Leonid Polishchuk

1. Transition and Development: China, East Europe and North Korea 2009 Seoul National University WCU – Hong Kong University Conference October 30- October 31, 2009 A Tale of Two Decentralizations: Devolution of Government in Russia and China Leonid Polishchuk

2. Reflection on: ChenggangXu The Institutional Foundations of China’s Reform and Development To appear in the Journal of Economic Literature Leonid Polishchuk Legal Initiatives in Russian Regions: Determinants and Effects In: P. Murrell (ed.) Assessing the Value of Law in Transition Economies, University of Michigan Press, 2001

3. Difference in differences approach in institutional studies A good way to assess potential and limitations of institutions is through comparative analysis when similar institutional setups produce strikingly different outcomes. Such comparisons reveal complementarities and contingencies that could decide the fate of a policy reform. Case in point: decentralization in Russia and China In both countries decentralization was implemented almost simultaneously to advance modernization and reform of a formerly command economy in a large and diverse country.

4. Outcomes China Decentralization is sustained and institutionalized as a signature feature of the Chinese economic development model and powerful engine of economic growth. Russia Decentralization was a fiasco economically and politically and was curtailed and reversed in the early 2000s.

5. Russia and China on decentralization map

6. Explaining the difference Such multiplicity of outcomes begs explanations and should be related to differences in conditions, endowments, and path dependencies, as well as to choices of different decentralization modes.

7. Rationales and precedents China Decentralization was a deliberate choice of the central government, an innovative “made in China” approach to reform and itself a source of numerous institutional innovations. It had precedents in the country’s old and recent history, from the imperial times to the “Great Leap Forward”. Russia Decentralization was a spontaneous reaction to earlier failures of hyper-centralization, an ad hoc elite pact based on power-loyalty swaps, a pragmatic choice of the central government offloading risks and responsibilities of reforms to regions, and an attempt to grow market institutions “organically”, from bottom up.

8. Legal and political accommodations China Decentralization was implemented by an authoritarian regime (the RDAmodel) without a de jure federal basis that includes inter alia elections of regional governments. “Federalism, Chinese style” (Montinola, Quian, Weingast, 1995) combines far-reaching economic decentralization with unwavering political centralization. Instead of standard “best practice institutions”, including private ownership and the rule of law, “transitional” institutions” were put in place, which are gradually evolving to a more conventional institutional setup. Russia Decentralization was attempted in the format of a rule-of-law-based federal state with political checks and balances and constitutionally stipulated divisions of power. Decentralization was concurrent with an economic reform which emphasized private property and free market.

9. Quality of institutions: ex ante and ex post The Russian foundations appeared more solid and credible than China’s, and scored higher on conventional institutional measurement scales. Performance outcomes were exactly opposite. Do Institutions Cause Growth? (Glaeser et al., 2004) Checks and balances on executives could be less important than good policies pursued under authoritarian regimes. Imprecision of the Russian federal law and lax enforcement practices narrowed the gap between the two systems. What mattered were self-enforcing incentive-compatible equilibrium institutions (Weingast 1997; Aoki 2001) emerging in China and Russia.

10. Economic benefits of decentralization Earlier view: decentralized system of government customizes economic policies and provision of public goods to local needs and regulates inter-jurisdictional spillovers . Modern view: decentralization strengthens performance incentives for subnational politicians and public servants, and opens up a competitive market for regional and local policies. Incentive multipliers of decentralization: • competition for mobile factors of production • availability of comparative benchmarks (yardstick, or tournament, competition)

11. Solutions of subnational government agency problem China Top-down (accountability to the central government through appointments and subordination) Russia 1990s – bottom-up (accountability to voters through direct elections) 2000s – top-down (accountability to the central government through appointments and subordination)

12. Factors affecting performance and outcomes of decentralization • Economic structure • Economic trends • Objectives and capacity of the central government • Civic culture

13. Impact of economic structure • Concentration of production and high degree of specialization of local economies require unimpeded interregional exchanges which could be obstructed by local trade barriers. • Concentration of production and interregional division of labour raises importance of centrally supplied institutions, policies and infrastructure. • Concentration of production reduces short-run significance of competitive markets and private sector development. • Concentration of production increases the danger of capture of subnational governments by dominant economic and political interests (Bardhan, Mookherjee, 2000). • Dissimilarity of regional economic profiles and socio-economic conditions complicates interregional comparisons of government performance and devalues tournament competition.

14. Economic structure comparisons China Relatively even allocation of industries across the country and “completeness” of regional economic profiles. Similarity and comparability of economic conditions in various regions facilitates tournament competition. Russia High concentration of production and profound disparities in income and welfare. Importance of national markets and infrastructure. Susceptibility to capture of subnational governments by narrow interests. Difficulties in assessment of regional and local governments’ performance.

15. Impact of economic trends: strategic complementaritybetween decentralization and growth Economic growth and massive inflow of investments nation-wide strengthen performance incentives of regional and local governments: efforts to improve investment climate and supply market-enhancing institutions bring high rewards. Economic growth makes government reputation a valuable long-term capital asset and thus substitutes for the rule of law as a commitment device. Recession and a lack of investments devalue local pro-market efforts and reduce economic costs of reneging on policy announcements and expropriating private investments.

16. Costs and benefits of expropriation of external investments

17. Political economy of scale and endogenous rule of law High inflow of investments maintains “supply” of good institutions and lends credibility to government’s commitment to honour investors’ rights. In a rational expectations equilibrium good institutions and policies and private investments feed upon each other. When investments trickle in, violation of investors’ rights is a distinct possibility, making investors’ scepticism rational and self-fulfilled (Rodrik, 1991; Polishchuk, 2003)

18. Economic trends comparison China Fierce regional competition for massive inflow of foreign investments has been a powerful force for pro-market policies, which contributed to the nation’s reputation of an investor-friendly economic powerhouse. Russia Throughout the recession of 1990, capped by the 1998 financial crisis, foreign and domestic investments remained suppressed. Local efforts to attract investments were devalued by the overall negative investment profile of the country at large, which in its turn was sustained by predatory policies of regional governments.

19. Somewhere in Russia: a 1999 dialog between regional governor and investor Investor: “What are you doing?! No one will ever invest here again!” Governor: “Big deal! No one is investing here anyways.”

20. Objectives and capacity of the central government China The central government was consolidated and committed to economic growth and modernization. National interests were properly protected against regional attempts to e.g. raise local trade barriers. Proper enforcement incentives for regional officials were set and consistently applied and enforced. Russia Throughout 1990s the government remained weak, divided and unstable. It did not have, let alone being able to implement, a clear vision for the country, and surrendered much of its policy prerogatives to regions. The ability of the government to enact and enforce laws required to maintain “market-preserving federalism” was low throughout 1990s, and multiple regional transgressions into the federal domain (“sovereignties parade”) went unopposed.

21. Role of civic culture Economic benefits of decentralization hinge upon accountability of subnational governments. If economic decentralization is coupled with political one, civic culture, i.e. political awareness, participation and capacity for mobilization and collective action, is of paramount importance “to make democracy work” (Putnam, 1993). Civic culture keeps narrow interests in check. Russian mode of decentralization was highly sensitive to the capacity of the society to uphold democratic institutions

22. Social capital endowments China Economic decentralization was decoupled from political one, and the impact of civic culture was insignificant. Russia Past experience of political participation and self-government is nearly absent, and the stock of social capital, eroded by centuries of despotic rule, is low. Regional politics was easily manipulated and controlled by vested interests. Non-transparency of government and wide variations of local conditions further weakened accountability of regional administrations to voters.

23. Conclusions (i) Chinese economic structure was more conducive to “localization” of economic policy-making than the Russian one. (ii) Central government in China was able to clearly articulate its policy priorities and align incentives of regional governments in accordance with these priorities; it was also able to effectively police its relatively few areas of direct economic responsibility, such as unimpeded trade between regions and macroeconomic stability. (iii) Central government in Russia was unable to properly implement its role in the “market-preserving federalism” compact, and tolerated massive regional transgressions into the federal policy domain. (iv) Democratic processes in Russian regions failed to ensure accountability of regional governments to voters. (v) Economic structures of Russian regions and protracted recession distorted incentives of regional policy-makers away from improving market institutions and investment climate.

24. Regional policy innovations Economic decentralization allows – end encourages! – regional and local policy initiatives. Market-preserving federalism generates such initiatives, puts them to test through competitive selection, and facilitates dissemination and emulation of successful ideas throughout the country. Both countries counted on regional innovations. China relied on regions in navigating through unchartered waters of “transitional institutions”, where the main appeals were lower risks and local creativity in search of indigenous reform strategies. In Russia regional lead in reform was considered as an opportunity to sidestep policy gridlocks in Moscow and to demonstrate merits and potential of market reforms to other regions and nation-wide.

25. Regional initiatives in Russia and China Both countries had indeed produced a number of regional policy innovations that were massively emulated by other regions. However the impact of such initiatives was markedly different. In China the innovations that survived reality checks and competitive selection were usually conducive to economic growth. In Russia they were often detrimental to economic efficiency. China Land reform Privatization Special economic zones Township and village enterprises (TVEs) Bankruptcy procedures Russia Trade, investment and migration barriers Local price controls Takeover of federal economic prerogatives Floating of “junk” regional bonds Multiple local taxes and off-budgetary funds Issuance of monetary surrogates Bilateral “treaties” with the central government Collusions with firms to avoid remittance of federal taxes

26. Advantages of reform through local experimentation: the case of bankruptcy (M-form vs. U-form; Quian, Roland, Xu, 2006) The institution of bankruptcy was introduced in China through local trials and errors within loose centrally set guidelines. Regional experimentation gradually relieved political tension over bankruptcy and provided vital input into the final version of the national law. In Russia the trial and error process was nation-wide, leading to a costly legal roller-coaster: the first version of the national bankruptcy law set excessively high requirements to initiate a bankruptcy procedure, which rendered the institution defunct; the second version radically reduced those requirements, opening a floodgate of “contracted bankruptcies against sound businesses; the third version, presently in effect, raised the barriers back again.

27. Subnational governments’ direct involvement in private sector Both in Russia and China local public officials become entrepreneurs not only metaphorically (when they introduce policy innovations), but also directly. In China local governments are involved in the economy e.g. through TVEs, whereas in Russia such involvement takes various forms of “public-private partnership”. In China the TVE model served as transitional institution that secured property rights in lieu of their unavailable conventional legal protection, and strengthened incentives to provide local public goods (Che, Qian, 1998). The latter effect is of more general nature: it is argued that if an otherwise unaccountable government official acquires a stake in the private sector, his public policy decisions become better aligned with social needs (McGuire, Olson, 1996). However this is no longer the case if market interests of a politician-turned-entrepreneur value rent extraction over value creation (Polishchuk, 2008). In such case, common in regional “public-private partnerships” in Russia, the wedge between government priorities and social welfare does not get narrower, but grows wider.

28. Lessons learned Egregious failures of the Russian federal model prompted the newly consolidated central government to re-establish political control and directly subordinate regional governors to Moscow by turning them from elected politicians into presidentially appointed administrators. Liberal critics considered such measures as overreaction, especially since the resumption of economic growth and increased sophistication of voters improved chances for success of the Russian federalism. Still, “de-federalizaton” brought the Russian system of government closer to China’s, and was expected to improve performance of regional officials (Blanchard, Shleifer, 2001).

29. … a Tale of Two Centralizations Such expectations however did not materialize, which can be seen from continued deterioration of economic institutions, neglect of infrastructure, multiple complaints about public service provision, widespread red tape, corruption and government mismanagement and predation. Comparisons between the Russia and China still remain relevant – this time to shed light on uneven outcomes of political centralization.

30. “It’s economy, stupid!” Sweeping re-centralization in Russia was not confined to the political domain – it was extended into the economy by re-allocating tax revenues away from the regions to the federal government, and by radically reducing regional policy-making autonomy. The economic part of centralization was a clear departure from the Chinese approach. However, the centrally imposed constraints are not always sufficiently rigid and binding, and regional executives still exercise de facto considerable discretion over economic and social policies.

31. Corporate social responsibility as an alternative to taxes and regulation The new policy-making environment generated another wave of regional innovations, prominent among them – informal taxation and regulation of the private sector under the guise of “corporate social responsibility” (CSR). The conventional role of CSR is to serve as a private alternative to government regulation by allowing civil society groups to settle directly their relations with companies. In Russia CSR is largely dictated by regional governments or accommodates informal bargains between regional governments and firms (Polishchuk, 2009). This practice illustrates the “see-saw” effect whereby unforeseen and often informal reaction finds ways around an economic policy reform and thus diminishes its effect (Acemoglu, Robinson, 2008).

32. How effective is political control? Economic disparity between Russian regions did not get narrower, which ceteris paribus makes the task of performance assessment of government officials in Russia more difficult than in China. The main difference however is in policy priorities of the central government – in China the priority is given to economic growth, in Russia – to political stability. The second objective often contradicts with modernization and reform (Acemoglu, Robinson, 2006) and does not allow clearly identified and measurable performance targets.

33. The importance of staying focused Assessment of performance of regional officials – a critically important element of a politically centralized system of government – is based in China on economic growth indicators. While the Chinese assessment system is somewhat complicated and includes “hard”, “soft”, and “priority” targets, economic performance is the key concern which sets in motion competition between regions and thus performance incentives. In Russia a presidential decree has established in 2007 43 “primary” performance measures for regional officials, and a specially assembled government commission added to the list another 39 “auxiliary” indicators. Such incomprehensible and unwieldy system of tasks does not provide a clear focus for regional executives which are now supposed to be officially guided in their actions by the central government. Multitasking is also at odds with “yardstick competition” (Holmstrom, Milgrom, 1991). In reality practical indicators include social stability in the region, balanced relations with local elites, and expected election results in support of the ruling party. However controlled media and stifled political competition often suppress early warning signals, and elections are widely believed to be rigged to produce the “right outcome”.

34. Self-defeating purpose Stability as the main objective of the central government could be hard to maintain through credible sanctions against non-performing regional officials. When rule of law and formal institutions are weak, chief executives in Russian regions maintain stability through mostly informal and personalized networks built around them. Removing the key linchpin from such system could jeopardize the fragile socio-political equilibrium, which explains the longevity of some of Russia’s regional political players. While the task of sustaining economic growth is implementable through compatible with effective political centralization when the strong central government monitors performance and rewards leaders and punishes laggards, the task of maintaining stability is inherently at odds with such model.

35. Limits of the two models Institutional imperfections and flaws of the Russian and Chinese models of subnational governance are likely to become more pronounced and contentious than before. China   Profound structural distortions prior to the reform and enormous growth potential of the country allowed to sustain rapid growth as a Pareto-improving process without major re-distributional conflict. As reform deepens and development challenges become more complex, tasks of regional governments acquire multi-dimensional nature which make the top-down agency problem less adequate. Russia The crisis has exposed weaknesses of the Russian institutions and threatens the all-important stability, especially in single-factory cities (monogoroda). Suppressed private sector cannot generate adequate income and employment, and reduced fiscal resources of regional governments are insufficient to cushion off the recession.