China: Can Reform be Sustained

By C P Chandraskehar,



We reproduce this article on the Chinese Reforms for, since our own article “Socialism with Chinese Characteristics” in the August/September 1992 issue of Lalkar, it is one of the most thoughtful that we have come across. [From

People’s Democracy

of 18 July 1999, with thanks.] – Editor.


China’s drive towards a “socialist market economy” is facing new constraints. According to the official Xinhua News Agency, China’s labour minister Zhang Zuoji stated in a report to the financial and economic committee of the National People’s Congress that more than three million workers in China’s state-owned enterprises are expected to lose their jobs this year. They would join the six to seven million people who, having been retrenched from state firms earlier, have yet to find new jobs. Zhang reportedly cited a survey of more than 3,000 state-owned firms nationwide, which said that 95 per cent of those laid off had registered at re-employment agencies, and 94 per cent of those had been given basic living expenses.

However, he noted that while China would need 24.5 billion yuan (2.95 billion dollars) this year to provide basic living expenses to the laid-off workers, the amount currently available was only 19.5 billion yuan. This problem of inadequate support is bound to intensify if China persists with public sector restructuring involving partial retrenchment or closure, since there were an estimated 113 million urban workers employed by state owned firms in 1995.


This danger could hold back China’s reform process, which is now two decades old. During those years, not only has growth been remarkable, but the structural transformation of the Chinese economy has indeed been dramatic. Yet, none of the advocates of reform would hold that the process is anywhere near completion. This is essentially because the core of the centrally planned regime of the past, the huge state-owned industrial sector, still retains structural and organisational features characteristic of the old regime. According to one source, there were 118,000 such firms in China in 1998. Though the contribution of these state-owned enterprises (SOEs) to China’s industrial output had fallen from over 75 per cent in 1978 (when economic reform began) to less than 35 per cent in 1995, this was not so much due to the shrinkage of this sector as to the expansion in the rest of the industrial sector consisting of the collective enterprises, the individually owned enterprises, wholly foreign owned firms, and foregn joint ventures.

The point to note is that this expansion outside the state-owned sector was not necessarily competitive. Most often the expanding enterprises produced a range of commodities which were not within the purview of the SOEs, such as commodities belonging to the lighter, less capital-intensive industries, or those that catered to local or export markets which were not the principal targets of the SOEs. The SOEs, on the other hand, operate in the capital-intensive, heavy and basic goods industries characterised by lumpy investments and long gestation lags. Providing other industries and sectors differential access at differential prices to the commodities produced at these “commanding heights” was one of the means through which the priorities of the state were sought to be realised under the earlier system of central planning. It was in this sense that the SOEs were at the core of the centrally planned system which China’s rulers have been moving away from.

What is significant is that even now the SOEs dominate or even monopolise their chosen areas of operation. The significance of the state-owned enterprises comes through in other ways as well. For example, they still constitute the principal source of employment in urban China. In 1995, seven out of ten urban workers were employed in state firms. Such employment does not ensure just a wage, but a range of welfare benefits such as housing, medical care and retirement benefits. Further, state-owned enterprises constitute the primary source of tax revenue for government. In 1995, SOEs produced only 35 per cent of China’s industrial output, but contributed 71 per cent of government revenues. Thus, it is not only directly that the SOEs contribute to the government’s governance and welfare responsibilities, but indirectly, by providing the latter with the wherewithal to finance its own expenditures.

Given the crucial role of the SOEs, the fact that it is precisely this sector that has been the least affected by economic reforms suggests that the reform process has encircled the core of the old system, but has not managed to invade the core itself. This is not because of lack of efforts to reform the core. It is because of the failure of those efforts, which ensures that the centre of the industrial system remains untouched. This failure, according to protagonists of the reform, threatens to push China into a major economic crisis.


The purported link between the problem of state sector reform and national well-being is indeed complex. It begins with an assessment that state enterprise performance has been poor and with a specific delineation of the factors that are ostensibly responsible for that poor performance. Those advocating reorm trace the poor performance of state enterprises to the fact that they do not function as market-oriented enterprises, which produce for profit by curtailing costs and maximising revenues. State enterprises, according to them, cannot curtail costs for a number of reasons. First, SOEs expend considerable resources on worker housing, retirement benefits, and medical care, which are activities alien to operations in a market economy. Second, overmanning is a common problem, partly because of the social responsibilities imposed on the SOE by outside agents at various levels of government, and partly because the “iron rice bowl” does not encourage the discipline required for efficient labour use. Third, sinc output targets have to be met or even exceeded with inputs accessed from within the planned system, where shortages are common, “hoarding” is a common tendency. Thus the aim of inventory management in socialist firm is not to cut costs, but to have at hand inputs and/or outputs which can be used or made available when shortages arise.

Since these factors militating against cost effectiveness are combined with an administered pricing principle that keep the prices of core commodities and universal intermediates low, the likelihood of a unit recording an operating profit is low. The problem is further aggravated by the fact that various levels of government see the SOEs as a major source of revenue for their activities. Thus it is almost inevitable that the books show a post-tax loss. Actual internal cash flows could be even worse than suggested by these losses, because much of the revenues of an SOE could be a mere receivable from some other such enterprise or some arm of government, which could be long in arriving, if it does at all.

To explain why these problems and the firms faced with them continue to exist, analysts turn to Janos Kornai’s – now much-celebrated characterisation – of socialist firms as firms faced with soft-budget constraints. Even if making huge losses, these firms do not close down because they are kept in operation b the state through grants, subsidies, credit and the like. This, according to Kornai, completely distorts the objectives of the firm, which is merely concerned with realising ever-increasing, quantitative production targets, with little concern for quality, cost or profits. The productions and investment hunger that characterises the system soon results in a situation of shortage coexisting with slack, with shortages proving to be the binding constraint on growth and efficiency.

The question, however, remains as to why these problems persist despite reform which has provided SOEs considerable autonomy and even partially privatised some of these units.

The answer provided by the protagonists of reform starts from the governance problems created by the very nature of the large, capital intensive modern industrial firm. Such firms are not textbook type actors seeking to accumulate capital following market-based incentives. Rather they are complex organisations characterised by the separation of ownership from control and in which a multitude of stakeholders seek to influence the performance of the actual managers.

The task of modern industrial governance is the task of creating the governance mechanisms which can align and direct this constellation of often conflicting interests.


These governance mechanisms are normally both internal and external to the firm. Internally, in market economies, boards of directors monitor managers and ensure that the interests of the owners of capital are not sidelined. More crucial, however, are external governance mechanisms. The functioning of capital and equity markets, outside bank auditing, threats of bankruptcy and liquidation, all ostensibly combine to ensure that even with the absence of internal monitoring and effective management, efficient producers will be rewarded while the inefficient will be driven out of business.

The difficulty then, according to these observers, is that in China, outside governance institutions are either absent or, when present, malfunction and distort the internal operations of the individual firm. The fundamental reason is that there are too many objectives and interests that the individual firm serves, so that it is neither in the interest of anybody to ensure efficiency per se nor is it in the interest of anyone to allow the firm to close. Even if reform precludes the direct financing of the corporation by the state, different rungs of the state exercise their influence to force banks, who are supposed to monitor these corporations to keep them afloat with continuous infusion of finance. The soft budget constraint persists, not because of a direct relationship between the state and the SOEs, but because of the state engineered relationship between the banks and the SOEs. Savings are, in this view, sucked out of the household sector and sunk into the black hole that is China’s state enterprise sctor, with the banking system serving as intermediary. This not only means that growth suffers but that banks in the system are burdened with non-performing assets which their non-transparent accounting procedures conceal. But since this process cannot be continued ad infinitum, there is a real danger that that there could be a situation when the concealed bankruptcy of the SOEs breaks out in the open and takes the banks and the rest of the system down with it.

This characterisation of the functioning of public enterprises and the financial system also provides an explanation of why state enterprise reform in contexts like China’s tends to fail. Most of that reform is aimed at encouraging market behaviour by transferring property rights to different actors through decentralisation, corporatisation and even outright privatisation. But this in itself does not ensure market oriented behaviour because the institutional mechanisms required to make corporate governance function do not exist.

Hence, reform must, according to this view, seek not just to “open up,” but rather to create the institutional framework which sets up the pressures and structures to force economic agents to behave in ways that are not rent-seeking and value subtracting but productive and value creating. What is crucial is to do away with the soft budget constraint, which does away with credible threats of bankruptcy and liquidation. Hence, the argument goes, what is crucial is to introduce hard-budget constraints which make poorly managed, loss-making firms go out of business.


Unfortunately, the denouement in a tale where transition involves a shift from soft to hard budget constraints need not be this happily productive ending. It could mean widespread closure. After all, it is known that most Chinese enterprises not only bear an employment and welfare burden but have also made technology choices based on criteria which go beyond conventional profit maximising principles. This could mean that if these firms have to deliver a profit, prices would have to be set way above what would prevail in a relatively competitive market. If these firms operate in a monopolistic environment and are provided the autonomy to price themselves into profit, then, not only is there a danger of inflation, but there is an implicit softness in the budget constraint that operates on them. That would not be acceptable to hardline reformers. On the other hand, if domestic and international competition is encouraged in order to keep prices under check, closure may be inevitable. What we would then have is hge volumes of capacity rendered idle, which from a social point of view can hardly be considered efficient.

Unfortunately, reformers do not have an idea of how that challenge is to be met, especially given the “structural weaknesses” of SOEs when seen from a purely marketist point of view. This conceptual failure of reform is in part inevitable given two of its assumptions. The first is that the “firm” or “enterprise” is the same animal whether nurtured in an environment where it serves the profit motive or in a context where it is an insstrument for the realisation of other objectives, including social objectives like promoting employment, guaranteeing basic need and mobilising resources for the state. The second assumption is that whatever the goals, there exists no other disciplining mechanism other than the market for ensuring the realisation of those goals.

The reality is that if objectives other than profit are the goals firms are created to further, then non-economic mean of ensuring discipline are the only way out. Reform then involves the search for institution and structures which would constrain different actors as well as motivate them to realise the defined objectives in the most efficient way. On the other hand, if firms created in a non profit environment are subjected to market discipline, the closure is inevitable. The baby here, the state owned enterprise sector, would have to be thrown out with the bath water of inefficiency. Since the Chinese state cannot risk that prospect, it is not surprising that reform has been successful in the town and village enterprise and the export sectors, populated largely by firms that grew in the wake of marketisation, while it has left virtually untouched the SOE sector. SOE reform of the kind advocated today can work only if the system can bear a major and painful upheaval. This is what Zhang Zuoji’s figures corrborate. It is also why the Chinese government has been hesitant to take the risk, leaving the market-friendly reform agenda unfinished.