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5

Growing out of Socialism: Capitalism with Chinese Characteristics

After almost a decade of strong economic growth, China’s economic reform encountered its first full-blown crisis in the late 1980s. This culminated in the 1989 Students Movement, the tragic end of which further compounded and prolonged the economic crisis. The year preceding and those that followed the 1989 Tiananmen incident are often referred to as the Tiananmen interlude (1988–1992). The Chinese term for crisis literally means danger and opportunity, and this four-year period was full of danger for the reform agenda; there was a real possibility that reform might be rejected altogether.

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In September 1988, the Chinese government launched an emergency austerity program, both to curtail rising inflation (which in July was running at 19.7 percent), and to end the panic buying and bank withdrawals seen in many Chinese cities.¹ In August, the volume of retail sales jumped 38.6 percent above that of the previous year; it put further pressure on inflation.² The austerity program included tightening bank credit and money supply, while withholding and even reversing a selection of reform measures – particularly those pertaining to the private sector. Installed to rein in the overheated economy and control rising inflation, this program acted as a brake on an accelerating economy and effectively stalled the economic reform. Six months later, in March 1989, the Guardian’s headline was “Beijing’s reforms grind to standstill.”³ After the crackdown on the student movement on June 4th, the outlook for the Chinese economy became even gloomier. Newsweek ran an article on “Deng’s Great Leap Backward”⁴ and The Economist’s analysis was entitled “How a dragon stagflates.”⁵ Quoting a document freshly released by the Central Intelligence Agency, the Washington Post reported that “China’s economy is in a deep recession that shows no sign of abating and is threatening the country’s social stability.”⁶

The evidence on the ground corroborated this view. Local governments all over rural China had been hit hard by the austerity program and were short of credit. In the summer of 1990, local governments were forced to issue credit notes to peasants in payment for grain, which caused widespread discontent. During the students movement a year earlier, Chinese peasants had been largely absent from the demonstrations. However, as the birthplace of riots and rebellions in the past, including the Chinese Communist revolution, rural China remained politically vulnerable.

Furthermore, the number of single proprietorships (private entities with seven or fewer employees) in China declined by 15 percent in 1989. The number of private enterprises (with more than seven employees) fell by more than half from over 200,000 in 1988 to a little above 90,000 by the end of 1989. It remained at this level throughout 1990 and only rose slightly to 107,000 in 1991.⁷

Moreover, the main trends in political discourse seemed to have reversed. If Chinese economic reform had been “deadlocked” between planning and market at the end of the 1980s, as some scholars have rightly observed,⁸ the political tide was now pushing the economy back to its former state. The political coalition Deng had assembled in support of reform at the end of the 1970s had begun to crack by the mid-1980s. This led to the resignation of Hu Yaobang in early 1987, and the coalition virtually collapsed after the 1989 Tiananmen crackdown. On November 23rd, 1989, Premier Li Peng of the State Council gave an exclusive interview to Manfred Schell, editor-in-chief of Die Welt. Asked about China’s policies on economic reform and opening up, Li Peng explained that “China’s reform is a self-improvement of the socialist system. Economically, to combine the planned economy with market regulation is not to lead China to capitalism.”⁹ Li equated the market economy, the direction of reform since 1984, explicitly with capitalism. The political consensus supportive of market reforms had been destroyed. As we discussed in the preceding chapter, the dictum “the planned economy as primary, market adjustments as auxiliary” had long been ingrained in Chinese socialism. Originally formulated by Chen Yun in 1956, it was widely embraced by Chinese leaders after 1978. Though it had served well in guiding Chinese leaders during the early stage of reform, the dichotomy represented by the planned versus the market economy, and the dogmatic defense of the plan’s preeminence, led to its rejection in 1984. After that the development of a market economy replaced socialist modernization as the goal of Chinese economic reform, but from 1989, market reform lost its political support and Chen Yun’s economic thinking was restored.

This reversal in the orientation of reform had an immediate impact on economic policy. When addressing the National Planning Conference on December 11th, 1989, Li assured his audience that economic reform and opening up would continue, but in a different manner.¹⁰ His main message was to defend the austerity program and recommit the Chinese government to socialism; that is, to the preeminence of public ownership and central planning. Specific measures were proposed to curtail the growth of the non-state sector and to reverse price deregulation. First, township and village enterprises – the most dynamic and fastest-growing economic force since the inception of reform – were to be co-opted into state planning. This had been proposed in the late 1970s but had never been considered seriously.

Township and village authorities should earnestly organise and lead collective economic activities and service systems of various kinds; on the other hand, collective economy should become the foundation for consolidating township and village regimes. We should encourage development of town and township enterprises in accordance with the principle of adjusting, consolidating, reforming and improving, and should affirm the role played by town and township enterprises. These enterprises are an important form of economic activity for developing rural economy, improving production conditions in rural areas, and increasing employment opportunities in rural areas. Some unhealthy practices by township and village enterprises should be corrected, and the positive side of these enterprises should be protected and supported. The important thing is to ensure that township and village enterprises carry out the state’s industrial policies, improve product quality, reduce material consumption and cater to market demands. Banks at all levels should provide appropriate amounts of operating funds to town and township enterprises in 1990 (italics added).¹¹

Second, Li set in motion a more ambitious plan to bring the whole private sector into the orbit of the state, which, if implemented, would effectively destroy the private sector altogether.

Individual and private economy is a beneficial and necessary complement to socialist economy. We should strengthen management of them, provide better guidance for their development, and continue to encourage them to develop within the bounds set by the state, so that they can play an active role in developing production, accommodating people’s daily life and creating new employment opportunities. At the same time, we should limit those negative effects that are unfavorable to developing socialist economy.¹²

Third, in contrast to the previous policy of price liberalization, Li recommended price control as a tool to fight inflation.

It is necessary to strengthen, in a strict manner, the management of market prices and to control the range of price rises. To reduce the inflation rate and the range of price rises year by year is a basic task to be carried out in improving the economic environment and straightening out the economic order. The task of controlling the range of price rises in 1990 will be a very arduous one. One primary measure to control rising prices is to control continuously the total social demand. Price rises by departments and enterprises themselves must be strictly controlled. A policy to stabilize the prices of the necessities for people’s basic daily life, as well as labor charges, should be adopted. Such a policy should stipulate in explicit terms that the prices of some necessities are not to increase. It is necessary to check conscientiously on various criteria for fees and to ban strictly or forbid wanton price rises and excessive charges. Efforts must be made to strengthen the controls over market prices, as well as supervision and inspection in this regard. It is particularly necessary to give full play to the role played by the masses and public opinion in controlling prices. The price-control responsibility system should be continuously implemented. Control over the range of price rises must continue to be an important gauge in evaluating the performance of governments at various levels in 1990.¹³

I

The shift in economic policy was reinforced by a wave of political campaigns against market-oriented reform, implemented throughout China in 1990. These campaigns singled out the fledgling private sector as the economic bastion of bourgeois ideology, which the Chinese government saw as the fundamental cause of the student demonstrations, culminating in the 1989 Students Movement. On February 22nd, 1990, the People’s Daily published an article on the front page entitled “On Bourgeoisie Liberalization,” in which the author suggested that the “liberalization of the bourgeoisie” – the move towards capitalism – was economically rooted in the private sector.¹⁴ This initiated a year-long political diatribe against market reform. For orthodox Marxists and Maoists, the private sector was the hotbed of capitalism. From their standpoint, the 1989 Students Movement was a blatant attempt at “peaceful evolution,” luring China into capitalism without fighting a bloody war. To preserve the socialist regime in China, the government felt compelled to nip capitalism in the bud.

The political sentiment against market reform was further exacerbated by the fall of the Soviet bloc and the domino-like bankruptcy of communist countries in late 1989–1990. These events shocked the Chinese leaders, who had just survived their own political crisis. The swift and bloodless conversion of the Soviet bloc to capitalism put the Chinese government and the Chinese Communist Party on high alert, making them ever more conscious of the rivalry between capitalism and communism. This sense of insecurity and vulnerability held by the Chinese leaders helps to account for their unusually strong antipathy towards the market in the early 1990s.

A deeply ingrained ideological prejudice against the private sector was further compounded by a plausible but mistaken economic judgment. After the economic reform began to suffer a serious setback in 1988, economists and government officials alike began to look critically at reform policies implemented before the onset of runaway inflation in 1988. Policymakers took the view that the fast growth of market forces since 1984 had been responsible for price rises and runaway inflation. After 1984, the strong growth of the non-state sector, particularly the township and village enterprises, facilitated by support from local governments, the dual-track pricing system, and easy credits from banks, helped to generate inflationary pressures. In early September of 1985, a conference was held on the Yangzi River.¹⁵ It has since become known as the “Ba Mountain Boat Conference,” after the tourist boat on which it was held. A delegation of leading Chinese economists met preeminent economists from around the world to discuss China’s macroeconomic problems. The western delegation included the Hungarian economist Janos Kornai, Alexander Cairncross, and Wlodzimierz Brus from Oxford, and the Nobel laureate James Tobin from Yale. The consensus reached was that a simultaneous growth in both investment and wages was pushing the Chinese economy to the verge of hyperinflation. This warning, however, was ignored by the Chinese government in its continuing pursuit of rapid economic growth.¹⁶ Now, in the aftermath of the 1988 hyperinflation and the 1989 Students Movement, some Chinese economists came to believe that the 1984 Decision on the Economic System Reform, which had essentially embraced the market economy, was the ultimate culprit. They found market reform guilty of causing both economic woes and political risk.

On July 5th, 1990, the Politburo of the Central Committee of the Party invited a dozen or so economists to discuss current economic affairs and policy strategy. The economists were deeply but unequally divided. The larger group believed the market reform from 1984 onward had been the catalyst for 1988’s runaway inflation and the 1989 Students Movement. They argued vehemently for a retreat to the pre-1984 position, “the planned economy as primary, market adjustment as auxiliary.” The voice of the few economists on the other side, defending the market-oriented reform, was totally overwhelmed. The eighty-six-year-old Xue Muqiao, a staunch supporter of market reform, was so disturbed by the attack from the other side that he was unable to speak.¹⁷

Throughout the whole of 1990, debates on the direction of reform and the nature of socialism occupied the center stage of Chinese politics, particularly in Beijing. South China, as we will see shortly, was in a different mood; here, market reforms had gone deeper than anywhere else. At the time, however, only one voice was heard in China; the dissenting views were silenced. The view of the Beijing government was best captured by a belligerent article in the People’s Daily on December 7th, 1990, entitled “Socialism Bound to Replace Capitalism.”¹⁸ It attributed all the economic difficulties and political disturbance that China had suffered since the late 1980s to market reforms undertaken in the early part of the 1980s, and it urged China to return to socialism to end the political and economic troubles. The author claimed that “the market economy is to eliminate collective property, mounting to the denial of the leadership of the Communist Party and denial of socialism, and to commit China to capitalism.” If this view had been fully translated into economic policy, China’s market reform would have been stillborn.

II

The beginning of the 1990s in China was a time of uncertainty and self-doubt. Beijing was consumed by a sustained political lambasting against capitalism; economic reform was stalled. With a mixture of luck, determination, and foresight, China emerged from this period of political wavering with a renewed commitment to market reform, and by the end of the 1990s a dynamic market economy was in operation all over China. China’s joining the World Trade Organization in 2001 further consolidated market reform at home and expanded its role in economic globalization abroad. China by then had been irreversibly transformed into a market economy. At the end of the decade, the financial meltdown in Wall Street led to a severe economic recession and the West began to doubt the soundness of the global market order. China, however, stood firmly behind the market and economic globalization: January 1st, 2010 effectively saw the beginning of a free trade agreement between China and ASEAN (the Association of South East Asian Nations). This created the world’s most populated free trade zone (1.9 billion), and the third largest in volume of production after the European Economic Area and North America Free Trade Area.

We may wonder what provided the Chinese leaders with such faith in the market to carry them through the storm of uncertainty. However, this would be the wrong question to ask. During the Tiananmen interlude, the question as to whether China could grow out of socialism was wide open. It was absolutely not the case that the Chinese leaders were prescient and held a strong belief in the market, which guided them through the downturn of the Tiananmen interlude and ultimately led them to adopt a market economy. When China began reform in the late 1970s and early 1980s, it was as a series of marginal revolutions that introduced the private sector and market forces, which overshadowed the state-led reform initiatives and gave the reform a strong orientation towards the market. The market reform in the early 1990s survived in similar fashion, largely in a way unintended by the Chinese government.

China’s economic reform and open-door policies were always intertwined, each supporting the other. During the Tiananmen interlude, although the Chinese government halted many of the planned reforms and reversed others, it remained committed to opening China up to the outside world. As early as June 9th, 1989, Deng Xiaoping warned the Chinese leaders that

The important thing is that we must never turn China back into a country that keeps its doors closed. A closed-door policy would be greatly to our disadvantage; we would not even have quick access to information. People say that information is important, right? It certainly is. If an administrator has no access to information, it’s as if he was purblind and hard of hearing and had a stuffed nose. And on no account must we go back to the old practice of keeping the economy under rigid control.¹⁹

A week later, at a meeting with new members of the Central Committee, Deng suggested

[The State Council] should do more to facilitate reform and opening to the outside. Joint ventures involving foreign capital should be set up, and local areas should be allowed to establish development zones. If we absorb more foreign capital, it will surely benefit foreign businessmen, but we too shall benefit eventually. For example, we can collect taxes, introduce professional services for foreign-funded enterprises and establish some profitable enterprises ourselves. In this way our economy will be invigorated. Since foreigners are afraid that we shall close our doors again, we should do some things to demonstrate that our policies of reform and opening to the outside world will not change but will be further implemented.²⁰

When addressing a gathering for the tenth anniversary of the Special Economic Zones in Shenzhen on November 28th, 1990, Jiang Zemin, General Secretary of the Party, clearly reiterated the socialist orientation of the reform: “Our reform is designed to improve and develop the socialist system, to eliminate various structural flaws of the past and to bring out the superiority of the socialist system.”²¹ Jiang also restated China’s open-door policy:

Our effort to open to the outside world is intended to actively develop foreign economic and technical co-operation and exchanges, to learn the advanced technologies, scientific management experiences and progressive cultural achievements of foreign countries, including capitalist developed countries, to resist the corrosive influence of negative and corrupt elements in capitalist society and to inherit and enhance all the fine ideological, moral and cultural traditions of the Chinese nation.²²

It was ironic for him to acclaim the “superiority of the socialist system” in Shenzhen, an experiment set up to explore capitalism for the sake of saving socialism. Fortunately, Jiang was able to justify and celebrate the experiment on the basis that Shenzhen had served China well as a conduit for modern science, technology, and management or, in his own words, “a vanguard in conducting reform and opening to the outside world.” In his speech, Jiang confirmed that “Opening to the outside world is our country’s long-term, basic policy. This policy will not change.”²³ At a time when market reforms were publically denounced and harshly vilified in Beijing, it was fortunate that the Shenzhen experiment and open-door policy were allowed to continue.

The separate treatments of reform and opening up worked out well at a time when reform was being questioned as a betrayal of socialism. Opening up was less politically sensitive and thus less vulnerable. Even the staunchest defenders of socialism would not question the desirability and necessity of China learning advanced science and technology from the West and accessing western capital. It is also noteworthy that Jiang reversed Mao’s radical anti-Chinese tradition policy. He stressed that in “promoting the socialist material and spiritual civilizations,” it was important for China “to inherit and enhance all the fine ideological, moral and cultural traditions of the Chinese nation,” and “to learn the advanced technologies, scientific management experiences and progressive cultural achievements of foreign countries, including capitalist developed countries.”²⁴ Since the 1990s China’s commitment to socialism has no longer entailed enforced ignorance of the outside world, or a rejection of its own long history, as was the case during much of Mao’s era, particularly during the Cultural Revolution.

The continuation of the open-door policy during the late 1980s and early 1990s protected some elements of China’s economic reform from the impact of both the austerity program and the uncertain political environment. The most significant development of China’s opening up in the early 1990s was the setup of the Pudong Development Zone in Shanghai in April 1990. This began the revival of Shanghai as the financial and commercial center of China.²⁵ Two years later in 1992, the State Council approved the establishment of the Pudong New District. Within a decade, Pudong would become the showcase of China’s economic modernization. Separated from Shanghai by Huangpu River, Pudong was mainly rice fields at the beginning of the 1990s. Modeled after Shenzhen, Pudong became the central focus of China’s opening-up policy in the 1990s. If Shenzhen was the symbol of China’s opening up during the 1980s, Pudong became the flagship in the 1990s. Soon, the Yangzi River Delta around Shanghai would be rivaling the Pearl River Delta in South China, as a second engine of Chinese economic growth.

III

In 1990, Shanghai saw another significant development, the official opening of the Shanghai Stock Exchange on December 19th.²⁶ This came after more than a year of intense preparation, and in the face of an uncertain political climate. Widely regarded as a symbol of capitalism, the bond and stock trade had previously been confined to the forbidden zone of Chinese economics. In the mid-1980s, some state-owned enterprises turned themselves into joint-stock companies, in another form of enterprise reform. Bonds and non-tradable stocks were sold to their employees and the public as a new way of raising capital. The first exchange to allow a secondary market for company bonds and stocks on a trial base arose in August 1986 in Shenyang, a city in northeastern China with a strong industrial base in the pre-reform era and which had many state-owned enterprises.²⁷ This exchange office provided a platform for employees of state-owned enterprises to trade their bonds and stocks. Although the office was small and primitive in infrastructure, it was the very first attempt to experiment with a secondary bond and stock market and thus attracted much public attention, particularly from the foreign media. Three months later, at the end of September, another office opened in Shanghai. When John Phelan, Chairman of the New York Stock Exchange, was invited to a conference organized by the People’s Bank of China in Beijing and met Deng Xiaoping in November 1986, he insisted on visiting the stock exchange office in Shanghai – a single room of merely 12 square meters.²⁸

The first stock exchange to make a real economic impact was in Shenzhen.²⁹ Since 1986, joint-stock companies had been emerging in Shenzhen, and their number rose to more than 200 by the end of the 1980s. In June 1988, the municipal government of Shenzhen formed a Leadership Group on Stock Exchanges to explore the possibility of opening up a stock exchange market. Shenzhen’s repeated applications to Beijing for permission were denied, but a stock exchange was opened anyway and was quite active, particularly after 1989. By mid-1990, Shenzhen already had more than 300 offices where people could buy or sell stocks, despite the fact that there was no official permission to trade in this way.³⁰

This lag between practice and regulation was actually quite common throughout the Chinese economic reform. The phenomenon is aptly referred to in China as “get on the bus first, buy the ticket later.” It may seem irresponsible or even negligent on the part of government regulators to let a new practice go ahead without first putting in place proper regulatory rules. But without the practice being tried first on the ground, how could the regulator know what and how to regulate? However, when a novel practice was first experimented with, particularly in a regulation-free environment, it was bound to go awry, giving its political opponents sufficient justification to close it down. To allow this strategy to work, the government had to be tolerant, open-minded, and learn to act quickly – either setting up a regulatory framework to allow the practice to develop or shutting it down when the experiment turned sour. The policymakers could certainly be guilty of halting promising practices too soon, as well as neglecting to end bad practices. More importantly, since the effectiveness of a practice was sensitive to the institutional environment in which it was tried, a small change in the regulatory environment could make or break it. In addition, a slight modification of the practice itself may turn it from a failure to a success. As a result, whether a new practice would be sanctioned by the government was largely determined by a race between the two sides. On the one side were its proponents, who were trying hard to make it work during the experimental stage, modifying the practice after some trial runs and adjusting the supporting institutional environment within the political perimeters. On the other side, its critics were eager to end it by pointing to the mistakes made during the experimental stage and using them as legitimate reasons to challenge their opponents. For those who wanted to push reform forward by introducing new and viable practices, the most effective method was to experiment as much as possible to find something workable within a limited time window, while recognizing the risk that more mistakes were bound to occur when more experiments were run. Indeed, this was the logic behind Deng’s aphorism, “Don’t argue; try bold experiments and blaze new trails.”

In the case of the stock exchange market, the Chinese government headed by Jiang took a similar stance, but for different reasons. Taking office after the Tiananmen incident, Jiang did not have the political clout to overcome political hostility toward the market-oriented reform and recognize the stock exchange officially. At the same time, he was unwilling or unable to take draconian measures to suppress local experiments already under way. Thus the government officials of Shenzhen were walking a tightrope by allowing the stock exchange to continue without legal regulation or official recognition. It was not until July 3rd, 1991 that Beijing approved the opening of the Shenzhen Stock Exchange.³¹

IV

Despite a few encouraging signs of reform during 1990, the austerity program prevailed and the political atmosphere was largely hostile toward market reform. Throughout the reform era, when a political debate was conducted in China, it was rare to hear the two sides actively trading arguments. More often than not, only one voice would be heard. The voice of the opposition would be muted, seen by the prevailing political forces as incorrect or vulnerable. However, as history has shown, the opposition was merely waiting for the right moment. After a year of continuous attacks on market reform in 1990, it was time for the other side to speak out. On February 15th, 1991, the Liberation Daily, based in Shanghai, published an editorial under a pseudonym, entitled “To Be the Bellwether of Reform and Opening up.” It was followed by three other editorials on March 2nd (“Reform and Opening up Need New Thinking”), March 22nd (“Be Stronger in the Awareness of Opening up”), and April 12th (“Reform and Opening up Need Many Cadres with Both Ability and Integrity”). Taken together, these editorials sent out an unmistakable message that market reform should be restarted.³²

Few people knew at the time that the series of editorials were based on talks Deng had given in Shanghai where he was spending the Chinese New Year. Consequently, the editorials quickly attracted censure from other newspapers and journals, mostly those based in Beijing, directly challenging the views expressed in the four editorials point by point. On April 20th, Current Thought, a monthly journal based in Beijing, published a bold political tirade, “Can Reform and Opening up Disregard the Debate between Socialism and Capitalism?”³³ The article assailed the once-popular view promoted by Deng that China’s economic reform should embrace any measures that helped to improve the economy, whether they were capitalist or socialist. “A disregard of the difference between socialism and capitalism,” the article warned, “would inevitably mislead the reform to the road of capitalism and destroy socialism.”³⁴

As competing views started to engage with one another, this became another rare occasion in China when the political debate was not monopolized by one voice, similar to the 1978 debate on the criterion of testing truth. The first issue of Social Sciences of China in 1991 published an article by Xue Muqiao, entitled “On Several Theoretical Issues of the Socialist Economy,”³⁵ in which Xue criticized the entrenched and erroneous understanding of socialism as meaning economic central planning free of market forces. The Chinese economic system, as Xue argued, was a planned market economy based on the public ownership of the means of production, and planning itself must be based on market principles and economic laws. The domain of planning should be limited to the macro- balance of the economy, including the total social demand and the total social supply and the proportionate relations among various sectors of the national economy. Xue emphatically stressed that the production and circulation of all goods and services should be left to the market.

But there was no question which side dominated, especially in Beijing. The People’s Daily ran an editorial on September 2nd, entitled “Three Questions on the Current Reform.”³⁶ It claimed that “reform and opening to the outside must maintain a correct orientation.” As the article explained,

in carrying out reform, we must uphold the four cardinal principles and must not practice bourgeois liberalization. If we privatize the economy, practice the Western multiparty political system and ideologically abandon the pluralist guide of Marxism-Leninism-Mao Zedong Thought, our party and our country will be in chaos, and all the successes achieved by the party and the people during the past 70 years will come to nought. On this issue concerning the life and death of socialism, we must have a firm and clear-cut stand, and must not have even a little bit of confusion or wavering.³⁷

Another People’s Daily editorial published on October 23rd, “Correctly Recognize Contradictions of the Socialist Society,” used even more radical rhetoric, claiming that class struggle in China – the rivalry between socialism and capitalism – had never been more intense.³⁸

V

China faced the real risk of being trapped again in the snare of ideology. Never before had China’s economic reform faced a grimmer future. At this time, Deng, an eighty-eight-year-old man with no formal position in the Party, the army, or the government, decided to intervene. By then Deng had lost two long-serving protégés, Hu Yaobang in 1987 and Zhao Ziyang in 1989, both of whom had worked hard to push forward the reform agenda from the very beginning, without directly challenging the socialist ideology. And Deng could no longer simply call in the Party General Secretary or the Premier to give his orders.³⁹ With no formal means to exercise his influence in Beijing, Deng had to use indirect means. Accompanied by his family and staff, Deng left Beijing on a train on January 17th, 1992, heading south to the region where market reform had gone furthest, and resistance to Beijing’s austerity program was strongest.⁴⁰

The train arrived at its first stop, Wuchang station in Hubei, the next day. While the train halted for twenty minutes to take on water and load other supplies, Deng briefly met the Party secretary and governor of Hubei province on the station platform, spelling out his concerns.

One of our problems today is formalism. Every time you turn on the television, you see a meeting being held. We hold countless meetings, and our articles and speeches are too long and too repetitious, in both content and language. Of course, some words have to be repeated, but we should try to be concise. Formalism is a kind of bureaucratism. We should spend more time on practical matters. That means saying less and doing more. Chairman Mao never held long meetings, his essays were short and concise and his speeches succinct. When he asked me to draft the work report to be delivered by Premier Zhou Enlai at the Fourth National People’s Congress, he said it should be no more than 5000 Chinese characters. I kept to 5000 characters, and they were enough. I suggest you do something about this problem.⁴¹

Before getting back on the train, Deng gave one last piece of advice to his visitors, who were still trying to absorb his denunciation of formalism: “Do more real work and engage in less empty talk.”⁴² The train made another stop at four o’clock in the afternoon, at Changsha, the capital of Hunan province, where Deng met with the provincial Party secretary. Encouraged by Hunan’s economic growth reported by the secretary, Deng told his visitor to “take bolder measures to carry out the reform, and further speed up the economy.”⁴³

On January 19th Deng arrived at Shenzhen.⁴⁴ Eight years had elapsed since his last visit in 1984. Deng was eager to find out how his boldest experiment had fared, and particularly whether Shenzhen had succumbed to capitalism, as his critics had maintained.

In the next few days, Deng toured the city, visited factories, and met with the provincial authorities of Guangdong and the city officials of Shenzhen. In eight years Shenzhen had been transformed beyond recognition, with high-rise buildings everywhere, heavy traffic on the street, and a buoyant stock market. Deng was pleased with what he saw in Shenzhen. On the 22nd, addressing the municipal government officials, Deng urged them to be open-minded and encouraged them to continue moving forward.

We should be bolder than before in conducting reform and opening to the outside and have the courage to experiment. We must not act like women with bound feet. Once we are sure that something should be done, we should dare to experiment and break a new path. That is the important lesson to be learned from Shenzhen. If we don’t have the pioneering spirit, if we’re afraid to take risks, if we have no energy and drive, we cannot break a new path, a good path, or accomplish anything new. Who dares to claim that he is 100 per cent sure of success and that he is taking no risks? No one can ever be 100 per cent sure at the outset that what he is doing is correct. I’ve never been that sure. Every year leaders should review what they have done, continuing those measures that have proved correct, acting promptly to change those that have proved wrong and tackling new problems as soon as they are identified.⁴⁵

Responding to the prevailing concern that China’s economic reform had introduced too much capitalism, and that China had deviated from socialism, Deng reiterated a theory he had long cherished:

The proportion of planning to market forces is not the essential difference between socialism and capitalism. A planned economy is not equivalent to socialism, because there is planning under capitalism too; a market economy is not capitalism, because there are markets under socialism too. Planning and market forces are both means of controlling economic activity. The essence of socialism is liberation and development of the productive forces, elimination of exploitation and polarization, and the ultimate achievement of prosperity for all. This concept must be made clear to the people. Are securities and the stock market good or bad? Do they entail any dangers? Are they peculiar to capitalism? Can socialism make use of them? We allow people to reserve their judgment, but we must try these things out. If, after one or two years of experimentation, they prove feasible, we can expand them. Otherwise, we can put a stop to them and be done with it. We can stop them all at once or gradually, totally or partially. What is there to be afraid of? So long as we keep this attitude, everything will be all right, and we shall not make any major mistakes. In short, if we want socialism to achieve superiority over capitalism, we should not hesitate to draw on the achievements of all cultures and to learn from other countries, including the developed capitalist countries, all advanced methods of operation and techniques of management that reflect the laws governing modern socialized production.⁴⁶

Deng was certainly not the first to recognize common ground between capitalism and socialism. “Market socialism” – an economy in which firms are all owned by the state but sell their products to consumers in a competitive market – had long been debated among scholars and experimented with in Eastern Europe in the 1950s and 1960s. In China, Gu Zhun, Sun Yefang, and other economists had earlier stressed that socialism as a viable economic system had to observe basic economic principles. But as a political leader, Deng went far beyond the familiar boundary of market socialism. There was no ism, no dogma of any kind to defend in Deng’s view of socialism.⁴⁷ Socialism was, rather, an open system that should “draw on the achievements of all cultures and learn from other countries, including the developed capitalist countries.” Socialism was no longer exclusively identified with collective ownership and central planning. Rather, “the essence of socialism” was “the ultimate achievement of prosperity for all.” At a time when the Chinese leadership was anxious to preserve socialism and ward off capitalism, Deng simply set aside a meaningless and distracting ideological debate and focused on the practicalities of moving the Chinese economy forward.

After Shenzhen, Deng continued his southern tour, reaching Zhuhai on the 23rd. This was another Special Economic Zone in Guangdong province, opposite Macau. Deng spent a week in Zhuhai, visiting a number of high-tech firms and meeting the local officials. He continued to press government officials for economic development.

It seems to me that, as a rule, at certain stages we should seize the opportunity to accelerate development for a few years, deal with problems as soon as they are recognized, and then move on. Basically, when we have enough material wealth, we shall have the initiative in handling contradictions and problems. For a big developing nation like China, it is impossible to attain faster economic growth steadily and smoothly at all times. Attention must be paid to stable and proportionate development, but stable and proportionate are relative terms, not absolute. Development is the absolute principle. We must be clear about this question. If we fail to analyze it properly and to understand it correctly, we shall become overcautious, not daring to emancipate our minds and act freely. Consequently, we shall lose opportunities. Like a boat sailing against the current, we must forge ahead or be swept downstream.⁴⁸

Addressing the deep-rooted tension between the “Left” and “Right” tendencies within the Party, Deng emphatically warned against the danger of the “Left,” deviating from the entrenched view held by Chinese Communist leaders since the birth of the Party.

At present, we are being affected by both the “Right” and “Left” tendencies. But it is the “Left” tendencies that have the deepest roots. Some theorists and politicians try to intimidate people by pinning political labels on them. That is not a “Right” tactic but a “Left” one. “Left tendencies” have a revolutionary connotation, giving the impression that the more “Left” one is, the more revolutionary one is. In the history of the Party, those tendencies have led to dire consequences. Some fine things were destroyed overnight. “Right tendencies” can destroy socialism, but so can “Left” ones. China should maintain vigilance against the “Right” but primarily against the “Left.” The “Right” still exists, as can be seen from disturbances. But the “Left” is there too. Regarding reform and the open policy as means of introducing capitalism, and seeing the danger of peaceful evolution towards capitalism as coming chiefly from the economic sphere are “Left tendencies.” If we keep clear heads, we shall not commit gross errors, and when problems emerge, they can be easily put right.⁴⁹

On January 30th, Deng left Zhuhai for Shanghai, the last stop of his southern tour. The Pudong Development Zone had broken new ground less than two years earlier. Shanghai, the economic and financial center of China before 1949, clearly lagged behind Shenzhen, which, before the reform started, had been no more than a fishing village. Deng was apologetic to his hosts.

In developing the economy, we should strive to reach a higher level every few years. Of course, this should not be interpreted as encouraging unrealistic speed. We should do solid work, stressing efficiency, so as to realize steady, coordinated progress. Guangdong, for example, should try to mount several steps and catch up with the “four little dragons” of Asia in twenty years. In relatively developed areas such as Jiangsu Province, growth should be faster than the national average. Shanghai is another example. It has all the necessary conditions for faster progress. It enjoys obvious advantages in skilled people, technology and management and can have an impact over a wide area. In retrospect, one of my biggest mistakes was leaving out Shanghai when we launched the four special economic zones. If Shanghai had been included, the situation with regard to reform and opening in the Yangtze Delta, the entire Yangtze River valley and, indeed, the whole country would be quite different.⁵⁰

When Deng was taking his southern tour, China had reached a pivotal time in the course of its economic reform. The new Chinese leadership that emerged after the 1989 Students Movement was cautious, hesitant, and drifting, distracted by domestic economic and political instability and disoriented by the fall of the Soviet bloc. Beijing’s vehement criticism of the editorials in the Liberation Daily must have disturbed Deng deeply. It was at this juncture that Deng took it upon himself to rekindle the embers of China’s market reform. In essence, Deng’s main message on his southern tour was to encourage further reform to save China’s second revolution. Tian Jiyun, Vice Premier between 1983 and 1993, wrote in 2004 that “Deng Xiaoping observed with cold eyes for three years [1988–1991]. He could no longer remain silent, however, seeing the reform and opening up that he advocated was in danger of collapsing. He was determined to visit the south, and make the southern tour speeches, shocking China and the outside world alike.”⁵¹

Deng’s southern tour was kept a secret at the time. The Chinese media was totally silent on the affair. More than a month after Deng returned to Beijing, the Shenzhen Special Zone Daily ran a long article on Deng’s tour on March 26th. The Xinhua News Agency broadcast the whole paper on the 30th. The next day, the article reappeared in many national and local newspapers, and in the evening program on the same day, Chinese Central Television broadcast the whole article. Deng’s southern tour and the many talks he had given quickly attracted national attention. At the time, when market reform was still under severe political attack, Deng’s unequivocal endorsement of the market and unreserved call for further reform compelled Beijing to act. But as Deng no longer held any formal position, his talks had to be backed by Beijing before they could exercise any real influence on central government policy.⁵² As Deng’s talks were publically circulated, opposition to market reform began to decline but still persisted. On April 14th, the People’s Daily published a long combative article entitled “Firmly, Accurately, and Comprehensively Implement the Party’s Basic Line.”⁵³ It urged China to maintain “vigilance against bourgeois liberalization” in order to avoid the fate suffered by Eastern Europe and the Soviet Union. On April 25th, 1992, Vice Premier Tian Jiyun took a lead in endorsing and elaborating on the speeches Deng had given during his southern tour.⁵⁴ In a talk at the Central Party School, Tian launched a direct attack against both leftists who openly opposed market reforms and those who “bend with the wind.” They should go and live in a “special leftist zone,” as Tian put it, with a purely planned economy and shortage and rationing everywhere. Tian’s talk was videotaped and copies were quickly on sale on the streets of Beijing.

Clearly Deng was not Mao; China in 1992 was different from China in 1966. Three months after his return to Beijing, Deng visited the Capital Steel Corporation on May 20th. Addressing the managerial team and city officials, Deng remarked that “in regards to my talk, some people oppose it, some people take a wait-and-see attitude, and some people have been wholeheartedly working on it.”⁵⁵

In the many speeches he made on his tour, Deng was clearly preoccupied with the stagnant economic reform and urged more daring initiatives to restart it. But China faced another, more fundamental challenge: how to reconcile socialism with its policies of economic reform and opening up. The seeming contradiction between a continuing political commitment to socialism on the one hand, and market reform on the other, had confused many Chinese leaders and ordinary people, particularly those who remained loyal to orthodox Marxism. For generations of Party members who had grown up knowing nothing else but the doctrines of socialism, the market reform must have profoundly challenged their political beliefs and created some confusion. If Deng wanted to succeed in “keeping clear heads,” he also had to fight a battle of ideas.

In Zhuhai, Deng warned the local leaders in plain language that what threatened Chinese socialism most was not the “Right tendencies,” but the “Left tendencies.” This was a radical departure from the views held dear by Chinese leaders that capitalism (or the “Right” in Chinese political terminology) was the number one enemy of socialism. As a devoted Party member, Deng never abandoned his political belief in Marxism. Yet he creatively redefined Marxism to make it not only compatible with China’s market reform, but an indispensable epistemic requirement.

In studying Marxism-Leninism we must grasp the essence and learn what we need to know. Weighty tomes are for a small number of specialists; how can the masses read them? It is formalistic and impracticable to require that everyone read such works. It was from the Communist Manifesto and The ABC of Communism that I learned the rudiments of Marxism. Recently, some foreigners said that Marxism cannot be defeated. That is so not because there are so many big books, but because Marxism is the irrefutable truth. The essence of Marxism is seeking truth from facts. That’s what we should advocate, not book worship. The reform and the open policy have been successful not because we relied on books, but because we relied on practice and sought truth from facts. It was the peasants who invented the household contract responsibility system with remuneration linked to output. Many of the good ideas in rural reform came from people at the grassroots. We processed them and raised them to the level of guidelines for the whole country. Practice is the sole criterion for testing truth. I haven’t read too many books, but there is one thing I believe in: Chairman Mao’s principle of seeking truth from facts. That is the principle we relied on when we were fighting wars, and we continue to rely on it in construction and reform. We have advocated Marxism all our lives. Actually, Marxism is not abstruse. It is a plain thing, a very plain truth. (italics added)⁵⁶

Here, Deng demonstrated the pragmatism he shared with Chen Yun, making an indirect reference to Chen’s adage, “do not rely on higher authorities, do not rely on books, but rely on facts.” Since Chen was widely respected in the Party as a staunch defender of socialism, Deng reached out to Chen to rebuild the political coalition for reform. Even though practice was highly stressed by Marx, and he and his disciples preferred materialism to idealism, no Marxist had ever placed such a heavy emphasis on seeking truth from facts.

Mao, of course, had written an influential article in 1937 called “On Practice,” which had been widely circulated and must have been carefully studied by Deng. Concluding the article, Mao wrote:

Discover the truth through practice, and again through practice verify and develop the truth. Start from perceptual knowledge and actively develop it into rational knowledge; then start from rational knowledge and actively guide revolutionary practice to change both the subjective and objective world. Practice, knowledge, again practice, and again knowledge. This form repeats itself in endless cycles, and with each cycle the content of practice and knowledge rises to a higher level. Such is the whole of the dialectical-materialist theory of knowledge, and such is the dialectical-materialist theory of the union of knowing and doing.⁵⁷

But Mao’s view on practice was tainted and severely debilitated by his class analysis. Mao believed dogmatically that the practice and knowledge of the politically progressive class, the proletariat, was superior to that of the bourgeoisie. This philosophy of class struggle had been absorbed into the blood of the Party. It gave the Party an identity as the self-claimed vanguard of the Chinese people in a revolutionary war for national independence. This self-serving rhetoric would have led the Party to isolation and self-destruction if it had not always been balanced in practice by Mao’s persistent efforts to build what he called a “united front” before the Chinese Communist Party took power in 1949. Once in power, however, Mao felt no more need for the united front and the virulent ideology of class struggle was quickly instilled to penetrate every part of Chinese society. Terror and violence were sanctioned against anyone who was viewed as a class enemy. In its most ludicrous form, as seen during the Cultural Revolution, knowledge in the hands of the bourgeois class was denounced as useless and treacherous. It was thought that it was better to be an ignorant member of the proletariat than an educated petty bourgeois. In rejecting class struggle and stressing practice as the only criterion of testing, the Chinese economic reform started on a sound epistemic foundation.

In his re-embracing of pragmatism Deng tried to make his interpretation of Marxism compatible with Mao’s teachings, while still downplaying the idea of class struggle. But Deng acted too generously when he attributed the principle of seeking truth from facts to Mao or Marxism. Mao clearly popularized this principle, making it the motto for the Anti-Japanese Military and Politics University in 1937, and later the Central Party School in 1947. But Mao picked up the principle of seeking truth from facts from the Yuelu Academy in Changsha – Mao was a student there between 1916 and 1919 – which also used the principle as the school motto. Around the same time, Beiyang University, the predecessor of today’s Tianjin University, also adopted “seeking truth from facts” as its motto. However, this principle has deep roots in Chinese history. It first appeared in the writing of a famous Chinese historian during the Han Dynasty, Ban Gu. In the Song Dynasty, Zhu Xi, the neo-Confucian thinker, proclaimed that “investigating of things is the surest way to gain knowledge” and that “theoretical principles lie in practical affairs.” If “seeking truth from facts” serves as a prescription, an even older teaching of Confucian philosophy, traced to Mencius, serves as its proscriptive counterpart: “better not to have it if we accept everything a book says.” Together, these principles cultivated a strong anti-dogmatic tendency in Chinese habits of thought. To reach any decision in practical affairs, so the principles say, requires thorough investigation of the facts in the first place; this is indeed a plain truth.

Deng’s reinterpretation of Marxism in line with the pragmatic spirit of Confucianism provided a solution to the ideological predicament that had constrained and confused the Chinese since the very beginning of reform: how could socialism and market reform coexist? By defining the essence of Marxism as seeking truth from facts, Deng simplified Marxism and turned it from an “abstruse” political ideology into “a plain truth.”

VI

The private sector responded quickly and enthusiastically to Deng’s call for further reform. Having been beset by ideological hostility since the austerity program began in 1988, the private sector bounced back strongly. By 1993, the number of private firms rebounded to 1988 levels, reaching 237,000. By 1994, that number was 432,000, and the amount of capital registered under private firms increased by almost twenty times between 1992 and 1995.⁵⁸ As the private sector enjoyed its resurgence, it attracted more and more talent from the state sector. This prompted a great reversal of social attitudes. Throughout the 1980s jobs in the private sector had been looked down on as insecure, disrespectable, and dishonorable. Even Hu Yaobang’s campaign of 1983, which sought to elevate the social status of the private sector by calling it a “glorious project,” failed to change public opinions. After Deng’s southern tour, people began to vote with their feet, leaving the state sector for the private sector. The most eye-catching development in the wake of Deng’s southern tour was the phenomenon of “xiahai” – government officials, managers, and employees of state-owned enterprises, and scholars at universities and research institutes, letting go of their “iron bowl” to open their own private businesses. According to the Ministry of Personnel, 120,000 government officials left their jobs in 1992 to start private businesses. In addition, there were more than 10 million government officials taking unpaid leave to start up a private business.⁵⁹ They were joined by millions of professors, engineers, and college graduates. Even the People’s Daily published an article that year entitled “Want to Get Rich, Get Busy.”⁶⁰

As Deng’s southern tour became more widely publicized and his speeches were being read all over China, the ideological opposition to reform started to fade and the political atmosphere changed once more; 1992 eventually became “the year of reform and opening up.”⁶¹ On March 20th, Premier Li announced that the austerity program had accomplished its task and the stage of readjustment was to end. This opened the door to further reforms. After three years of retraction, the pendulum of reform began to swing ever higher once it was released again.

After almost a year of preparation, the Fourteenth Congress of the Chinese Communist Party opened on October 12th, 1992. Deng’s call for further economic reform was fully embraced. Jiang Zemin, in addressing the Party Congress, called for “quickening the pace of reform, opening up and modernization and striving for greater success in building socialism with Chinese characteristics.”⁶² Most important, the market economy was, for the first time, officially recognized as the ultimate goal of China’s economic reform. After the torrent of anti-market rhetoric and policies that had swept through China in the preceding years, Jiang’s endorsement of the market economy reaffirmed China’s commitment to market reform. Compared with the 1984 Decision on Economic System Reform passed at the Third Plenum of the Twelfth Central Committee of the Party, which sanctioned the presence of a market economy in China’s economic reform, it was accorded a much more elevated role by Jiang. However, Jiang stopped short of fully adopting Deng’s pragmatic stance. In Jiang’s speech, China’s market economy was qualified as “socialist”; the tension between socialism and the market persisted and would occasionally erupt in the years to come. Nonetheless, sixteen years after Mao’s death (1976) and thirty-six years after the socialist transformation (1956), China finally embraced (or re-embraced) the market economy.

The most serious defect of China’s economic reform in the 1980s was the lack of price reform, which had resulted in chaotic pricing, massive resource misallocation, and economic disorder. Even though the Chinese government was aware of the urgency of price reform, it missed a window of opportunity in the early 1980s, and opted for a compromise strategy, the dual-track pricing system. When the government finally attempted to force through price reform in 1988 it failed mainly because of unfavorable macroeconomic conditions. Not surprisingly, the most urgent demand made of China’s developing market economy was to reform the distorted price system.

In 1992 the Chinese government took a series of decisions that would ultimately abolish price control. The list of prices for raw materials, capital goods, and transportation services to be set by the central government was reduced from 737 to 89 (it would be further reduced, to 13, in 2001).⁶³ The market for grain was fully liberalized nationwide at the end of 1992. The National Planning Commission halved the mandatory production plan for 1993, leaving more room for market forces to operate. China also significantly reduced the import tariffs for more than 3000 items, beginning at the end of 1992. The process of price deregulation would continue throughout the coming years. In 1993, the dual-pricing practice used for steel and machinery products was ended; in 1994, dual pricing for coal and crude oil ended. By 1996, the dual-track pricing for industrial inputs became history.⁶⁴ The share of producer goods transacted at market prices increased steadily from almost zero in 1978, to 13 percent in 1985, 46 percent in 1991, and 78 percent in 1995.

The removal of price controls was greatly helped by the presence of a strong private sector which had been working for more than a decade to bring about a functioning price system. In this regard, the use of dual-track pricing was an advantage; prior to price deregulation both private and state-owned enterprises had already been more or less exposed to the market and had become familiar with the operation of market forces. By allowing economic actors to become familiar with the market, the dual-track pricing practice had reduced the cost of adjustment and learning, particularly for state-owned enterprises. The downside was a lengthened period of chaotic pricing for all, which not only brought about severe macroeconomic distortions, but also made it difficult for firms to respond to price signals. Moreover, the price discrimination suffered by non-state enterprises also led to resource misallocation. Yet it is difficult to assess how price reform would have fared without the transition period of dual-track pricing, making it almost impossible to fully evaluate the net welfare gain caused by dual-track pricing. Nonetheless, after several years of dual-track pricing, the introduction of the 1992 price reform went more smoothly than the Chinese government had expected, with few noticeably disruptive effects on society.

In the Party’s embrace of the market economy, the 1992 price reform was by far the most critical step in developing a market system. Now, the price signal was able to function the way it does in any market economy, informing firms of what to produce to meet the demand of consumers and allocating resources to where they could be utilized most profitably. With a few exceptions, all firms, including both state and private enterprises, started to pay the same prices for all their materials. The black market for raw materials that had flourished under the dual-track system contracted rapidly. Private enterprises now had open access to all raw materials and intermediate inputs (with the one exception of bank loans).

But price liberalization did not automatically give birth to a functioning pricing system across all markets. Price deregulation helped to remove the distortions that had severely undermined the price system; it made possible the rise of a market-based pricing system. But when and how the system developed depended on a large number of factors. In general, a market price emerged quickly for all those goods that had been subject to dual-track pricing. When the economics textbook draws a supply curve intersecting a demand curve, the market price is magically determined at the point of intersection. But the two curves, or what Alfred Marshall called the two blades of the scissors, do not readily exist in the market economy, not in the way that business firms do once they are created. The demand and supply curves are theoretical concepts; the real movers behind them are consumers and business organizations. The conventional emphasis placed on demand and supply in the economics textbook as the moving forces in the market is thus misleading, if it is accepted literally. Rather, demand and supply forces result from the continuous process of bidding and tendering between buyers and sellers, who are constantly alert to changing opportunities. After price liberalization, it did not take long for a market price to emerge for those goods and factors with existing buyers and sellers; they had some experience of bargaining with each other under the dual-track regime. But for capital assets, which had never had a market under socialism, it was a wholly different matter. For example, how should one price an insolvent state-owned enterprise? For all goods and factors that had not previously been subject to market evaluation, it would take much learning and risk-taking on the part of buyers and sellers for prices to emerge.

VII

While freedom to set prices helped to remove many price distortions, as well as barriers among firms when they engaged in market transactions, there existed another kind of barrier standing between the state and firms in the Chinese economy. The wide use of managerial contracts in state-owned enterprises presented a prohibitive obstacle for the rise of market order during the 1980s.

The adoption of the managerial contract responsibility system in enterprise reform formalized the earlier effort of “delegating rights and sharing profits”; the goal had been to give more autonomy to the enterprises. The use of a contract between the management of a state enterprise and its supervising authority was easy to set up once the idea of the contract responsibility system became common knowledge after the implementation of the household responsibility system in rural China. This explains its wide use in enterprise reform in the 1980s.

While the household responsibility system had set Chinese peasants free, the responsibility contract failed to free Chinese state enterprises from bureaucratic red tape. With the spread of the contract responsibility system, each enterprise struck an individually negotiated contract with the state or its local agent. As a result, each enterprise ended up with a highly idiosyncratic set of constraints – what inputs to receive at what subsidized price, how much tax to pay, and so on.⁶⁵ In addition to dual-track pricing, this was another important source of price distortion in the Chinese economy. Due to their combined effects, the Chinese economy lacked a unified pricing system for all enterprises throughout the 1980s.

Under the managerial contract responsibility system, each enterprise, including those in the private sector, faced a different set of prices and tax rates. Indeed, taxes did not exist for the state-owned enterprises until 1983. The government simply collected all their profits as its main source of revenue. In 1983, the state-owned enterprises began to pay taxes instead of turning over their profits to the government. This ended a practice that had endured since the founding of the People’s Republic. However, a problem remained. The amount of tax was included in the managerial responsibility contract and the tax rate varied across industries and enterprises, even after the 1983 tax reform.⁶⁶

Moreover, the contract system was also utilized by the central government in collecting taxes from the provincial governments throughout the 1980s. This was first introduced in 1980 to give more autonomy and incentives to local governments. Despite repeated changes made throughout the 1980s, China did not have a unified tax structure and the fiscal relations between the central and provincial governments varied on a case-by-case basis until the tax reform of 1994. Some provinces paid a certain fixed amount of tax to (or received a fixed amount of subsidy from) Beijing; other provinces were taxed at a certain rate, which was often open to negotiation every few years. This inequality in the tax burden across provinces was a constant source of discontent, particularly among provinces that were at a similar level of economic development. Since a provincial government with a light tax burden would end up with less pressure to tax the firms under its jurisdiction, the tax system (or rather its absence) contributed significantly to the chaotic pricing system in the 1980s.⁶⁷

The old tax system had another weakness, at least as seen from Beijing. Ever since the beginning of reform there had been a significant decline in government revenues. To make things worse, the proportion of government revenues collected by Beijing also went down. For example, the government’s fiscal revenue represented 27 percent of GDP in 1979. It declined to 21 percent in 1986 and was down to 14.5 percent by 1992. During the same time period, the revenue going to Beijing declined from 46.8 percent of total revenue in 1979 to

38.6 percent in 1992, while the share of revenue left to local governments increased.⁶⁸ As a result, the Chinese government ran deficits during most of the years of reform.

To address both price distortions in the economy, and its declining fiscal strength, the Chinese government in 1993 decided to overhaul the old contract-based tax and fiscal regime. This came after experiments carried out in nine provinces or cities in 1992. Zhu Rongji, Vice Premier in charge of economic affairs, was directly responsible for mobilizing support from both Beijing and provincial governments, and for renegotiating a new fiscal and taxation system. In the first part of 1993, Zhu convened many meetings in Beijing to reach a consensus among all ministers and central government offices involved in taxation and fiscal policies.⁶⁹ From September 9th to November 21st, Zhu visited seventeen provincial governments to secure their support. On December 25th, the State Council announced the new tax system, to be implemented on January 1st, 1994.⁷⁰

The comprehensive tax reform of 1994 represented another critical step towards the removal of price distortions in the Chinese economy.⁷¹ These reforms consisted of three main components: tax simplification, tax sharing, and tax administration. The most noticeable aspect of the 1994 tax reform was the replacement of a complicated multi-tiered system of taxes on turnover by a uniform 17 percent (with a few exceptions when the rate was 13 percent) valued-added tax, applied to all manufacturing firms. A business tax was applied to services, at a rate of 3 or 5 percent of turnover depending on the nature of the business. The new tax code simplified an extremely complicated tax structure. For example, under the previous tax regime, there had been twenty-one different rates of product tax, ranging from 3 to 60 percent, and four business tax rates, ranging from 3 to 15 percent. The new tax code also eliminated the tax previously applied to foreign enterprises, which had forty rates ranging from 1.5 percent to 69 percent. As a result of these simplifications, the 1994 tax reform removed severe price distortions created by the previous tax regime, putting an end to redundant investments in sectors with lower tax rates and artificially high profit margins.

The second component of the 1994 tax reform was the establishment of a national tax administration, which greatly improved the state’s capacity to collect taxes. The tax revenue collected by the government as a percentage of the GDP increased from about 10 percent in 1995 to 15 percent in 2002 and has remained between 15 and 20 percent ever since; about half of it goes to the central government.⁷²

The third component of the new tax regime was to end the individually negotiated system of revenue sharing between the central government and provincial governments, and to introduce a new uniform tax-sharing scheme. Under the new tax regime, some taxes were assigned to the central government, including excise taxes, customs duty and enterprise income tax collected from financial institutions. Others were assigned to the local government, including urban land-use tax, valued-added tax on land, property tax, and business tax not covered by the value-added tax. Some were shared; these included the value-added tax (75 percent for the central and 25 percent for local government).

Even though all taxes introduce price distortion in an economy, the new tax-sharing scheme was critical in removing preexisting market distortions. The most fundamental change occasioned by the new tax system was to free Chinese firms from the direct and immediate impact of the central government’s fiscal policy, separating the microeconomic environment from the government’s macroeconomic policy. Under the previous tax system, the fiscal and taxation policy was an important component of the constraints that each Chinese firm faced, which was decided on individual negotiation. The 1994 tax reform greatly helped to create a competitive microeconomic environment for all Chinese firms. This was achieved in two steps.

First, recall that under the previous revenue-sharing scheme, all taxes were first collected by the provincial government, which then turned over to Beijing a certain percentage or a fixed amount in accord with an individually negotiated agreement. Since the new tax regime was to apply uniformly across China, it closed the door to favoritism and put all provinces (and enterprises under their jurisdiction) on an equal footing. Second, by eliminating the product tax, the new tax-sharing scheme weakened the incentives for local governments to pursue protectionism.⁷³ The product tax was paid by the enterprises to local governments based on sales irrespective of their profitability, and was introduced in the 1983–1984 tax reform. It has since become the main source of revenue for local governments. Prior to the new tax reform, local governments had strong incentives to protect their enterprises from outside competition, effectively fragmenting the national economy. As long as the enterprises were in operation, they had to pay product taxes to local governments even when they did not make any profit. After the new tax reform, the value-added tax became the main source of revenue, and enterprises had to be profitable to pay the value-added tax. As a result, the 1994 tax reform helped in reducing market distortions. This turned out to have far-reaching effects, transforming regional economic dynamics from chaotic fiefdoms into a sustainable and efficient competition. Now, local governments competed against each other to attract investment by improving their infrastructure and business environment. Regional competition has been primarily responsible for China’s remarkable economic dynamics since the mid-1990s. How this came to be and the role local governments played will be our focus later in this chapter.

VIII

After Deng’s southern tour and the Fourteenth Congress of the Party, the 1992 price reform and 1994 tax reform helped to reduce or eliminate many price distortions and pave the way for the rise of a single price system in the economy and a common national market. At the same time, another wave of enterprise reform was spreading all over China. With the endorsement of a market economy as the ultimate goal for China’s economic reform in 1992, the proponents of enterprise reform gained a new mission: turning state-owned enterprises into independent, autonomous, and market-oriented economic entities. This pushed the Chinese enterprise reform to a new stage, beyond the basics of “delegating rights and sharing profits” and the contract based managerial responsibility system. Building a modern enterprise system freed from government intervention and disciplined by the market became the goal of the next stage of enterprise reform.

At first glance, this whole idea appeared counterintuitive. How could a state-owned enterprise be kept free of state meddling? There existed an inherent dilemma in the enterprise reform: a state-owned enterprise could not possibly free itself fully from the state. How was it possible to turn state enterprises into autonomous profit-seeking business firms while they were still owned by the state? What could be realistically hoped for was to cut down bureaucracy and red tape, streamline the relationship between the government and state enterprises and subject state enterprises to market competition. In addition, the number of state-owned enterprises had to be reduced, since the majority of them were already insolvent and had become a financial burden to the state. As we will see later, this was exactly what the Chinese government was able to achieve.

In some ways, a state-owned enterprise under socialism might look like a publicly listed company under capitalism. In both cases, the owners of the firm are faceless. A state enterprise belongs to “all the people,” a public company belongs to shareholders. Management is separate from ownership in both cases. This similarity had been frequently stressed by defenders of state ownership in China. What was ignored was the fact that the operation of a publicly traded company depends on a whole set of legal and economic institutions, which in the West have developed over centuries. Still, scandals in the western corporate world frequently surface when management blatantly abuses its power and violates its fiduciary duty of care and loyalty to shareholders. The difficulties that the Chinese state-owned enterprises faced reflected more the deficiency of the state in establishing a proper regulatory framework than the defects of the enterprises themselves.

The embrace of the market economy by the Chinese government in 1992 could not, and did not, deal a quick death to the ideas of socialism that had long formed the established way of thinking for many Chinese leaders, economists, and ordinary citizens. In any case, what the Chinese government had instituted was, as they put it, “a socialist market economy.” State ownership was still widely believed to be the economic foundation for the political rule of the Party. This strong and persistent political preference for state ownership made privatization the last choice for enterprise reform. In addition, this ideological bias against privatization was bolstered by an ingrained cultural prejudice. In the Chinese context, the word “public” (or gong in Chinese) is closely associated with public spirit and sacrifice for the common good. The word “private” (or si in Chinese), on the other hand, falls into the swamp of moral low ground. Throughout the 1980s and 1990s, the word “private” was almost a taboo in public discourse. Chinese private enterprises, for example, were referred to as “people’s enterprises” in contrast to state enterprises. The political and cultural hostility toward privatization was strong.

On the other hand, by the mid-early 1990s, after more than a decade of enterprise reform, more and more state-owned enterprises had sunk into insolvency. They had become a growing financial burden to the Chinese government. It was reported that in 1988 about 10.9 percent of state enterprises were insolvent. The rate rose to 16 percent in 1989, 27.6 percent in 1990, over 30 percent in 1993, and 40 percent in 1995.⁷⁴ A survey of state enterprises in 16 big cities, including Shanghai, Tianjin, Shenyang, and Wuhan, jointly conducted by nine central government ministers and bureaus in 1994 revealed that 52.2 percent of state enterprises were insolvent.⁷⁵ At the same time, the share of state enterprises in industrial production plummeted from 77.6 percent in 1978 to 54.6 percent in 1990 and 34 percent in 1995.⁷⁶ In 1980, covering the losses of state enterprises accounted for 3.1 percent of government fiscal revenues; in 1994, it went up to 9.3 percent. Chinese economists and policymakers alike were compelled to ask themselves what had gone wrong with the previous rounds of enterprise reform. What prevented the state enterprises from growing with the private firms and township and village enterprises?

The most striking symptom observed among state enterprises at the beginning of reform was their lack of “vitality.” The expansion of autonomy and the implementation of the managerial responsibility contract were intended to improve the incentives of workers and managers, injecting more “vitality” into the state enterprises. Under the dictates of socialism, the reform did not touch the ownership structure. State-owned enterprises, from the legal point of view, belonged to all the people. But economic resources open to everyone belong to no one, a situation which Chinese economists called “the absence of owner” in state ownership. At the time, Chinese economists drew much theoretical inspiration from a growing school of thought in modern economics, the economics of property rights, as mainly developed by Armen Alchian, Steven Cheung, Harold Demsetz, Douglass North, as well as Ronald Coase. What the Chinese economists and policymakers found particularly relevant was the idea that the delineation of rights is a precondition for a market economy.⁷⁷ If China was moving toward a market economy, it had to clearly define all property rights. This basic idea of property rights economics thus suggested a convenient way to “get property rights right” without changing the ownership structure via privatization.

While the Chinese government shied away from letting broken state enterprises close and economists debated the issue of property rights, Zhucheng, a small county-level city in Shandong, quietly privatized 272 out of its 288 state or collective enterprises. This happened between late 1992 and mid-1994.⁷⁸ Chen Guang, who became mayor of the city in 1991 and Party Secretary in 1993, oversaw this radical episode of enterprise reform. As mayor, Chen quickly found out that the majority of state enterprises were actually insolvent and had to rely upon government subsidies to survive. The local government, however, could no longer afford to subsidize the loss-making state enterprises. The first state enterprise was sold to its employees in December 1992. To stay in line with state policy, which then prohibited outright sale of state assets, the city government originally proposed to retain 51 percent of the share, selling the rest to managers and workers. This proposal, however, was rejected by the employees, who wanted outright control. In the end, the employees bought out the whole enterprise, with a contribution of 90,000 yuan from each of the nine members of the managerial team, 20,000 yuan from each of the twenty or so middle-level administrative staff, and 6000 yuan from each of the 250 or so workers. The new enterprise was registered as a “stock cooperative.” It was not until after the Third Plenum of the Fourteenth Central Committee in 1993 that stock cooperatives become recognized as a tool to restructure state enterprises. After most of the state enterprises being privatized or simply closed, Chen faced little resistance in abolishing five government bureaus formerly in charge of administering state enterprises.

Around the same time, a similar scheme of restructuring state and collective enterprises was underway in several other small or medium-sized cities, including Shunde in Guangdong province, Haicheng in Liaoning province, Yibing in Sichuan province, Bing County in Heilongjiang province, Shuozhou in Shanxi province, Dongbo in Henan province, Ningde in Fujian province, and Nantong in Jiangsu province.⁷⁹ However, none of these initiatives received much media attention. For the rest of the 1990s, Chen Guang and Zhucheng remained causes of controversy at the center of national debates on enterprise reform. In a policy paper published in Beijing in early 1995, the enterprise reform conducted at Zhucheng was criticized as “privatization” and “taking the capitalist road.”⁸⁰ As late as 2001, an article published in a journal based in Beijing criticized Chen for “destroying socialism.”⁸¹ In July of the same year, Zhucheng was approved in a provincial meeting on enterprise reform organized by the provincial Party Secretary and Governor. In January 1996, a delegation of twenty-three members from nine different Ministries was sent by Zhu Rongji, Premier of the State Council, to visit Zhucheng for a week.⁸² Their report enthusiastically approved the Zhucheng experience of restructuring state enterprises. In March, Zhu himself led a delegation to Zhucheng, visiting many restructured enterprises. After his visit, Zhu pointed out some shortcomings in Zhucheng’s enterprise reform, but praised it as a model that deserved serious consideration for other cities.

In the early 1990s Shanghai developed a different approach to reforming big state enterprises. Shanghai had long been China’s economic center, including during the socialist period. The rise of Shenzhen and the Pearl River Delta in Guangdong province in the 1980s had significantly reduced the relative economic status of Shanghai. Nonetheless, Shanghai was home to many of the largest state enterprises. Moreover, the setup of Pudong as a new Special Economic Zone in 1990 and the rapid economic development in Zhejiang and Jiangsu provinces gave Shanghai a new mission. To reform their state enterprises, most of which had been the pride of China during Mao’s time, officials from Shanghai visited several western European countries to study how they managed their state assets.⁸³ Afterward, they formulated a new plan for Shanghai.

The innovation was to set up a new government agent, the State Assets Management Committee, which would take over all state enterprises that used to be run by various government departments. The Committee established a number of state asset management companies, each becoming an investor and owner of many state enterprises. A small number of critically important state enterprises were owned singly or jointly by state asset management companies. For a bigger but still limited number of less important state enterprises, state asset management companies would hold majority control, but welcome private investors. All others – by far the largest group – were turned into limited liability corporations and joint-stock companies. Usually these had a diverse structure of owners, including other state enterprises, foreign investors, and domestic firms and individuals. Many small and medium-sized state enterprises were simply liquidated. As a result, their number was cut dramatically. Even those remaining were separated from direct government control and put in the hands of a few state asset management companies. In principle, the state asset management company would behave like a private investor, subject to certain political constraints. Moreover, all state asset companies reported directly to the State Assets Management Committee, slashing the bureaucratic red tape that had plagued state enterprises in the past.

The practices of both Zhucheng and Shanghai were incorporated into the “Decision on Issues Regarding the Establishment of a Socialist Market Economic System,” which was passed at the Third Plenum of the Fourteenth Central Committee of the Party in November 1993. This meant that those practices were now part of the main approach to reforming state-owned enterprises. The strategy was then called “holding on to the big and letting go the small.” Until then, the Chinese government had been firm in resisting privatization despite a rapidly growing private sector and the failure of previous enterprise reforms to revitalize state enterprises.

IX

In addition to ideological considerations, several practical reasons had been significant enough to hold back privatization. The most constraining factor was concern about massive unemployment and its dire social and political consequences. Throughout the 1980s and early 1990s, China did not have a functioning labor market to absorb or retrain laid-off workers if state enterprises should be privatized. Hence, the Chinese government forbade state-owned enterprises from laying off their workers during restructuring. At a conference held in Beijing in 1994, Vice Premier Zhu Rongji challenged a dozen or so Chinese and foreign economists in the audience to work out a strategy of enterprise reform without massive layoffs of state employees. Anyone who could come up with a solution, according to Zhu, would surely deserve a Nobel Prize.⁸⁴ Because of this concern of social stability, even though China passed its first Bankruptcy Law at the end of 1986, over the next five years, only twenty-seven enterprises declared bankruptcy.⁸⁵ Not surprisingly, a common method used to privatize small and medium-sized state enterprises was to sell them to their managers and employees, with no or limited layoffs. Essentially, this was similar to the previous round of enterprise reform of turning state enterprises into joint-stock companies. By the end of 1991, China had more than 3200 joint-stock holding companies, more than 85 percent of them with substantial employee holdings. This form of privatization avoided large layoffs and helped to mitigate the incentive problem that had long troubled state enterprises. However, it did have its limitations.

Second, the state enterprises provided an “iron bowl” to their employees, which meant lifetime employment as well as nonwage benefits, including housing, daycare and schooling for children, medical care, and pensions. The entitlement to jobs was even frequently passed from retirees to their adult children. In addition, the state enterprise was also a central anchor in an employee’s social and political life. Not surprisingly, employees of state-owned enterprises, particularly the big ones, had a strong attachment to and identification with their employers. This system of the “iron bowl” essentially tied the Chinese workers to a single employer from the beginning of their career to the end of their lives. Chinese state employees literally belonged to their work units. This made it virtually impossible to separate employees from state enterprises. At the same time, however, under the managerial responsibility system, the workers had little opportunity to voice their concerns and only limited chance to “exit”.

In support of its efforts to turn state-owned enterprises into modern corporations, the Chinese government took a series of measures to create a labor market so that laidoff workers from state-owned enterprises could be easily reemployed elsewhere. It also put into place a social safety net for retired workers as well as for workers who were caught between jobs. The first component of the social safety net was unemployment insurance, which was instituted in 1993.⁸⁶ This effort was made easier in 1994 by China’s official recognition of “unemployment,” replacing the odd phrase, “waiting to be employed.”⁸⁷ By 1995, more than 70 percent of state employees were covered by unemployment insurance. At the same time, pensions for state employees were gradually separated from employers and taken over by a state pension fund. Housing reforms also began in 1994 and were basically complete by the end of 1990s; public housing was sold below the market price to current occupants to separate state employees from their employers. Employees of state enterprises could now change jobs without losing their homes.

At the Fifteenth National Congress of the Party in 1997, the role of the non-public sector was stressed as “an important component” of the socialist market economy. Joint-stock companies were officially recognized. Privatization was no longer seen as undermining socialism. Afterward, the state-owned enterprises went through a drastic process of restructuring and downsizing, resulting in massive layoffs. Like the previous rounds of enterprise reform, local initiatives played a leading role after Beijing loosened restrictions. In this round, a practice originated at Changsha, the provincial capital of Hunan, quickly attracted national attention in the new millennium.⁸⁸

After privatization was officially approved in 1997, officials were challenged with the problem of restructuring state-owned assets – many of which had little or even negative market value – while relocating millions of state employees. What emerged at Changsha was referred to as “dual substitution,” a simultaneous shift in both property rights structure and employment relations. First, the state gave up its position as the sole owner of state enterprises and became a minority shareholder by inviting outside investors and/or employees to become the majority shareholders. Second, employees of state enterprises gave up their “iron bowl” in exchange for a cash settlement, which was mainly determined by their years of service. What made the Changsha experiment work was that it successfully solved the two intertwining problems that had consistently plagued previous enterprise reforms, state ownership and unemployment.

A critical factor that allowed this scheme to succeed was that the municipal government put state assets with market value and property (which had seen significant appreciation in its value) from all state enterprises into a common pool; this meant that even insolvent state enterprises and their employees were not excluded from the benefits. The compensation received by state employees was equalized across different enterprises, which was widely perceived as fair and readily embraced by workers. To put all state assets in one common pool also helped to create a state property market, easing the transfer of assets. After its successful implementation in Changsha, the practice of “dual substitution” became the main approach to the reform of state enterprises throughout China.⁸⁹

In the new millennium, a particular form of enterprise reform emerged and it deserves special attention: this is the use of IPOs (initial public offerings). Some state enterprises were restructured for IPOs in the domestic stock market (the Shanghai Stock Exchange and Shenzhen Stock Exchange) and also foreign stock markets, with the Hong Kong Stock Exchange being the most popular destination. This gave enterprises another means of raising capital, and it also stimulated the development of the domestic stock markets. Since its setup in 1992, the Securities Regulatory Commission had perceived the stock market as a privilege for state enterprises to enable them to raise capital directly from the public. The vast majority of listed companies were either state enterprises or those with state enterprises as the majority shareholders. The first domestic private enterprise was not listed on the stock market until 1998. Even today, after two decades of operation, the Chinese stock market remains underdeveloped; it has limited capacity as a market institution to discipline the management of listed companies, and as a result only plays a marginal role in China’s fast growing capital market.⁹⁰

After 2000, the state-owned enterprises went through another, more aggressive round of restructuring. Between 2001 and 2004, the number of state-owned enterprises dropped by almost half. In addition, in March 2003, the State Council adopted the practice started in Shanghai more than a decade before and established a new ministerial level agent, the State Assets Supervision and Administration Commission, to manage the remaining 196 state enterprises that belonged to the central government (the number is down to 117 as of February 3rd, 2012).⁹¹ Similar commissions at lower administrative levels were created by all provincial and municipal governments that still ran state enterprises. As a result of this restructuring, all state enterprises are now under a single supervising body, greatly simplifying the relations between the government and state enterprises, but still giving many special privileges to state enterprises over private ones, including monopoly access to several sectors. After the Third Plenum of the Sixteenth Central Committee in October 2003, enterprise reform was no longer referred to as the “central link” in China’s economic reform.⁹²

The last round of enterprise reform began in 1992–1993 as privatization was initiated by local governments in a desperate attempt to save local finances from disaster. It ended in 2003, with the setup of the State Assets Supervision and Administration Commission, and can be considered a measured success.⁹³ It consolidated the state sector and kept the remaining state enterprises financially healthy. This was due partly to cost-reduction and improvement in productivity and partly to their remaining monopoly power and political influence. During this period, the measures taken by the Chinese government to reform state enterprises were dictated by what they saw as the root problem of state ownership: the lack of incentives on the part of managers and workers in state enterprises. This focus on incentives was also reflected in the official explanation of the success of the household responsibility system in rural China; private farming was embraced by peasants and turned out to be successful because it was better aligned with their incentives. However, the failure of state-owned enterprises was more complicated.

The lack of incentive was just one reason, but at least two other factors were just as important. First and foremost, firms in a market economy face constant market selection; those which fail the market test are forced to close and release their workers and capital to the market for alternative employment. There is no secret recipe to keep firms successful. Darwinian selection is the only mechanism available to keep economic resources in good hands while liquidating firms that cannot survive market competition. What a state can help with is to facilitate the creation of new firms, which will force existing firms to become more competitive or to fail. A state can also help to facilitate the liquidation of bankrupt firms so that their remaining resources can be easily released for better employment. But China’s state-owned enterprises seldom closed down once they had been set up. With no possible exit, it is no wonder that the state sector was unable to compete with township and village enterprises and other private firms, which were subject to a harsh market discipline. Moreover, since existing firms could not easily close, the setup of new firms was inevitably under strict control. A common but critical dynamics that underpins a market economy – the constant creation of new firms and annihilation of old ones – simply did not exist in China under socialism, certainly not in the state sector.

There is no doubt that poor management must take some of the blame for the inferior performance of state enterprises. However, illicit asset stripping by insiders, including managers and supervising officials, was another important factor. With no external oversight, some managers set up their own businesses to siphon money away from state enterprises. That asset stripping occurred on a large scale in state enterprises certainly had something to do with their state ownership. Their state ownership also made state enterprises unable to close. But both these factors are separate from the incentives issue.

The conventional justification for private ownership is that it solves the incentive problem. That is certainly a key advantage. After a state firm is privatized and bought by its previous manager, he becomes the private owner and residual claimant of the firm. As a result, he will now have a greater incentive in making the firm profitable. He probably will work harder and make sounder business decisions. While an improvement in incentives generally leads to higher productivity, this is not the only, or even the main, advantage of private ownership. The benefits of private ownership and privatization are more broad-based than the improvement of incentives.

First, private ownership facilitates the efficient allocation of resources and thus improves productivity. The delineation of rights makes economic resources readily transferable among economic actors, who compete to employ the resources in the most profitable way. Thus, to what degree privatization works depends on how much it helps to release economic resources to a free asset market. Without a well-functioning asset market, privatization cannot be a silver bullet for the economic problems besetting state ownership. However, this condition seldom exists in economies experiencing transition from a planned to a market economy. More often than not, privatization was pursued as a means to dismantle central planning and create such a market. But without a functioning market to reallocate resources to better reemployment, the economic benefits of privatization are limited.⁹⁴

Second, resource allocation in a market economy is a Hayekian process of discovery. There is no magic way to place all economic resources where they can be most profitably employed; the efficient utilization of resources is not a given in any economy. Entrepreneurs have no choice but to resort to trial and error to figure out where to put their resources; in their constant search for higher profits, they unintentionally move resources to where they generate the highest returns. Thus, resource allocation in the real world is categorically different from the paradigmatic choice problem defined in textbook economics as allocating limited means to satisfy given ends. The entrepreneur is always seeking to go beyond the given ends and explore new means. In other words, resource allocation is inevitably tied to the exploitation of resource utilization in a continuously changing economy. This process often involves experimenting with new products and founding new firms, while phasing out old ones, a process called “perennial gale of creative destruction” by Joseph Schumpeter.⁹⁵

Under socialism, factors of production are owned by the state and their distribution in the economy is carried out through economic planning, so a critical step in market transformation is the rise of a factor market to replace economic planning in resource allocation. In China’s market transformation, this emerged first at the local level, giving rise to regional competition with the active participation of local governments. Steven Cheung identified competition among xians – county-level local governments – as the key to understanding the miraculous rise of the Chinese economy.⁹⁶ Regional competition is certainly not confined to counties. It takes place from the provincial level down to the township level. But what exactly is competed for in regional competition? Answering this question takes us a long way toward understanding the nature of the Chinese market transformation.

X

Let us start with a less controversial subject: competition between firms. In textbook economics, a perfectly competitive market implies that many firms provide identical products to consumers, forcing firms to take whatever price consumers are willing to pay to clear the market. In reality, however, probably the most important competition that firms engage in is product innovation, that is, the design and provision of novel and better products. When firms are unable to differentiate their products, they have no choice but to cut costs and thus provide goods at a lower price than their competitors. The kind of competition epitomized in economics textbooks is actually the last resort for business firms. In addition, firms also compete in the factor market to attract the best human talents and obtain other resources necessary for their operation. Unless the firm can secure its supply of inputs from a factor market, it cannot compete in the product market, even if it has great products.

It is important to highlight the critical role played by various product and factor markets in making competition between firms possible. Markets provide a platform through which firms compete for both resources and customers. How effectively firms perform these tasks depends primarily on how open the markets are, including the markets for factors and products, and how free firms can be created and compete with each other. Essentially, firms’ effectiveness depends on how smoothly and quickly factors of production can change hands in response to competitive bidding, how easily factors and products can move across boundaries (physical and social) in the economy, and how readily new firms can come into being with innovative products or ideas on how to organize factors in fresh ways. The second and related operation of the markets is to provide feedback to firms, rewarding firms that do a better job in satisfying customers and punishing those whose goods and services fail to please buyers. This can be accomplished when firms that succeed in winning the patronage of customers also succeed in the factor market in securing the service of factors of production. A serious problem thus arises when an economy with an open product market does not have an equally open factor market.

Hence, in a market economy, the firm and the market work hand in hand to move resources to where they can be most profitably employed, a challenge frequently involving the introduction of new products and elimination of obsolete ones as well as the rise of new firms and demise of broken ones. While the cost of operating the market calls for the rise of the firm – otherwise all individuals would work alone and interact with each other through the pricing system – the presence of the firm does not imply the failure of the market.⁹⁷ The firm does not replace the market altogether or makes it unnecessary or less significant. Rather, the creation and operation of firms necessitate open and competitive markets, without which the firms would have no clue what to produce and how to operate their businesses. The Leninist reasoning that a national economy can be run as a giant firm without any market is an illusion, and attempts to follow this model have been disastrous. As the Chinese socialist experiment has made abundantly clear, the firm cannot perform properly without the constant support or discipline of various market forces. On the other hand, the presence of any given market cannot be taken for granted. Many modern markets require complicated rules and regulations and their operations change significantly over time. Many such rules are imposed by the state to regulate what the firms can do in hope to maintain a viable market. But like any other human endeavor, the effort of making a market more often than not ends in disappointment for various reasons. Information asymmetry between the buyers and sellers can certainly thwart the working of the market; regulations might turn out to be too restrictive or too lax to sustain market order; other factors may also limit transactions to such a low level that the cost of running the market cannot be recouped. How the firm, the market, and the state work in concert to maintain a flexible and resilient structure of production remains an intriguing issue.⁹⁸

As we come to competition between local governments, it seems obvious that local governments compete for capital investment. When local officials hold conferences all over China and even abroad to solicit business investment, meeting with businessmen over dinner and in karaoke bars, they try to persuade potential investors to come to industrial parks in their jurisdiction.

Since 1992, various industrial parks – sometimes called high-tech economic zones, free trade zones, export processing zones, economic and technological development zones – have mushroomed all over China at various administrative levels.⁹⁹ This effort followed on from the four Special Economic Zones set up in 1980, and the opening of fourteen additional coastal cities to foreign investment in 1984, as well as the development of Pudong in 1990. In this round of opening up, the State Council approved dozens of National Economic and Technological Development Zones all over China. The Suzhou Industrial Park, jointly run by the government of Singapore and China, and the Kunshan New and Hi-Tech Industrial Development Zone, both established in 1994, are two well-known examples. As of January 2012, there are 128 National Economic and Technological Development Zones, playing a significant role in the national economy.¹⁰⁰ On average, the national industrial parks enjoy an economic growth rate three times as high as the national GDP growth rate. In addition to national industrial parks, there are thousands of provincial, municipal, and county-level industrial parks all over China. Indeed, many township governments even have more than one industrial park. Local governments often choose to open industrial parks on the outskirts of cities, with convenient access to the highway. To a large degree, since the 1990s industrial parks have played a role similar to that of the Special Economic Zones in the 1980s. Both created fresh opportunities for entrepreneurship outside the existing economic structure where state enterprises tended to prevail. While the Special Economic Zones are limited in number and concentrated in coastal areas, industrial parks are found all over China.

To make their industrial parks attractive to potential investors, local authorities provide civic amenities, including water, sewerage, electricity, internet and telephone infrastructure, as well as land for investors to build their own office and industrial spaces (rental spaces are also available). Once an industrial park is open, local government officials are under great pressure to solicit firms to move in. Hence, in regional competition, local governments compete head on with each other for capital investment. They often create a local infrastructure and a friendly business environment to attract investment from the business community, which is expected to create jobs, develop the local economy, and generate tax revenues. Since industrial parks at various administrative levels (national, provincial and county) are spread all over China, competition is remarkably intense. In many places, a quota-like system is used, which requires every government office (even the bureaus of education and environmental protection) to bring in a certain amount of investment to the local industrial parks.

In an industrial park, some firms are aggressively recruited; they include established industrial leaders and promising stars in high tech industries. Most firms get in through open application. A small proportion of the firms are preexisting firms that were in operation elsewhere, but the majority will be start-ups. Among these, some may be spinoffs or transplants of a preexisting firm. For example, in the 1990s many firms in coastal areas moved to inland areas to avoid increasing labor costs. With the improvement of the business environment in inland provinces and the impressive development of the transportation infrastructure in China, including highways, aviation, and railways, many firms in Guangdong, Fujian, Zhejiang, and Jiangsu provinces moved inland; these became major targets for industrial parks in inland areas. An increasing number of start-ups are newly founded ventures in high technology with venture capital backing.

The administrative system of industrial parks varies in detail from one case to another. But a broad picture is still discernable. An industrial park is generally under the supervision of two offices, but staffed with a single personnel team, a phenomenon referred to as “two signboards, one team.” The first office is basically a local government branch set up exclusively for the industrial park. It provides all the governmental services needed for a business to open and operate, including registration, permits, and regulations. Instead of running from one government office to another to obtain various permits, the business in the industrial park can get everything they need in one place. The second office is non-governmental. Often called the Industrial Park Management Committee, it looks after the daily operation of the park and provides administrative services to all the resident firms. This theoretical separation between the local government and the managerial office of the industrial park has turned out to be a considerable advantage for the operation of industrial parks. Unlike the conventional government departments, the industrial park is often managed by young, enterprising, and well-educated staff members, familiar with economic affairs. The relation of the park management office and firms is like that of a service provider and its clients and bears little resemblance to the constricting bureaucratic relationship between the supervising authority and state enterprises.

At the same time, with the local government branch on its side, the industrial park management office is far from a usual business development office. Rather than passively waiting for investment, the local government reaches out to invite or solicit business. From the perspective of a businessman looking for a place to locate his firm, a key concern is the local business environment, including the efficiency of government services and access to the inputs required for his operation. In this role, the Chinese local governments act in excess of what a well-functioning local government would do in a market economy, which is no more than the provision of local public goods.

To appreciate the active role played by Chinese local governments, we first have to recognize that, in a country as big and heterogeneous as China, price deregulation and privatization do not automatically create a national market for factors of production (especially not for capital assets). The price reform of 1992 abolished price control, allowing the pricing mechanism to operate. A national market for products emerged quickly where consumer sovereignty prevailed. This was not true in the case of the factor market. Under socialism, all the means of production were owned by the state. Though privatization helped to release factors that had been controlled by the government, this did not necessarily mean that released factors could be competitively sold.

What the Chinese local governments did was essentially to provide organizational services – putting together all factors of production. This does not suggest, as we will see shortly, that local governments had better knowledge and were thus able to employ factors more profitably. The production function in textbook economics may imply that we can simply pile up factors of production and expect them to be automatically transformed into products, but this is not the case in a real economy. The transformation of factors into goods and services takes place within a structure of production in which factors are organized and coordinated by various arrangements, including the impersonal pricing mechanism, contracts, and non-contractual personal relations.¹⁰¹ In this vast and still poorly understood arena, organization is critical. Organization was considered by Alfred Marshall to be a “distinct agent of production.”¹⁰² But underdeveloped economies are characteristically defined by a want of organization. Indeed, organization is often in shorter supply than capital investment. In China, this vacuum was filled up by local governments, which still have enormous power to mobilize resources.

With industrial parks cropping up all over China to win investment, local governments had to convince investors that their industrial parks had everything needed to assure the success of a business. This was no easy task, given the variety of firms moving into a park. Some simply wanted to take advantage of low labor cost, lax regulation, or other benefits – in the late 1990s, the Chinese central government gave significant tax credits and other benefits to firms that invested in China’s underdeveloped western areas. Some were foreign companies or companies from coastal areas that were looking for a local partner to expand their operation. Some firms were start-ups, with promising business plans or a new technology but little capital, managerial personnel or skilled labor.

As a result, industrial parks often offered different services to different firms. For some firms, this simply meant a ready access to labor and local supplies; for others, it meant help with bank loans and senior recruitment. Thus, the local governments became heavily involved in the setup of some firms – particularly those which it was hoped would contribute significantly to local tax revenues or generate spillover effects for the park, such as enhancing its reputation and attracting other firms. The local government was eager to work with such firms to find local suppliers, hire skilled labor – sometimes even from other cities – and secure bank loans. Once the firms had moved in and started operation, the local government was happy to leave them alone.

XI

Since the mid-1990s a new kind of relationship between local government and business firms has emerged in China. In the 1980s, local governments were often an active or silent owner of state and collective enterprises, giving rise to what was called “local corporatism.”¹⁰³ By the mid-1990s with more and more state-owned enterprises becoming insolvent, local governments began to withdraw equity claims on local firms. This fundamentally changed the nature of the relationship between a local government and firms in its jurisdiction. When a local government owned some firms, it would be difficult, if not impossible, for it to treat private firms fairly, particularly those competing with its own enterprises. By the mid-1990s, less than one-third of state-owned enterprises was making any profit. The financial situations of state enterprises owned by local governments (provincial and below) were much worse than those owned by the central government. At the county level, it was common that only a small percentage of state enterprises would be solvent. When state enterprises became a financial burden, local governments were eager to develop industrial parks as a new source of revenue. Not surprisingly, when the State Council called for a “transformation of government functions” in 2001, local governments responded wholeheartedly. They quickly started to promote themselves as business-friendly service providers instead of as supervisors or regulators, slashing red tape and reducing government regulation in the economy.

In the intensifying competition for investment, it did not take long for local government officials to realize that a winning strategy was to distinguish their industrial park from its peers by focusing on certain industries with a promising long-term growth, rather than accepting a group of unrelated firms. This change in strategy helped to bring out a new dimension to China’s regional dynamism: the economies of localization. Even though localization of industry is a common phenomenon in the process of industrialization, regional competition in China adds a special twist to the familiar story. In the United States, for example, Silicon Valley is the preferred location for new start-ups in the computer industry. Founders of Facebook, graduates of Harvard, chose to locate their business in Silicon Valley instead of Boston. In a market economy, an entrepreneur, particularly as a new entrant to an industry, will understandably locate his firm at the established industrial center, taking advantage of various spillover benefits and in turn making his own contribution to the further growth of the center. This feedback loop reinforces the economies of localization.

In China, however, the economies of localization developed a distinctive character. The economies of localization do not necessarily imply that an industry will be concentrated in only one place. The sheer size of China encourages ambitious emerging industrial parks to challenge established industrial centers. Seemingly duplicative investment across regions in China has been a consistent feature of the economy throughout economic reform. This phenomenon has been criticized as evidence of serious inefficiency in the Chinese economy. But reality is more complicated. We have to realize that this is not a new development. Ever since Mao’s efforts at decentralization in the mid-1950s, fragmentation has been a constant character of the Chinese economy. Fragmentation was probably at its peak during the 1960s, when each region down to the county level was encouraged to set up an all inclusive and self-sufficient industrial structure. However, the repetitive investment resulting from Mao’s policy of self-sufficiency differs in kind from the repetitive investment prompted by regional competition. China now has a common national market for most consumer products, thus subjecting all firms, no matter where they are located, to the same market discipline. This is in sharp contrast to Mao’s policies to promote local economic self-sufficiency, where firms in each region were effectively sheltered from competition from others.

Nonetheless, the presence of duplicative investment across China seems puzzling. The fundamental economic logic of the division of labor and trade, as powerfully described by Adam Smith, states that we all specialize in supplying a single, or at most, a very limited number of products and buy most of what we consume from others. Since Ricardo, this logic of specialization has taken on a geographical twist, turning it into a law of comparative advantage. This simply states that each region will specialize in industries where it has a comparative advantage, while importing products it does not produce. Through specialization and trade, any specific industry will be concentrated in a few areas and different areas will specialize in supplying different products in accordance with their particular advantages. As a result, the fact that many regions in China make duplicative investments in the same industry is taken as unambiguous evidence of the presence of policy distortions in the economy, contradicting the economic logic of specialization and trade.

Take the automobile industry as an example. Prior to economic reform, the Chinese automobile industry was dominated by two state enterprises owned by the central government, China Number One Automotive Factory founded in 1953 in Changchun, and China Number Two Automotive Factory founded in 1966 in Shiyan; both mainly produced trucks. In the 1980s, many foreign automakers entered the Chinese market. Chrysler formed the first joint venture in 1984 with Beijing Automobile Company. Guangzhou, Nanjing, and Shanghai also emerged as important players in China’s growing automobile industry. In the mid-1990s when the rate of capacity utilization for truck production was 36 percent, bus production, 30 percent, and passenger cars, 65 percent, the Shanghai government decided to enter China’s already crowded auto industry, creating a brand new supply chain of automotive components for Shanghai Automotive Industry Corporation, a state enterprise controlled by the Shanghai municipal government.¹⁰⁴ In 2000, Changsha, the capital city of Hunan province, also entered the industry. Its aim was to attract new firms to the Changsha National Economic and Technical Development Zone, which broke ground in 1992 and was approved in 2000 as a National Economic and Technical Development Zone. Both Shanghai and Changsha were new to automotive components manufacturing; Changsha was barely recognized as a player in the industry even in the late 1990s.

The negative impact of such duplicative investment has been widely noted. As one critic put it, “as a result [of duplicative investment], regions do not specialize along the lines of their comparative advantages. Instead, they all push strongly into similar industries and product groups, resulting in a convergence of industrial production across different regions.”¹⁰⁵ The buildup in overcapacity and ensuing low utilization rates clearly suggest some inefficiencies in resource allocation in the Chinese economy. But we have to recognize that regional competition must imply duplicative investment in one way or another. Most foreign auto makers have multiple joint ventures in different locations with different local partners across China. GM, for example, agreed in September 2011 to open its eleventh joint venture in Shanghai.¹⁰⁶ Without some degree of duplicative investment across regions, it would be impossible to allow regions to compete with each other head-on. If we view the development of a market economy as an open learning process, in which economic actors must figure out what to produce and how to organize the production, some “waste” in duplicative investment on the part of firms is inevitable.

Moreover, while duplicative investment has led to the underutilization of physical capital, it has at the same time helped to spread manufacturing technologies and significantly improve workers’ skills all over China. The gains in human capital outweigh the losses from the underutilization of physical capital. From a different angle, the repetitive and duplicative investment across China can be seen as an effective mechanism of social learning: quickly spreading industrialization to a largely agrarian economy. When China was first opened to the outside world at the end of 1970s, Chinese factories could not produce some goods as simple as ballpoint pens, quartz watches, or mini cassette players. It is therefore an extraordinary achievement that Chinese enterprises by the end of the 1990s were able to produce a very wide range of industrial goods at internationally competitive prices. The changes in China’s exports tell a similar story. In 1980, primary materials, led by petroleum products, were the largest sector of China’s exports. Manufactured goods represented less than half of China’s exports, of which textiles accounted for more than 50 percent. This pattern persisted until the mid-1980s when manufactured goods became the leading export category. By 2000, 90 percent of Chinese exports were manufactured goods, and the contribution of textiles to that figure had declined to 25 percent. The extraordinary speed and scale of the growth in manufacturing capacity of the Chinese economy, as embodied in physical investment, human skills, and managerial know-how, must be recognized as the driving force behind the rise of China as a global powerhouse in manufacturing.

In the conventional argument for economies of scale, the underutilization of physical capital is seen as a sign of economic inefficiency. Duplicative investment is thus singled as the reason for the failure to take full advantage of economies of scale. However, our investigation of China’s industrial parks and regional competition leads to a more nuanced picture. Manufacturing requires both skilled labor and capital investment. The conventional analysis of economies of scale focuses on issues of physical and financial capital and what Alfred Marshall called the “internal economies” in the firm. What is ignored is the factor of labor and human capital and what Marshall called “external economies.”¹⁰⁷ Duplicative investment in China, and the consequent low utilization rate of capital investment, led to widespread industrialization and an explosive growth of human capital in modern manufacturing. Many small manufacturing businesses in China, for example, were founded by former migrant workers who had been employed in a factory and gained technical skills and managerial knowledge. In this way, the loss in internal economies of scale (to capital) was compensated for by a gain in external economies of scale (to labor).

In this process the local government played a highly visible role. As we mentioned above, in the usual market economy a single firm is compelled to locate itself in an established center, reinforcing the economies of localization. Any attempt on the part of a single firm to create a center of its own would be futile and, in most cases, suicidal. A local government, on the other hand, can challenge that status quo and launch a new center, if it can convince a sufficient number of firms to move into its industrial park and quickly reach a threshold level of scale. But the local government cannot possibly succeed without the endorsement and participation of private firms. The visibility of the local governments in the operation of industrial parks all over China does not change the fact that what the local government does is essentially to “set up the stage and let firms run the show,” as it is commonly put in Chinese. Moreover, intense regional competition can quickly punish those initiatives that fail to win support from the business community.

It is important to stress that the regional competition that has emerged in the course of Chinese economic reform is primarily a result of local initiatives. The 1992 price reform and 1994 tax reform have certainly helped by clearing price distortions and allowing the rise of a national common market; similarly, the privatization of state enterprises has helped to release both human talent and capital assets from state control. The privatization of local state enterprises has also made local governments an impartial service provider, creating a fair playing ground for all firms. However, the key players in regional competition are local governments and, behind them, private firms.

There is an extensive and growing literature on China’s decentralized political structure and its far-reaching impact on China’s market transformation.¹⁰⁸ As we have discussed, the legacy of Mao’s repeated efforts at administrative decentralization persists. But Mao’s legacy is itself rooted in China’s long history, under which the so-called junxian system prevailed. As reflected by the well-known Chinese axiom, “the mountain is high and the emperor far away,” the de facto autonomy enjoyed by the xian or county government has long been a distinctive feature of Chinese political structure.

But fiscal and administrative decentralization does not necessarily lead to regional competition. In Mao’s time, for example, regional competition did not arise. Instead, Mao’s repeated efforts at decentralization and his pursuit of local economic sufficiency was a top-down approach, seeking to turn the Chinese economy into a cellular stucture in which each region had a similar and independent economic status. Regional competition, however, is necessarily a bottom-up phenomenon. A decentralized political arrangement by itself can only provide a stage or platform for regional competition. We have to look elsewhere for the catalyst that animates the system and which, in China, generated a vibrant economic dynamism within the decentralized political structure.

This indispensable ingredient is intellectual or epistemic in nature. It can be best seen if we contrast Chinese leadership on the economy under Mao with that under Deng. Mao’s overconfidence in his economic policy and unyielding determination to carry it out against all resistance was in stark contrast to Deng plainly admitting to a lack of experience in reforming a socialist economy. This self-acknowledged ignorance on the part of Chinese central leadership gave rise to an experimental approach to reform and a willingness for the central government to delegate power to local authorities. We can better appreciate the experimental approach taken by China if we compare it with other transition economies. Leszek Balcerowicz, twice Deputy Prime Minister of Poland (1989– 1991 and 1997–2000), and a central figure overseeing Polish transition after the collapse of communism, was quoted as saying that “We are too poor to experiment. If the rich countries want to experiment, let them. For us, it is better to take proven models.”¹⁰⁹ Deng Xiaoping, on the other hand, admitted frankly to being “engaged in an experiment. For us, this is something new, and we have to feel our way. Since it is something new, we are bound to make mistakes. Our method is to review our experience from time to time and correct mistakes whenever we discover them, so that minor mistakes will not grow into major ones.”¹¹⁰

In addition, an economic experiment made independently by a local government is less costly and less disruptive if the experiment goes awry.¹¹¹ The logic of competitive local experiment has served the Chinese government well from the very beginning of economic reform, as was particularly noticeable in the case of agricultural reform. Once Beijing gave up its claim on a monopoly of truth in economic policy and allowed experimental policymaking, regional competition was able to take hold.

It is this profound shift in mentality on the part of the Chinese central leadership that gives life to what is called capitalism with Chinese characteristics. Still under one-party rule, economic freedom is not only tolerated but encouraged by both central and local government, although for different reasons. For Beijing, economic freedom enables local governments to take initiatives and experiment with various reforms at the local level, which has proved to be a workable approach to furthering reform. For local government officials, local economic performance is a critical criterion for promotion. All heads of Chinese local governments are appointed by the powerful Organization Department of the Party, which since the early 1990s has placed more and more stress on the growth of the local economy in its performance evaluations and promotion of local government officials.¹¹²

Regional competition has another important dimension that has so far eluded scholarly attention, which helps to reveal an important aspect of Chinese capitalism and sheds new light on the question raised at the beginning of this section: What exactly is competed for in regional competition? There is no doubt that investment has been the immediate target of competition between local governments. But as they compete, local governments also vie over different ideas of economic development. This subtle but critically important dimension of China’s regional competition will become clear if we put it into historical context.

Under Mao, the decentralized Chinese economy inevitably opened up some room for local initiatives. But none of them lasted long before being hijacked by Mao’s political campaigns. Many economic practices that were later criticized as having been responsible for Mao’s economic failures first emerged as local initiatives. For example, the public canteen hall first emerged in Henan province and the People’s Commune was first set up in Hebei province. The famous Dazhai model was born in Shanxi province. As a local response to local challenges, each of these local initiatives was effective. Once it was approved by Mao, however, a local invention was hailed as an economic tool that could be applied universally. All such local initiatives were promoted and imposed nationwide, regardless of local conditions. The disastrous results are apparent to all with any knowledge of this period.

Under Deng, however, the central government took a different approach to local initiatives. With the noticeable exception of private farming, Beijing became cautious in imposing a local initiative on the whole nation. More often than not, once a local initiative had won Beijing’s approval, local governments from elsewhere would visit the home region where the local initiative started. But in most cases, it was left for local governments to decide whether and how the invention could be adapted to their particular local circumstances.

As the local government of each region (from the provincial and municipal level down to the county and town level) attempted to find out how best to develop its local economy, China became a laboratory, with different economic experiments taking place all over the land. As a result, many development models emerged, each named after the city or county where it was first tried. Various experiments in institutional arrangements, different ideas in accelerating the local economy, and rival judgments on the prospect of a new industry or the future of an existing one are all put to the test simultaneously. The continental size and incredible heterogeneity of China provides space for all kinds of experiments and competition. At the same time, the unified price and tax system and common national market that have emerged since the mid-1990s impose a uniform market discipline and thus ensure that regional competition is, in general, an efficiency-improving phenomenon. Thus, the advantage that China has in space translates directly to the pace of economic development; this is key to understanding the seemingly miraculous speed of China’s market transformation. Instead of “big push industrialization” engineered by a coercive central government, a development strategy that China pursued under Mao, what has emerged in China since the 1990s is thousands of industrial parks, each embodying a local vision of economic development and a local initiative in industrialization. Mao’s idealistic wish of the mid-1950s, “let one hundred flowers bloom and one hundred schools of thought contend,” has come into being in the economic domain.

XII

China’s regional competition has another distinctive feature: the significant presence of foreign capital in China’s rising market economy. Foreign investment, particularly from Fortune 500 companies, has been and remains an important target for industrial parks. Since the very beginning, the Chinese government has stressed “opening up” as a critical component in China’s economic reform. As a result, China has consistently been a highly desirable destination for foreign direct investment. Even though foreign direct investment from Hong Kong and Taiwan flooded into China in the 1980s, the influx from other places only took off in the 1990s. During the 1980s, such investment averaged about 2 billion USD per year. After Deng’s southern tour, it increased rapidly and has remained between 40 to 60 billion USD a year since the mid-1990s.

The “pervasive presence” of companies with foreign investment has prompted some scholars to worry about China’s overdependence on foreign investment.¹¹³ In 1994, investment from foreign companies made up about 17 percent of all fixed asset investment in China. The ratio declined to about 10 percent by 2000 and has continued to decline despite the growth of foreign direct investment in China. But the predominance of foreign capital in the Chinese economy, particularly in manufacturing, has been a constant feature since the beginning of the country’s economic reform. At any point, it was common to find many industries dominated by foreign firms. In the 1980s, for example, firms from Taiwan enjoyed dominant equity positions in garments and footwear (71.8 percent), lumber and bamboo products (75.7 percent), and leather and fur products (79.6 percent). Unlike Japan and South Korea, China’s growing automobile industry has been, and still is, dominated by foreign companies from all over the world, including General Motors, Ford, and Chrysler from the United States, Toyota, Honda, Nissan, Mazda, and others from Japan, Hyundai-Kia from South Korea, as well as Volkswagen, Fiat, and Peugeot-Citroën from Europe. For many years, Volkswagen commanded the largest market share in China, until overtaken by General Motors in 2007.

Foreign direct investment brings at least three economic benefits to the recipient country. First and foremost, for poor economies with inadequate domestic capital, foreign direct investment provides a ready substitute. At the beginning of China’s opening up, foreign investment from Hong Kong and Taiwan to Guangdong province was critical to the rise of the Pearl River Delta. Second, foreign direct investment usually comes with advanced technology and managerial skills and thus helps the diffusion of modern technology and business management techniques to recipient countries. Third, foreign direct investment brings with it access to foreign markets. As a result of foreign direct investment, the recipient country gains a window into the home markets of foreign capital, which usually facilitates exports. In the Chinese case, special incentives are given to foreign companies if they are export-oriented. Not surprisingly, foreign companies contribute about one-third of China’s total exports. In certain sectors, foreign companies are the dominant exporters. As a result, China has grown from the thirtieth largest trading economy in 1978 to the largest trading nation in 2009; it is now the world’s largest exporter, and its second largest importer.

In the literature on foreign direct investment, it remains a moot question whether and to what degree foreign capital benefits the domestic economy through technological spillovers. Many econometric studies have tried to investigate to what degree the presence of foreign direct investment in an industry or a city helps to improve productivity of domestic firms in the same (or related upstream and downstream) industry. Several studies have not found any significant impact, and even those that do indicate that the impact is not as big as commonly expected. A significant amount of foreign direct investment has been attracted to China due to China’s low labor cost and lax regulations. This is commonly read as further reason to doubt the contribution made by foreign direct investment to China’s technological advancement.

Even when foreign capital does not embody cutting-edge technology, its wide presence in China makes it an important vehicle to transmit and spread technology. For example, the shoe-manufacturing sector in Guangdong was mainly started with investment from Taiwan in the 1980s. Despite its relative lack of high technology, such foreign direct investment has been an important transmitter of knowledge to Chinese workers. The state shoe-making enterprises in Shanghai might even have better technology than firms from Taiwan, but this cannot be taken as prima facie evidence that foreign direct investment in shoe-manufacturing does not contribute to technological growth in China. When a Taiwanese firm is opened, it hires migrant workers from rural China, who will learn the production technology. After a few years, the migrant workers may start their own businesses. If we recognize the speed with which private Chinese enterprises picked up modern technologies and improved the quality of their products as an important factor driving China’s industrialization over the past three decades, the critical contribution of foreign direct investment cannot be denied.

At the same time, foreign investors have earned high returns on their investment in China. For an increasing number of western companies, the Chinese market will become even bigger than their home markets. For example, a recent Wall Street Journal article predicted that China’s auto market would soon outpace home-market sales for several western brands, including Mercedes Benz, Audi, and several of GM’s models.¹¹⁴ The development of the Chinese market creates a great opportunity for the top automakers all over the world to grow. In one industry after another, China has become a showroom for global capitalism.

XIII

When Deng Xiaoping began his southern tour in early 1992, the private sector, which had enjoyed a decade of strong growth in the late 1970s and 1980s, was at its nadir; socialist ideology dominated contemporary political debate. After more than a decade of reform, the impressive growth of the non-state sector had brought much-needed vitality and dynamism to the Chinese economy, but state enterprises were still plagued by insolvency. Still committed to socialism, which was widely understood as requiring public ownership, the Chinese government in the aftermath of the 1989 Students Movement at home and the fall of the Berlin Wall abroad was deeply wary of the growing private sector and its potentially corrosive impact on the communist political regime. With the fall of socialist governments in Eastern Europe, the response in certain circles of the Party was to strengthen state ownership and contain the private sector, lest China should slide into capitalism. However, Deng thought otherwise. According to Deng, the main reason that the Chinese Communist Party had survived the 1989 Students Movement was because of the increased living standard made possible by previous economic reforms. Thus, Deng advocated further reform and opening up as an effective strategy to make China a strong and prosperous socialist country. At a critical juncture, Deng saved Chinese economic reform.

Deng’s call for further reform during his southern tour effectively launched the second round of Chinese economic reform after a few years of retreat between 1988 and 1992. Three major forces dominated this second round: the development of a common national market, the privatization of state enterprises, and the rise of regional competition. These factors meant that private firms could now openly compete with each other. In turn, competition at the firm level became more intensified and effective when regional competition turned China into a giant economic laboratory. Together, they brought about capitalism with Chinese characteristics.

The remarkable economic performance China has achieved in the past three decades of market transformation has clearly boosted the Chinese leaders’ and general public’s confidence in the market economy, no matter whether it is called socialist or capitalist. But it is important to keep in mind that the ultimate rationale for the market is human frailty. Were the central planner as omniscient and omnipotent as is presumed in the classical model of socialism, the market would indeed be a wasteful game. A significant point, which has not been given its due in the ongoing examination of China’s market transformation, is that the post-Mao Chinese leadership, particularly Deng Xiaoping, fully recognized their inexperience in building a market economy. Without a preexisting model to emulate or a blueprint to follow, they were compelled to take an experimental approach to reform. Under regional competition, the trial-and-error strategy worked well as an effective way of learning. Success breeds failure, however, when it leads people to believe that they have fortunately stumbled upon a fault-proof formula that works everywhere and forever.