-252. Cambridge, Mass.: Harvard Univ. Press, 1985. Reynolds, Bruce, “Reforms in Chinese Industrial Management: An Empirical Report.” In U.S. Congress,Joint Economic Committee, China under the Four Modernizations. Washington, D.C.: U.S. Govt. Printing Office, 1982. State Statistical Bureau, “Communique on the Fulfillment of China’s 1978 National Economic Plan.” Beijing Review 27:37-41, July 6, 1979. Sun Xuewen, “Some Problems in the Implementation of Profit Contracting.” Jingji Lilun yu Jingji Guanli (Economic Theory and Economic Management), no. 3; reprinted in Gongye Jingji 13:25-30, 1982. Tyson, Laura, “Liquidity Crises in the Yugoslav Economy: An Alternative to Bankruptcy?’ Soviet Stuides 29~2, April 1977. Wong, Christine P. W., “Rural Industrialization in the People’s Republic of China: Lessons from the Cultural Revolution Decade.” In U.S. Congress, Joint Economic Committee, China under the Four Modernizations, pp. 394-418. Washington, D.C.: US. Govt. Printing Office, 1982. Wong, Christine P. W., “Material Allocation and Decentralization: Impact of the Local Sector on Industrial Reform.” In E. J. Perry and C. Wong, eds., The Political Economy ofReform in Post-Mao China, pp. 253-278. 1985a. Wong, Christine P. W., “Economic Performance.” In S. Goldstein, ed., China Briefing, 1984, pp. 109-l 19. Boulder, Colo.: Westview Press, 1985b.

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Wong, Christine P. W., “Ownership and Control in Chinese Industry: The Maoist Legacy and Prospects for the 1980s.” In U.S. Congress, Joint Economic Committee, China in the 1980s. Washington, DC.: U.S. Govt. Printing Office, 1986. World Bank, China: SocialistEconomicDevelopment.Washington, D.C., 1983. Xing Hua, “The Frequent Changes in the Fiscal System during the Ten Years of Chaos,” Part 2. Caizheng 9:8-10, 1983. Xue Muqiao, “Manage the Economy According to Objective Economic Laws.”Jingji Guanli 1: 7-l 1, 1984. Xue Muqiao, “Problems to be Solved in Reforming the Economic Management System.” Jingji

Yanjiu 1:3-7, 1982. Zhao Ziyang, “The Current Economic Situation and the Reform of the Economic Structure: Report on the Work of the Government at the Third Sessionof the Sixth National People’s Congress.”BeoingReview16, April 22, 1985. Zhao Ziyang, “Report on the Work of the Government at the Second Sessionof the Fifth National People’s Congress.”RenminRibao, June 2, 1984.