The Fundamental Institutions of China’s Reforms and Development

1. The Fundamental Institutions of China’s Reforms and Development Chenggang Xu University of Hong Kong July 19-23, 2010 Chicago Workshop on the Industrial Structure of Production Chicago Law School, Chicago GSB, Coase Foundation

2. Outline of this talk • Compared with the rest of the world, China’s fundamental institution is unique • It is inherited from China’s unique long imperial history • The Chinese Communist Party’s rule since 1949 and the unique political-economic campaigns (the Great Leap Forward Movement and the Cultural Revolution) are directly responsible for shaping up China’s fundamental institutions • China’s fundamental institution is a double-edged sword • Responsible for China’s unprecedented economic growth • Also create grave political-socio-economic problems • Sustainability of China’s growth is determined by the stability of China’s political-economic system, which is determined by China’s fundamental institutions, including their reforms

3. Theoretical vs. empirical studies of institutions Divorced theoretical and empirical studies of institutions Theoretical literature (e.g. Coase, North, Hurwicz-Maskin-Myerson, Williamson, etc.) Studies basic mechanisms which govern the incentives of agents and coordinate activities in political/economic games The problems are universal but solutions are context specific Cross country literature (e.g. IMF, Acemoglu, Shleifer, etc.) Measure the distance of each country’s institution from the “best practice” institution Often ignore how specific incentive problems are solved Institutions of most of the countries in the world have an European origin: a standard approach may well apply Through colonization: N/S America, Australia, Africa, South Asia Through voluntarily adoption: Japan The “best practice” in general is path-dependent The optimal mechanism to solve incentive/coordination problems can be different for countries with different historical paths 3

4. The so called “China puzzle” • China is different: has never been a colony of Europe • By “best practice” based measurements Chinese institutions are worse than the average of developing/transition economies • Quality of government, law, finance, corporate governance, etc. • The coexistence of “bad” institutions and great growth performance of China contradicts the cross country literature => “China puzzle” • This “puzzle” is an illusion, since this “standard” approach ignores important Chinese institutions which deals with incentive/coordination problems • Institutions evolved from China’s unique long imperial history explain much of today’s development • The only empire on earth which last for more than 2000 years • These institutions also explain serious social/economic problems in today’s China

5. The fundamental institution of China:Regionally Decentralized Authoritarianism (RDA) • Highly centralized personal controls – in contrast to a federal state • Provincial level officials are controlled by the central government • Nested personnel controls over all level subnational officials • Personal control as incentive instruments for the central government to lead • China is one of the most politically centralized countries in the world • Highly decentralized in economy – in contrast to an unitary state • Subnational governments are enabled: control most resources in China • Most firms are under great influences of sub-national governments • Sub-national governments control most of the land • China is fiscally most decentralized economy in the world • Regions are relatively self-contained and are alike in structure • China is not one, but 22 countries (WSJ, 9/2009) • Provide conditions for regional competition and regional experiments • The RDA determines China’s policies, development, and problems

6. Stylized Governance Structure of ChinaThis governance structure is evolved over a long history 6

7. Stylized Governance Structure of China in 14th Century (Ming-Qing)is similar to today’s RDA regime 7

8. Centralized Political Governance • The central government controls • The personnel matters of sub-national governments • Commands high economic sectors (e.g. banking, railway etc.) • Party ideology and the mass media • Delegate/rescind power to regions (Chinese Constitution) • Centralized personnel control deals with incentive problems • Appointment, promotion, demotion and cross-region rotation of regional leaders as a control instrument • Rewards, penalties and regular performance assessments as essential control instruments • Personnel control as a key ingredient of regional competition • Personnel control as a key element of maintaining control & containing corruption • Highly decentralized implementation conditional on highly centralized personnel control

9. RDA as the institutional foundation forregional competition & regional experiment • Regional competition and regional experiment are the key reform strategies that make China’s market reform successful • Proper government support is a necessary condition for market development, the question is how • The RDA provides the institutional foundation for regional competition and regional experiment • Effective regional tournament competition requires • Officials’ career paths are linked to the performance ranking • Regions are alike in structure of regional economies • Regional competition => High powered incentives + autonomy => local governments initiate/implement reforms • Almost all early successful reforms were initiated by sub-national governments as regional experiments (e.g. HRS, SEZs, etc.) • Regional experimentation requires regional decentralization • Complementary tasks of an experiment in a region must be controlled by the sub-national government

10. Regional experiment is essential in pushing market reform forward • Without regional experiments market reform would not be started • Market reform is controversial (ideology and nested interests) • Under the “consensus based collective decision rule” every top leader can “veto” a market reform initiative • Experiment approach weakens political resistance to reforms • When a reform is tried only as regional experiments • When a new reform is an option: the dual track approach • Regional experiments lower risk of reforms • A failed experiment would not impact the national economy • Invite thousands of local officials to involve institutional innovations • Need locally invented new institutional arrangements to deal with intrigue political/incentive problems => new institutions • Locally initiated experiments have paved the road of national reforms • Land reform, special zones, TVEs (1980s); privatization, social security and large scale layoffs, industrial clusters (1990s); …

11. Regional competition is essential in pushing market reform forward • How to motivate government officials in reforming the institution in which they have nested interests determines the fate of the reform • Tournament-like regional competition provided powerful incentives to sub-national governments in early reforms • High powered incentives to take risks in experimenting reform policies locally • High powered incentives to implement tested experiment results • Regional competition is a de facto selection mechanism in regional experiments to contain negative impacts of conservative ideology • Some local experiments are not in market reform directions, but what matters in regional competition is performance • Among all experiments being tried, outcomes of market reform experiments often dominated others in regional competitions

12. Characteristics of China’s RDA Regime Compared with Other Regimes

13. Decentralization and Incentive compatible reform • Why decentralization is crucial? • Incentive issue makes engineering approach (or central planning approach) of reform unfruitful • Reforming an institution affects and is affected by interests of stakeholders of this institution • Reforms ignoring interests of majority stakeholders of the existing institution will fail • Local incentive problems and local institutional arrangements varies greatly over the nation • Local history determines local stakeholders interests • A decentralized evolutionary approach is more likely to be incentive compatible and to fit with local conditions • Decentralized institutional innovations are essential in dealing with local problems • Most successful reform policies were evolved in the process of resolving local incentive and coordination problems

14. Why decentralization functioned in China “China is the only country [in the world] where the local governments have played a leading role in increasing rates of growth” (Bardhan and Mookherjee, 2006) What institution of China contributes this? The national government is sufficiently strong To keep political and economic stability To keep macro control The central government’s objective Priority on growth and economic efficiency Preference in supporting market economy Subnational governments are enabled: they have controls over sufficient amount of resources in wide ranges A condition for regional competition/experiment Particularly important when many markets are to be developed Subnational governments are empowered: they are authorized to take reform initiatives or development-enhancing initiatives 14

15. Enablement of subnational governments • Enablement of subnational governments is almost overlooked in the literature • Enablement does not come out automatically with empowerment • Enablement is a necessary condition for commitment and institutionalization of decentralization • Not enabled subnational governments would not be able to take policy actions and decentralization would not work even when they are empowered legally • The high degree of enablement of subnational governments is a powerful double-edged sword: it is also create serious problems in today’s China • Enabled to intervene judicial process: local courts are de facto (historically had been de jury) subordinates of local governments • Enabled to appropriate land: as de facto landlords • What does this powerful double-edged sword do depends on the nature of regional competition/experiment • It can be highly destructive as well

16. Grave problems created from regional competition: Multi-equilibriums under regional competition • Regional competition and experiment function well when there is single well-defined objective, e.g. GDP growth • When subnational governments have multiple tasks regional competition may lead to multi-equilibriums • Tasks in conflict with GDP growth are often ignored: e.g. inequality, citizens’ rights, environment, etc. • Subnational governments may race to the top/bottom for different tasks • Multi-equilibriums in regional experiments: what to be experimented are determined by the nature of the race • May experiment novel ways of corruption • May experiment how to block judicial independence • May refuse to promote tested welfare-enhancing policies • Race to the bottom in regional competition/experiment explains most of today’s serious socio-economic problems

17. An ultimate limitation of an authoritarian regime • A large number of performance indicators are used in assessing subnational governments; some of them are conflicting to each other • GDP, social stability, environment, family planning etc. • There are unsuccessful attempts of designing a comprehensive indicator which summarizes all relevant objectives, e.g. Green GDP • If this approach succeeded the multi-task problem would be resolved • Difficulties with this approach: information/incentive problem • Information related to market activities is summarized by GDP • To find correct information for activities unrelated to markets is challenging • If the information is used for incentives of local officials and if the information is only available locally, then local officials have incentives to distort the information • New incentive problems in solving multi-task problem

18. Marginal improvements as a transition • It may be possible to design some mechanisms to solve these new incentive problems, but these mechanisms may be very costly • A combined approach is to take away some tasks from subnational governments, which will substantially reduce the multi-task problem • Market activities should be separated from subnational governments • This will preserve strong incentives for firms when multi-task problem weakens subnational governments’ incentives • Responsibilities for those activities with strong cross-region externalities should be centralized or be regulated by the central • Tasks to be handled by the central should be divided into groups and handled by specialized ministries, special courts, and special regulatory regimes • Given the information problem, using a decentralized approach to preserve decentralization is likely to be more effective • Improving judicial independence and free press are among the most important fundamental reforms that China should take further

19. Judicial independence & free press • Chinese local courts had been subordinates of local governments • This de jury relationship is abolished officially but de facto local courts are often backyards of local governments • Without judicial independence the petition (上访) system is a chance for citizens to address their cases, but it does not work &getting worse • Judicial independence is a key to solve many “unsolvable” problems • Illegal land expropriation, rent-seeking, corruption • Measures to build judicial independence • Litigations against a local government should be allowed to be launched outside of the jurisdiction of this government • The appeal system should be re-built in order to check and constrain local governments’ abusing power • Monitoring via free press is a key to check and to constrain local governments effectively but there exist serious problems nationwide • Maintaining and improving judicial independence and free press should be major aspects of personal performance assessment; violations should be punished heavily

20. Concluding Remarks • China’s long run growth depends on its political stability • Conflicts between local government and citizens are getting worse in recent years – threatens social stability • Worsened strikes by workers’ being laid off • Worsened violent protests by peasants' losing land • Nervousness lead to tightened censorship • Ultimate solution: transform the RDA regime into a democratic federal state • Officials at all levels should be elected • Local governments should be accountable to their constituencies, not the upper level government • The multi-task problem of government officials will be transformed into one dimension, being elected

21. Increasingly intensified conflicts between local government and peasants 2010年1月11日江苏邳州市运河镇事件 Thank You