The Modality of the Pursuit of Private Sector Development

2.1 PRC Economic Reform: Gradualism

In general, Chinese economic reform is characterized by gradualism and a problem-solving approach, i.e. beginning with the easiest part on an experimental basis and then gradually expanding the experience to other parts, for example, "from small to large," "from non-SOE to SOE," and "from east to middle and west", making compromises with vested interests in the planned economy. When difficulties are encountered, it seeks another approach. It was proved to be an effective way to avoid disorder and maintain social and political stability during the transition process.

Soviet Union-style socialist practice was followed by the Communist Party for over 60 years until 1978, when the PRC launched its reform and opening up policy toward the outside world. The socialist economy achieved miracles in some specific areas and some specific historical periods, thanks to the guidance of socialist ideology, which advocated a spirit of dedication to others and society as a whole. However, since this spirit ran against the intrinsic human nature of pursuing self-interest in the long run, the traditional socialist planned economy was not able to reach economic growth similar to the capitalism economies.

Why weren't the traditional socialist countries able to achieve economic development? Traditional socialist theory assumed that people in socialist countries had common interests and would work hard to attain them. The relation between people was considered to be cooperative rather than competitive. Communist party members were supposed to have no individual selfinterests other than the people's interest as a whole. People's motivation to work was to be promoted by the cooperative spirit. These assumptions were clearly different from those of neoclassical economics originating from Adam Smith, which regarded human being as entities pursuing self-interest. This behavioral pattern of pursuing self-interest is seen as human nature, not having any relationship with what and how much education people receive.

Under the constraints of Marxist dogma, people's activities to attain wealth, consumption goods, freedom and democracy were greatly suppressed. However, the reality was far from the ideology and theory. People didn't like to work harder for the common interest; in fact they may have tried to work less. It can be concluded that traditional socialist practice was no success, and the promise of the Communist Party to improve the people's standard of living was never fully realized. However, at least one basic principle of the "materialism" advocated by traditional socialist economic theory seems to be relevant, i.e. "the economic base determines the social superstructure." It seems that the Communist Party understood clearly that it would not be able to maintain the socialist advantages and strengthen its political power without having a strong economic base, and it tried to satisfy people's demands for food, clothes, bigger houses, good means of transportation, etc. People also have non-physical needs, such as democracy and freedom. In fact, the objective of improving living standards was never given up by Chinese ordinary people. Even at the time of the planned economy, when the demand for goods was distorted and suppressed and private business was regarded as unlawful, the desire for a better life never seems to have disappeared. In most cases, private business existed underground.

There are many modes of reform in the world. Academically, they are usually classified into two types: gradualism, as exemplified by the reform in the PRC, and the "big bang," such as the reform in Russia. Why did the PRC choose to take a gradualist approach?

There seem to be at least three main factors that might account for this reform style. Firstly, the PRC was basically an agricultural country, where the rural population accounted for 80% of the total population. Rural households had very low productivity and few vested interests compared to other social classes, such as workers in SOEs or party cadres and intellectuals. They belonged to the poorest class of society in terms of living standard.

Secondly the PRC was one of the most populous countries in the world, and it faced long-term unemployment problems. To maintain social stability and improve living standards, the government tried to provide employment opportunities for a growing labor force. People in rural areas and unemployed people in urban areas were the first focus of the government. However, vested interests group and the political atmosphere at the time made it difficult for the government to deal with this. The easiest way seemed to be to carry out some reforms gradually on an experimental basis, while making sure not to harm people working in SOEs and the government sector (vested interests group). This is what Deng Xiaoping meant when he said, let a part of the people become rich first.

In addition to these socio-economic factors, it seems that the gradualist approach can be attributed to the mindset of Chinese people. Regardless of socialist ideology, Chinese people seem to be very pragmatic and always look for realistic solutions like Deng Xiaoping's famous remark; "whatever color a cat is, so long as it could catch mouse, it is a good cat.", which reflects his pragmatic attitude. He also once described Chinese reform using the phrase, "go across the river on stepping stones," meaning that during the process of transition from a socialist mandatory economy to market economy, which had never been experienced before, the Chinese would have to go step by step. Whenever they found something wrong they would need to make corrections right way, unlike the "big bang," which made it difficult to restore order. Their view is that a perfect solution with some friction may not necessarily be the best, and that it is preferable to live with a satisfactory solution with less friction. In fact, an unidentified source confessed that, just like other countries, most documents released by the Communist Party were the outcome of compromises among government ministries representing various interest groups, and they could not necessarily be justified from the a theoretical point of view.

2.2 The Mode of Private Sector Development: Three Phases

In carrying out privatization², there are also generally two approaches. The first is to privatize existing government agencies. The second is to keep existing government agencies intact and allow private enterprises to enter into new areas (this is called parallel privatization or "shuangui zhi," and also sometimes called the "Taiwan [sic] model"). The ratio of SOEs to private enterprises in Taipei,China, for example, was once 80:20. It is now 15 to 75. Yet, nearly all of the SOEs continue to exist. The second approach is more gradual and smoother than the first. In developing the private sector, the PRC's government also tried to pursue the second approach. However, since privatization was once a very sensitive issue in the PRC, though 'opening up', 'reform' and 'competitive force' frequently appeared in official documents, the word 'privatization' was seldom used in the past.

However, in recent years the PRC began to accelerate the privatization of SOEs or to sell SOE assets through the Asset Management Commission, which was established in 2002. In the past, the provincial governments were simply agents entrusted to tasks by the central government. Now, however, as owners of SOEs, they are able to dispose of SOEs and put the sales earnings into their own budget resources. With the encouragement of the central government, revenuehungry local governments have rushed to privatize small and medium SOEs under their jurisdiction. The South China Morning Post in January 5 2004 [27] recently reported that 90% of provincial SOEs in the capital of Hunan province have been sold. The State Asset Commission indicated that 80% of small SOEs at the county level and 60% of municipal SOEs have been privatized.

Looking back at reform in the PRC, private sector development has experienced three periods: the development of rural agriculture and individual business (1978-1984), self-development of private enterprises and contract responsibility reform in state-owned and collective enterprises (1984-1995), and the privatization of small-medium sized SOEs (1995-present). During the first period, the household contract responsibility system was introduced for the first time in a rural area, Fengyang County in Anhui Province. Under this system, farmers contracted with local government to deliver a fixed quota of grain in exchange for the rights to use agricultural land for private purposes. This system was imitated by other counties in the province and then encouraged by the provincial government and eventually the central government (Qian Yingyi, 2000 [23]). The household contract responsibility system was described as "paying enough to the nation and leaving enough (according to contracts) to collectives, with all residuals belonging to individuals". While the contract responsibility system strengthened the link between individual income and production output and was a great success in the rural economy, the so called "big pot dinner" (Da guo fan) was completely destroyed and tremendous unemployment was created. In addition, many young intellectuals who had been sent to rural areas during the Cultural Revolution now came back to cities, adding further unemployment stress in urban areas. This in turn created space for the development of private enterprises. To mitigate the stress, government was forced to give urban individual businesses a legal position. By 1982, when the legality of the individual economy was granted by the amendment of the Constitution, 2.61 million individual businesses had been set up.

In late 1980s and early 1990s, the great success of agricultural reform and the rapid development of individual businesses and TVEs came as a great shock to the state-owned sector. With the spread of agricultural reform, the advantages of the urban area and state-owned sector were gradually disappearing. People working and living in urban areas and the stateowned sector made strong demands for higher living standards. This led to urban reform and SOE reform. Learning from the experiences of rural reform, SOEs and collective enterprises also began to adopt a contract responsibility system. This was the second phase. However, unlike the rural contract responsibility system reform, which gave farmers long-term land using rights, contract periods for SOEs were usually shorter, in many cases lasting just two or three years. This led to "myopic behavior," meaning that the concern of contractor was only to maximize revenues within a short period of time, making utmost efforts to get bank financing, increasing investment and output and making heavy use of existing machines and facilities. The value of state-owned assets and the long-term development of SOEs were ignored.

It appeared that this process of SOE reform had nothing to do with state-owned property rights. In fact, however, the privatization process of property rights began simultaneously with the contract responsibility system. Under the contract responsibility system in the early stage of SOE reform, managers and workers signed a contract stipulating how much money the contracted enterprise would pay to the government over a certain period of time. Once the enterprise fulfilled their commitment to the government, the managers and workers could share the extra profits. This indicates that the interests of the SOEs were directly linked to short-term profits.

Assuming that a contracting enterprise with labor (H), capital (K) and technological level (A) faces fixed labor costs (W) and capital costs (R) (in either a competitive economy or a planned economy), the production function follows the Cobb-Douglass style GDP = AKεH^{1 - α} , where GDP represents the output of a representative enterprise. The enterprise's objective is to maximize the objective function:

O = k(AKεH^{1 - α} - C - HW)

Since C, the contracted profit paid to the government, is fixed in the contract; k, the ratio of total product less labor costs and fixed costs paid to the government, is also fixed in the contract; and the wage rate and number of employees cannot be changed under the labor system (meaning Tie Fan Wan), the objective is equivalent to maximizing GDP = AKεH^{1 - α}. Thus, managers and workers tried to maximize their interests by increasing investment. This inevitably led to excessive demand for investment³. Theoretically, when an unlimited demand for investment is satisfied, return on capital must approach zero. Hence, this kind of reform led to overheating investment and subsequent long-term inflation in the mid 1990s (Zhao, 2002 [43]).

It seems that it is only the reform before 1995 that can be regarded as gradualism. A significant characteristic of first two periods is that it was a Pareto improvement process. Under this process the existing SOE system was either maintained intact or at least not clearly privatized, while the agricultural sector and private sector developed quickly. The status of workers in SOEs did not deteriorate, but those in the agricultural sector and private sector experienced absolute improvements. In this sense the process was a Pareto improvement.

By 1994, inflation worsened under the effects of the contract responsibility system and soft budget constraints⁴ of SOE, reaching over 20%. Curbing inflation and avoiding the risk of banking sector was actually the most important policy issue for the third period. On January 1, 1994, the PRC introduced a series of comprehensive tax and fiscal reforms, which put the country more in conformity with international practice. Fiscal policies were tightened. Beginning from 1993, monetary and credit policy was tightened. In 1995, the PRC passed a "Central Banking Law," making monetary policy independent from local governments. The budgetary constraints on local governments became stricter in the late 1990s. These tougher budget constraints created difficulties for SOEs and collective enterprises. A great number of small and medium sized SOEs suffered losses, and a tremendous amount of non-performing loans were accumulated in the banking sector. The government was unable to help the many ill-performing enterprises and the banking system came to the verge of collapse. In 1995, the central government formulated a policy called "Zhua da fang xiao," meaning "keep the larger ones and let the smaller ones go" This policy marked a departure from gradualism and the beginning of radical reform. The government decided to keep 500 to 1,000 large SOEs under state ownership, and to transform all other small SOEs through policy package measures including reorganizations, mergers and acquisitions, leases, and sales.⁵

2.3 Future Reform and the Power of Control of the State-Owned Sector

For recent years, Chinese academics and government officials have had philosophical arguments about the "power of control of the state-owned sector over the whole economy." The power of control of the state owned sector is a new concept put forward in the report of the Fifteenth National Congress of the Chinese Communist Party in 1997. With the progress of economic reform, the ratio of GDP produced by the public economy to total GDP continues to decline. Some people are concerned about the PRC’s privatization and movement to capitalism, and wonder whether the PRC will be able to maintain its socialist system. To clarify this issue and erase people’s misgivings during the pursuit of economic reform, the Fifteenth National Party Congress put forward this concept, which at the time was considered to be a theoretical breakthrough in the PRC reform process.

According to Zhang Zhuoyuan, 1997 [41], the control power of the state-owned economy has two meanings. One is that the state-owned economy controls the lifeline of the national economy; the other is that state-owned economic elements play a dominant role in large-sized enterprises and corporation groups. This means that, by selling part of the equity of statedowned enterprises, and adjusting capital input, the influence and role of the state-owned economy will be enlarged. "So long as the public system is maintained as the main body and economic lifelines are controlled by the nation (government), control and competitive power will be strengthened, and the weight of the state-owned economy, whether growing or shrinking, will not impact the characteristic of socialism."

"As stated above, traditional socialist theory maintains a basic principle that "social productivity determines the relations of production, and the economic base determines the upper social and political structure." Traditional Marxist theory also argues that the fundamental difference between capitalism and socialism is that in socialist countries, property rights are held by the public sector. Therefore the PRC government seemed to assume that only when SOE sector took a relatively larger proportion, could the socialist system be guaranteed. Based on this understanding, in the early stage of SOE reform, the government always emphasized the importance of the power of control of the state-owned sector.

However, the concept of the power of control power of the state-owned sector has changed along with economic progress. At the initial stage of economic reform, the government insisted that "the planned economy is the central pillar and the market economy should be a supplement." Later, the private sector came to be considered as an important supplement to the socialist public system, and finally it was positioned as an important component of the socialist market economy. More recently a National Statistical Bureau report in 2000 argued that SOEs should only exist in a limited number of crucial sectors such as national defense and critical high-tech industries, and even in such a case so long as these sectors are state-owned and its control power is maintained, there must be no significant change in the socialism.

It seems that the role of state ownership now only has political implication rather than economic one. We could say that regardless of such political and philosophical discussion, reality is going ahead much faster. Political and philosophical discussion might be important but economic force seems to be dominating political force. As a sound and competitive market environment is built, the power of control power of the SOEs may become less important for the government. The government will finally realize that the economy, whether private or state-owned, can be controlled through sound laws and regulations and a competitive market policy.

On the other hand, if the government tries to maintain its control over the whole economy through the ownership of SOEs and delays political reform, there may be a spread of corruption and "myopic behavior" in the economy, leading to excessive demand for investment and eventually causing long-term inflation. The value of state-owned assets, the quality of banking assets and the long-term development of SOEs may be ignored. If the government fails to demonstrate the ability to deal with the many ill-performing enterprises and banking system, more radical reform will become inevitable.

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