Transition to market: economic reform in china and russia



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TRANSITION TO MARKET: ECONOMIC REFORM IN CHINA AND RUSSIA
The latter part of the twentieth century was notable for the transition of many developing countries from government-directed to market economies. The 1980’s debt crisis was the catalyst for reforms in Latin America, although all of these countries generally had some market activity before the implementation of market-oriented reforms. More dramatic were the reforms of China and Russia, two nations that had experienced Communist revolutions in the first half of the 20th century and subsequently attempted to create the socialist “workers’ paradise.” Ultimately, both transformed themselves from centrally-planned economies to market-directed, China’s reforms commencing in the late 1970’s and Russia’s in the early 1990’s. However, the circumstances and the pace of the reforms were different in the two countries. Russia’s reforms were put in place relatively quickly after the demise of Communism. In China, the market-oriented reforms occurred gradually over many years and were overseen by its Communist government.
By the early 1990’s, economists generally agreed that moving economies from centrally planned to market-directed required three general changes: stabilization (sound macroeconomic policies to control inflation and the international balance of payments), liberalization (prices determined by market forces rather than government bureaucrats), and privatization (production units transferred from government to private ownership). However, economists engaged in debates about the desirable pace of reform, that is, how quickly these changes should be introduced. One influential school of thought was that they should all be introduced as quickly as possible in bold moves that came to be known as “shock therapy.” Shock therapy was the underlying philosophy behind Russia’s reforms. However, China’s approach was different. After its reforms began in earnest in 1978, it generally maintained a stable macroeconomy, but liberalization of markets and prices and privatization came much more gradually. Comparing the reform strategies pursued by the two countries and the successes and short-comings of each teaches the lesson that there is no right or wrong way to move toward a market economy. Policymakers have to pay attention to each country’s unique situation and characteristics to choose the right path of reform.
GRADUAL REFORM PRODUCES DRAMATIC GROWTH: A CASE STUDY OF CHINA
By Linda Kinney
1. Introduction.
From 1978 to 2006, the economy of China grew at an average annual rate of about 9% per year. This is one of the fastest rates of growth in history. As a result, China transformed itself economically. Its income per capita in 2006 was more than five times higher than it had been in 1978. There were dramatic reductions in poverty: by one estimate, the number of absolute poor fell from 53% of the population in 1981 to just 8% in 2001. Given China’s huge population, this translates into 400 million fewer people living in extreme poverty. [Todaro and Smith, p. 193]. A calculation by Angus Maddison in 1998 predicted that China’s total production (measured by purchasing power parity GDP) would begin to exceed that of the United States in 2015. [Qian 2003, p. 298]
There is much debate about the causes of China’s phenomenal development. One factor that many believe facilitated China’s explosive growth was its “painstaking, gradual, systematic implementation of reforms.”[Todaro and Smith, p. 195]
2. Historical Context of Chinese Reforms.
2.1. China before the Communist Revolution.
While Europe stagnated during the Middle Ages, China was the richest and most advanced country in the world. However, by the end of World War II, it was one of the poorest.
Between the 8th and 12th centuries, China experienced a burst of economic growth that brought it to a level of commercial and industrial development unparalleled elsewhere until the end of the 18th century. This period saw the invention of gunpowder, printing, and a water-powered spinning wheel; the use of coal in smelting iron; and the digging of canals and building of locks that, together with rivers, formed a 30,000-mile network of navigable waterways. China had also started out on the same path of world exploration that Europe was to follow in later centuries. In the early 15th century, the Chinese admiral Zheng He undertook voyages of exploration as far as the east coast of Africa. Despite this impressive beginning, the Chinese economy stagnated. While Europe industrialized and spread its influence over the rest of the world, China became increasingly insular. Europe’s standard of living surpassed that of China around 1750, and at the time of the Opium Wars in the middle of the 19th century, China found itself defenseless before the onslaught of an industrialized Europe.

[Weil, pp. 20-22]


Why did China decline relative to Europe? Many historians blame the Chinese unwillingness to adopt ideas and technology from abroad which was deeply rooted in its culture. In their dealings with the wider world, Europeans showed a great willingness to copy the best that other countries had to offer. Inventions from the rest of the world, such as paper and gunpowder from China itself, were eagerly adopted by Europeans and played a crucial role in Europe’s economic ascent. China, by contrast, took a disdainful attitude toward the rest of the world. Contacts with foreigners were treated as opportunities to display the superiority of Chinese culture. The European outlook is exemplified by German mathematician Gottfried Leibniz’s instructions to a European traveler going to China “not to worry so much about getting things European to the Chinese, but rather about getting remarkable Chinese inventions to us.” Contrast this view with the haughty letter that the Chinese emperor Gian Long sent to King George III, turning down the British request to open a trade mission in China (1793): “Our dynasty’s majestic virtue has penetrated unto every country under Heaven, and Kings of all nations have offered their costly tribute by land and sea. As your Ambassador can see for himself, we possess all things. I set no value on objects strange or ingenious, and have no use for your country’s manufactures.” Partially as a result of this difference in openness to new ideas, the technological gap between China and Europe became a yawning chasm in the centuries between 1500 and 1900. [Weil, p. 409]
[Whatever the reason for China’s decline, from the mid-19th century on, the power of the Chinese monarchy progressively weakened and the central government ceded power to a host of warlords and foreign nations. In addition], “unequal” trade treaties were forced upon China by the western powers, and the country was undermined by civil and international wars. [In 1949] the Communist Party’s People’s Army…united the nation [after] the evacuation…of [Chiang Kai-shek’s] Kuomintang to Taiwan.

[Jaggi, Rundle, Rosen, and Takahashi, pp.8-9]


2.2. Central Planning in China: 1953-58.
Initially after the Communist take-over, the government was quite popular among the majority of the lower class people. In the first three years of the People’s Republic of China, private industrialists were allowed to continue operating their enterprises. There was however a land reform in the rural areas in which the landlords were forced to surrender their land to the tenant farmers. In the process, the landlord class was extinguished, often by violent means.
In 1953, China began to implement its first Five Year Plan with the goal of building a socialist state and economy. With input from advisors from the Soviet Union, China began to move toward a centrally planned, Soviet-style economy.
The capitalists were asked to surrender their enterprises step by step, until they became only managers…and had to follow government instructions if they were to remain a part of it. [Chow, p. 26] The number of enterprises subordinated to the central government increased from 2,899 in 1953 to 9,300 in 1957, and their output accounted for 50% in state industry. The number of material items allocated by the Planning Commission of the central government increased from 55 in 1952 to 231 in 1957… [Qian 1999, p. 22] The farmers were organized into cooperatives under the pretense that this would improve production and marketing, but they were soon forced to surrender their produce to government procurement agencies. Trade in farm products by private traders soon ceased, and the government became the sole distributor.

[Chow, p. 26]


The result of these reforms was a “decline in managerial initiative and service quality of industrial and commercial enterprises” which “brought about many complaints from consumers. Some Chinese economists sharply criticized the planned economic model from the autumn of 1956 to the spring of 1957 when Mao was promoting a policy of ‘letting a hundred flowers blossom and a hundred schools of thought contend’ and when the political atmosphere was quite free and academic discussion was quite active.” [Wu, p. 36]
Even Mao joined the critical voices, though his concerns were based more on ideology and politics than economics. In his 1956 speech, “On Ten Important Relationships,” he argued:
Our territory is so vast, our population is so large and the conditions are so complex that it is far better to have the initiatives come from both the central and the local authorities than from one source alone. We must not follow the example of the Soviet Union in concentrating everything in the hands of the central authorities, shackling the local authorities and denying them the right to independent action.
The central authorities should take care to give scope to the initiative of provinces and municipalities, and the latter in their turn should do the same for the prefectures, counties, districts and townships; in neither case should the lower level be put in a strait-jacket.

[From Selected Works of Mao Zedong quoted in Qian 1999, p. 23]


The Chinese criticisms of central planning and the subsequent move to delegate decision-making away from the central government were in line with what was happening in other Communist countries, including the Soviet Union and Eastern Europe, at the same time. Khrushchev, First Secretary of the Communist Party of the Soviet Union, attacked Stalin’s economic policies and proposed that workers in State enterprises be given more material incentives. In the early 1950’s, Yugoslav authorities began to allow enterprises more independence in day-to-day production decisions. The subsequent increases in output prompted further reforms that resulted in a relaxation of planning.
2.3. Decentralization of Economic Activity in China: 1958 - 1978.
The upshot of the criticisms of Chinese central planning was a period during which the government decentralized economic decision-making by transferring power to and sharing revenue with governments at the local and regional levels. Ownership of property, however, was not transferred back to private hands.
This era began with 1958’s “Great Leap Forward.” The architects of the strategy believed that it could generate an economic rate of growth high enough to overtake Great Britain and catch up with the United States in 15 years. One component of the program was the transformation of the rural cooperatives into the “People’s Communes.” The purpose of the communes was to combine “ ‘industry, agriculture, military, learning, and commerce’ together into one entity,” [Qian 1999, p. 24] ultimately resulting in a Communist economy with an agrarian base. In these communes, people worked as a team and even ate together in mess halls. Mao assigned unreasonable agricultural output targets to the communes in the belief that this organizational change would motivate huge increases in output. Within two to three months, 99 percent of the peasants were organized into 24,000 communes, with an average size of about 5,000 households. In December 1958, the central government delegated many formerly centralized activities to the communes, including commerce and banking in rural areas. Thus, though the communes resulted in the collectivization of economic activity, each commune was able to make many decisions independent of the central authorities, clearly a movement away from Central Planning.
The first Five Year Plan of 1953 had introduced central planning to the urban industrial sector. This was reversed in 1958. The country was divided into seven “cooperative regions,” and each of them was required to have a complete industrial structure of its own. Most state-owned enterprises were delegated to local governments. This reduced the number of enterprises directly controlled by the central government from 9,300 in 1957 to 1,200 in 1958. Planning continued, but on a regional, not national, basis. Most decisions about fixed investment (construction of plant and equipment) were made by local authorities. Local authorities were ordered to base their expenditures on locally collected revenue rather than on funds transferred from the central government.
Initially, local responses to both the communes and decentralization were enthusiastic. For example, small local non-agricultural industries boomed for the first time. In 1958, the communes established a large number of commune and brigade enterprises that produced non-agricultural products (steel mills in every backyard, as Mao intended). By the end of 1958, these enterprises employed 18 million people and yielded a total output of 6 billion yuan, which increased to 10 billion yuan in 1959.
However, the effect of the reforms on agriculture was disastrous. The lack of incentives in communal agriculture, the waste of food as a result of collective dining on the communes, and bad weather produced the most severe famine in Chinese history. From 1958 to 1962, over 25 million people died of starvation. [Chow, p. 27]
In January 1961, a new policy of “readjustment, consolidation, replenishment, and upgrading standards” was adopted. [Qian 1999, p. 25] This involved a transfer of many urban industries back to central government control. Between 1959 and 1965, central government enterprises increased form 2,400 to 10,533. However, a more liberal policy was implemented in the rural areas. Communes remained but became less powerful. Production teams, comprised of about 40 – 50 households, became the basic production and accounting units. Peasants were also allowed to cultivate small private plots, run sideline productions, and open rural free markets.
After the failure of the “Great Leap Forward,” Mao’s political clout within the Party declined. Partly to regain power he initiated the Cultural Revolution in 1966. “Mao was a perpetual revolutionary. It was not enough to overthrow the Republic of China on the mainland. He now wanted to overthrow the bureaucracy of the Party and government that he had built himself. To do so, he appealed directly to Chinese youth, who were organized into the Red Guard. The Chinese government administration and economic system came under attack by millions of Red Guards…” [Chow, p. 28] Intellectuals and others who were deemed to be lacking the requisite revolutionary zeal were harassed and sent off to be “re-educated.” Those targeted included leaders of the Communist Party such as Deng Xiaoping, who eventually oversaw the beginning of China’s reforms. “[He] was attacked as a ‘capitalist roader’ and subjected to intense abuse; he spent two years in solitary confinement. He and his wife were both put to work in a tractor repair plant. His son was paralyzed as a result of physical assault by the Red Guards.” [Yergin and Stanislaw, p. 188] Due to the chaos created by the Cultural Revolution, the economy suffered. With many bureaucrats sent away for re-education or in hiding, those parts of the economy run directly by the government could not function. For example, the Planning Commission of the central government did not make annual plans in 1967 and 1968.
By 1970, the revolutionary zeal of the Cultural Revolution had worn out, and a second wave of decentralization occurred. It shared many of the features of the 1958 decentralization but went further. Most large-scale state-owned enterprises, which had been renationalized after 1958, were again delegated to provincial and municipality governments. Another significant change was the introduction of lump-sum fiscal contracting. Previously, the central government unilaterally decided how much in taxes each provincial government would pay and how much of what the central government collected in taxes would be transferred back to each provincial government. Now, the provincial governments gained some control over their finances: provinces would contract to remit a fixed amount of funds to the central government annually and were permitted to retain for their own use all revenue they earned above the fixed amount.
3. The Era of Systematic Reform: 1979 – Present.

(This section borrows liberally from Qian 1999. Other sources are noted in the text below).


Most of the developing countries that implemented market reforms in the 1980’s and 1990’s were prompted to do so by severe macroeconomic disruptions (the Latin American macroeconomic imbalances that resulted in the international debt crisis) or wholesale political change (Eastern Europe and the Soviet Union). There were no such extreme disruptions in China: inflation, budget deficits, and trade deficits were low and the Communist Party remained firmly in control. Despite this, Chow suggests that:
There were four reasons why the time was ripe for reform. First, the Cultural Revolution was very unpopular, and the Party and the government had to distance themselves from the old regime and make changes to get the support of the people. Second, after years of experience in economic planning, government officials understood the shortcomings of the planning system and the need for change. Third, successful economic development in other parts of Asia – including Taiwan, Hong Kong, Singapore, and South Korea… - demonstrated to Chinese government officials and the Chinese people that a market economy works better than a planned economy. This lesson was reinforced by the different rates of economic development between North and South Korea, and between countries in eastern and western Europe. Fourth, for the reasons stated above, the Chinese people were ready for and would support economic reform.
Given these four reasons, was economic reform in 1978 inevitable? My answer is yes. The first two reasons alone were sufficient to motivate the government to initiate reform. The Cultural Revolution made the government so unpopular that both it and the people badly wanted change. The direction of change was clear because economic planning was recognized to be a failure. …there was no other way to go.

[Chow, pp. 47-48].


The Party’s desire for change created a situation in which Deng Xiaoping and his allies, known as pragmatists and long-time critics of Mao and the other “hardliners,” could ascend to leadership. Over the years, Deng had criticized the Party’s economic policies, not for ideological reasons, but for not producing results in the form of adequate increases in the standard of living of the Chinese people. As early as 1962, he had argued: “It doesn’t matter whether a cat is white or black so long as it catches mice.” Despite suffering during the Cultural Revolution, Deng emerged as the Party leader after Mao died. Under his watch, reforms began.
China’s transition to a market economy has been gradual and is still not complete. To summarize its strategy for developing markets and freeing prices from central control, analysts have used the term “dual-track approach”: the planned economy continues, but a market-track is allowed to grow along side it.
Its basic principle is as follows. On one track, economic agents are assigned rights to, and obligations for, fixed quantities of goods at fixed planned prices as specified in the preexisting plan. At the same time, a market track is introduced under which economic agents participate in the market at free market prices, provided that they fulfill their obligations under the preexisting plan. In essence, prices were liberalized at the margin while … plan prices and quotas were maintained for some time before being phased out. Clearly this approach differed from the two approaches experienced by the eastern European countries…
In the first approach, practiced in Hungary for example, after its 1968 reform, bureaucrats set prices administratively, supposedly in accordance with supply and demand. But in reality, prices were set through bureaucratic bargaining, often to serve the political objectives of bureaucrats, such as keeping state firms afloat. Such reform satisfies bureaucrats’ interests but does not improve efficiency in any significant way because prices are not really determined by the market…After 1990, eastern European countries have adopted a standard approach: prices are freed in one stroke and determined solely by the market. [China’s approach] differs from [the eastern European] experience prior to 1990 because real market prices and markets as a resource allocation institution were created immediately. It was also different from their experience after 1990 because of the continued plan track

[Qian 2003, p. 307].


3.1. First stage: 1979-83.
The Third Plenum of the 11th Communist Party Congress, held in December 1978, formally shifted the Party’s focus from “class struggle” to “economic development.” The accepted ideology during the first phase of reform was the idea of “ ‘planning as a principal part and market as supplementary part’ ” [Qian 1999, p. 4].
Reforms in Agriculture. The major focus at this time was on the agricultural sector which had been stagnant since the ascension of the Communist Party to power and periodically produced food shortages. The government continued to set production quotas but increased prices paid to farmers for grain by 20 percent and decreased the prices of agricultural inputs to provide farmers with incentives to keep production high.
A significant development at this point was the emergence of the “household responsibility system.” This was created spontaneously by the peasants themselves in poor rural areas. The first recorded occurrence was in December 1978 in the Xiaogang Production Brigade of Fenyang County in Anhui Province where 20 peasants, representing 20 households, put their fingerprints on a contract to divide the commune’s land among the individual households. They promised to fulfill their collective government quota but would keep any output above the quota and could dispose of it however they wished. While they did not have the right to dispose of the land itself, the contract gave them control over the land’s production. The practice spread and was endorsed by the governor of Anhui Province though not by the central government. In fact, the 1978 Party meeting that initiated the reforms explicitly prohibited cultivation by individual families. Why it was tolerated is not entirely clear. It could be that it began “under the radar,” that is, away from Beijing where the leaders of the central Communist Party resided. Eventually, it spread and surely was noticed, but, by this time, the leaders may have begun to observe that agricultural output was rising. Given the mood of pragmatism and therefore an interest in doing what worked, the authorities may have decided to ignore it. In any event, the Party began to officially endorse the household responsibility system in early 1982. By 1984, almost all rural households had adopted it.
The significance of the “household responsibility system.” was that, from the early stages of reform, agriculture followed the “dual track approach.”
The commune (and later the household) was assigned the obligation to sell a fixed quantity of output to the state procurement agency as previously mandated under the plan at predetermined plan prices and to pay a fixed tax to the government. It also had the right to receive a fixed quantity of inputs, principally chemical fertilizers, from state-owned suppliers at predetermined plan prices. Subject to these conditions, the commune was free to produce and sell whatever it considered profitable, and to retain any profit. Moreover the commune and households could purchase grain (or other) outputs from the market for resale to the state to fulfill its responsibility.

[Qian 2003, p. 309]

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