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Emerging Markets

The secret of China’s success

Thirty years since its economic reforms kicked off, China’s achievements remain poorly understood. But as China’s policy-makers ponder their next steps, getting the facts about China’s story right is more critical than ever

Economists know a lot about the highly observable part of Chinese economic performance, such as GDP growth, FDI, exports and so on, but many have no direct knowledge about the economic policies and institutions that have led to such staggering results.

Many believe, for example, that township and village enterprises (TVEs) were publicly owned but were also “functionally efficient”. Another widely held view is that China did not liberalize its financial sector until very recently (albeit mainly to foreign investments). This was beneficial, the story goes, because financial controls helped stabilize the economy at a time when market-based policy instruments did not exist. Mathematically sophisticated models abound to explain these seemingly peculiar aspects of the Chinese economy.

But a direct examination of Chinese economic policies – including directives, operating manuals, and memos issued by top managers of Chinese banks over the past 20 years – flatly contradicts the heterodox interpretation of Chinese reforms: Chinese economic success, just as success elsewhere, is in fact a result of private entrepreneurship, financial liberalization, property rights security – and even political reforms.

What’s in a name?

It is no exaggeration to say that township and village enterprises (TVEs) laid down the foundation for China’s economic miracle. But as far as much of the academic study of China’s economy is concerned, TVEs remain something of a mystery. Nobel economist Douglass North, for instance, wrote in a 2005 Wall Street Journal article: “This system in turn led to the TVEs and sequential development built on their cultural background. But China still does not have well-specified property rights, town-village enterprises hardly resembled the standard firm of economics, and it remains to this day a communist dictatorship.”

Because many economists have a rather dim view of government ownership, the supposed juxtaposition of publicly owned TVEs and rapid growth has led to elaborate theories about why TVEs worked. One theory, popularized by Nobel prize winner Joseph Stiglitz, is that TVEs helped the government curb private stripping of public assets. Yet for such a widely held view, it is remarkable how few economists have actually taken the trouble to document empirically whether TVEs were owned by the local governments.

As my research has recently uncovered – after a thorough investigation of original sources, including a raw database maintained by the Ministry of Agriculture (which was in charge of collecting data on TVEs) – TVEs were in fact, from their inception, almost completely private.

This discrepancy is largely down to a fundamental gulf between western and Chinese definitions of a TVE. Western economists view “township and village” as an ownership concept whereas the Chinese refer to TVEs as a geographic phenomenon i.e. firms located in townships and villages, not owned by townships and villages. Just how big is this gap between the western and Chinese understandings of TVEs? Of 12 million TVEs in 1985, 10 million were private, and between 1985 and 1996 every single net entrant was a private TVE. In other words, the TVE phenomenon is probably the world’s largest confirmation of the superiority of private ownership. The real China model is not unique at all.

One-way street

One of the deepest puzzles in the history of Chinese economic reforms is why the supply response of rural entrepreneurship was so massive in the seemingly harsh political environment of the early 1980s. Isn’t it the case that China today, let alone in the 1980s, is a strong one-party system? Why should millions of rural entrepreneurs have taken upon themselves considerable risks and put up a lot of capital when they could not trust the state? After all, the historical record of the Chinese state in keeping its promises and delivering on its commitments was not good, to put it mildly.

The key here is to differentiate between a static political story and a dynamic one. Statically, the Chinese political system now – and in the early 1980s – is authoritarian. But dynamically, it has been moving in a liberal direction. And it is this directional liberalism that lay behind the explosion in entrepreneurship when China’s economy began to take off.

Yet the perspective of aspiring Chinese entrepreneurs in the 1980s was not informed by a Westministerian system of checks and balances, which would have cast the Chinese system in a poor light. Rather, their reference point was the China of the 1966–76 Cultural Revolution, when Chinese politics can be safely described as “nasty, brutish and short”. The Chinese political system in 1980, as arbitrary and as absent of self-constraints as it was, marked a substantial marginal change from the status quo ante of the Cultural Revolution. Hopeful private entrepreneurs felt increasingly assured of the safety of their assets. This was “directional liberalism” in action.

There had been extreme ideological antagonism toward capitalism during the Cultural Revolution era. Private businesses were strictly forbidden, and in urban China all vestiges of capitalism were completely eliminated. Anyone who went into private business faced the immediate risk of being arrested or severely persecuted.

But entrepreneurs in the China of the early 1980s by and large no longer faced such risks, and the incentive effect for would-be entrepreneurs of not getting arrested was substantial. In this way China moved very far and fast in the 1980s toward establishing the security of the proprietor – a necessary condition for property security – even though the country lacked, and still lacks, well-specified property rights security.

There were also objective – and objectively large – differences between China of the 1970s and China of the 1980s. The almost instant credibility of Chinese reforms is largely down to the fact that Deng Xiaoping – and not somebody else – presided during that period at the helm of Chinese politics. This is the Deng Xiaoping effect, which speaks to the question whether the aspiring entrepreneurs in the early 1980s viewed as credible the political and policy signals that they would not be imprisoned.

What’s most relevant about Deng in this regard is not his reformist inclination or his political power but his credibility vis-a-vis the would-be entrepreneurs: none of his reform push would have mattered from the point of view of peasants’ incentives and their sense of property rights security if he was not viewed as credible. The importance of Deng is that he was observably different from Mao.

The key word here is “observable”. Deng had a set of credentials that were commonly known. And the entrepreneurial response came from hundreds of millions of Chinese peasants scattered in far-flung places, not from the urban elite. The former had to believe that the policy change under Deng was permanent rather than cyclical and that Deng’s China was objectively different from Mao’s China.

Deng mattered because he had been purged three times by Mao while one of his sons was crippled by Mao’s red guards during the Cultural Revolution. No other Chinese leader commanded such overwhelming credibility.

Three decades later

This year marks the 30th anniversary of economic reforms. As China ponders its next policy steps, it is critical to get right the story about its successes and failings to date. While GDP has grown fast, income distribution is now approaching the level of Latin America, a fact which puts China at odds with the rest of east Asia.

The biggest reason for this is the rural-urban income gap. In the 1980s when TVEs developed vibrantly, the rural-urban income gap was actually shrinking. Contrary to conventional wisdom, the policy environment in the rural areas became progressively more illiberal in the 1990s. Many of China’s problems today – stagnant rural growth and a huge rural-urban disparity – can be traced to these policy changes: the government reversed the financial liberalization of the previous decade; the policy emphasis shifted to state-directed urbanization programmes and on “pillar” enterprises (many, state-owned enterprises); and rural entrepreneurship – beneficial to the majority of the Chinese population – was systematically neglected and it atrophied.

Chinese policy-makers must urgently rethink and repudiate the economic model of the 1990s, which led to fast GDP growth but diminished the welfare improvement of the average Chinese. In that decade, the country also backtracked on political reforms, but many observers, both within and outside China, concluded that the country could grow even without property rights security. Yet the directional liberalism of the 1980s would contradict this view: the evidence suggests that the gains of growth were better distributed when the political environment was trending in a liberal direction.

The China model also holds a valuable lesson for other developing countries. Many economists interpret China’s success as evidence of a heterodox approach. They recommend others to imitate China’s cautious deregulation, selective financial controls, semi-government ownership of its corporate sector, and even strong political controls. But the real China model is not heterodox at all but instead quite conventional. The credit for its success goes to private-sector dynamism, entrepreneurship and financial liberalization. Given what’s at stake, it’s worth getting the China model right.

Yasheng Huang is associate professor of international management at MIT

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