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Lessons of China’s Transition
from a Planned to a Market
Economy
Justin Yifu Lin
Peking University and Hong Kong
University of Science and Technology
Introduction
• Socialist countries’ transition is one of the most
important events in modern history
• China started the transition in 1979 with a gradual,
dual-track approach and achieved remarkable
performance from the very beginning
• When EEFSU started their transition in the early
1990s, most economists favored the big-bang
approach and predicted the EEFSU to outperform
China
• In the 1990s, Chinese economy continued to growth
dynamically whereas the EEFSU experienced an “Lcurve” in their GDP growth
Does Chinese Experience have
General Implications?
• Chinese approach violates almost all the basic
propositions for a successful transition
• The debates:
– China’s success is attributable to its unique initial
conditions
– China’s success poses a challenge to the wisdom of
Washington consensus
• The EEFSU had no other choice but a big bang
approach. However, no matter what approach is
adopted, the actual process will be a gradual
process.
The organization of the paper
• Logic origin of the traditional planned
system in China and EEFSU
• Process of China’s Transition
• Lessons from China’s experience
• Concluding remarks
Main Arguments
• Economic institutions of the plan economy are
endogenously shaped the CAD strategy due to the needs
to protect/subsidize the nonviable enterprises in the
priority sectors
• The Shock therapy fails due to its negligence of the
endogenous nature of the planned institutions
• The dual track approach is desirable because it liberalizes
the previously suppressed sectors meanwhile continues to
provide supports to the nonviable enterprises in the
previously priority sectors
• The completion of transition to a market economy depends
on giving up the CAD strategy and resolving the issues of
nonviable firms
Characteristics of Heavy Industry
projects
• Characteristics of Heavy Industry projects
– Long Gestation
– Needs for Equipment Imports
– Lump-sum Investment
• Characteristics of low-income economy
– Scarce of capital
– Scarce of foreign exchanges
– Difficulty of mobilizing funds for large project
• Firms in priority sectors is not viable in an open,
competitive markets
Macro-Policy Environment and
Shortage
• Market Monopoly
• Macro arrangement for solving the conflicts:
– Suppression of Interests
– Over-value of exchange rate
– Suppression of prices of raw materials and intermediate
goods, and suppression of wage rates
– Suppression of prices of living necessities
• The distortions and shortages
Shortage and Planned Allocation
Mechanism
• To guarantee the limited resources would be
allocated for the projects in the priority
sectors, the market is replaced by the
following institutions:
– National Planning
– Administrative allocation according to national
plan
Lack of Competition and
Corporate Governance
• Information asymmetry and incentive
incompatibility are prevalent
– Firms are nationalized in order to guarantee the
investment of economic surplus on priority
projects
– Managerial autonomy are deprived to avoid
managerial discretions
Planned Economy and Rural
Institutions
• Monopolized Procurement and marketing of
agricultural products
• Collectivization
The performance of Traditional
System
• Through the above institutional
arrangements, the government was able to
establish a complete heavy industrial sectors
• The economy was inefficient due to
misallocation of resources (allocative
inefficiency) and incentive problems
(technical inefficiency), as shown in Figure
2
China’s micro-first approach
• China pursued perestroika to stimulate
dynamism but avoid glasnost to avoid the
collapse of communist party
• This approach differed not only the big
bang approach in EEFSU but also the
IMF/World Bank’s standard macro first
approach to transition
Micro-management System Reform
• The transition started with a spontaneous
replacement of collective farming system with the
Household Responsibility System
• The SOEs were giving partial autonomy and
allowed to share profits through
– Profit retention
– The contract system
– The modern corporate system
• The productivity in agriculture increased
significantly. The productivity in SOEs also
increased but their profitability declined.
Resource Allocation Mechanism Reform
• To make the increase in managerial autonomy a
reality, SOEs were allowed to obtain additional
inputs and to sell extra outputs outside the plan,
leading to the emergence of a dual-track system
• An unexpected result is the entry of TVEs and
other non-state enterprises
– Improving resource allocation
– Competitive pressure on SOEs
Macro Policy Environment Reform
• Dual-track prices system were introduced
alongside the dual-track resource allocation
system
• The price of a resource would be liberalized when
the resource was mostly allocated by the market
tract
• Except for the interest rate, the prices for most
commodities and services have been liberalized by
the mid 1990s.
The Achievements and Problems
of China’s Approach (1)
• The dual-track approach resulted in stability and
continuous growth, as illustrated in Figure 3.
The Achievements and Problems
of China’s Approach (2)
• Due to institutional incompatibility, the economy is
troubled by
– Large non-performing loans
– Widespread rent-seeking activities
– Regional disparities
• The problems are related to the needs of supporting SOEs.
• The final completion of transition depends on the
successful elimination of SOEs’ viability problem and
social burdens so that the state is not obliged to
subsidize/protect the SOEs
Challenges of China’s Transition to Early
Consensus
• Early consensus:
– Quick Privatization is necessary for real market
competition and for Elimination of soft budget
constraint
– Big-bang price liberalization is necessary for
preventing output fall and a dual-track system
encourages arbitrage, corruption, and diversion of
scarce resource from high-value to low-value uses
• China’s experience shows:
– SOE’s soft budget constraints arise from policy burdens
– Competition on a level-playing field is more important
than ownership
Why Previous Attempts for Gradual
Reform Failed in EEFSU
• SOEs were not allowed to set their prices, which
prevented the improvement of resource allocation
• Entry of nonstate enterprises were subject to
severe restriction, which prevented the
competition
• Managers were allowed to set the workers’ wage
levels, which led to the sharp decline of state
revenue
• The wage inflation caused the worsening of
shortage
Will People in EEFSU respond to
Opportunities from Dual-track Reform
• Workers and farmers received heavy subsidies in
EEFSU and thus some argued that only by ending
the subsidization of the state sector was it possible
to free labor from state sector to non-state sector
• In effect, although the opportunity costs for a
worker to leaving state sector were higher than in
China, the expected gains for doing so in EEFSU
were also much larger.
An Analogy
• When a chasm is narrow, it’s all right to
jump over it.
• When a chasm is too wide and too deep, it
is desirable to fill and to narrow the chasm
before making the jump
Lessons
• The state can take measures to improve micro incentives
by granting partial autonomy and encouraging local and
private institutional innovation
• The state can introduce a dual-track price and allocation
system so that to improve the resource allocation and
maintain the survival of SOEs
• The state can liberalize the price when the commodity is
largely allocated by the market
• The final success of the transition to a market economy
depends on the elimination of SOE’s viability problem and
social burdens so that the state is not obliged to
subsidize/protect SOEs