It has been estimated that there are 150 million surplus labour in the rural sector waiting to be transferred to non-agricultural industries. Even if China succeeds in transferring 8 million surplus labour a year, the whole process would take 20 years (Wu 2005). Many economists have differing views of how this could be achieved.

According to Wu (2005), there were two main schools of thoughts on how China can go about its urbanization and to absorb more of its surplus rural labour. One school opines that the cities are already overstretched and the best way to accommodate the surplus rural labour is to develop the non-agricultural industries in the rural areas which in time will evolve into small cities. In other words, protagonists of this school of thought see Chinese economy as having a “triple economy structure” comprising of an agriculture sector, a rural industry sector, and an urban sector. The second school of thoughts, on the other hand, sees Chinese economy as having a “dual economic structure”, comprising of only a rural agricultural sector and an urban industrial sector. Protagonists in this school see serious weaknesses of TVEs that are currently scattered in the rural areas.  They consider them inefficient and incapable of generating the agglomeration effect that is critical in driving industrial development. Urban areas, on the other hands, have the necessary infrastructure and amenities for large scale industrial development. Therefore, development should be focused on expansion of the cities to enable these areas to absorb more surplus rural labour.

Recognizing the importance of the migrant workers’ role in and contribution to China’s industrialization effort, the 16^th National Congress of the CPC passed the resolution on “improving the environment for the transfer of rural surplus laborers” in October 2003. Among other things, it was determined that the plans for the coordinated development of urbanization and industrialization should include efforts to prepare the rural surplus labour for the migration. Both the education hardware and software needed to be upgraded to ensure that the children in the rural areas have the same starting line as those in the cities. Financial assistance would be provided for students from poor rural family to pursue their tertiary education in the cities. In addition, a system of vocational training had to be put in place to equip the migrant workers with adequate skills. At the same time, besides carrying out reforms to improve the operations of existing TVEs, conditions must be made more conducive for the more entrepreneurial to start their own small and medium enterprises which could in turn create more jobs for other migrant workers. Finally, regulations with regards to residence registration needed to be reformed to ensure that migrant workers with stable jobs and residences in the cities could get to enjoy the same rights and share the same social obligations as the urban folks.

Development of TVEs over the last three decades supports the second school of thought. Many TVEs located in the inland regions failed to develop successfully because, among other factors, their locational disadvantages translated into low efficiency and high costs. On the other hand, over the last three decades, many small towns near the coastal region where TVEs gathered during the 1980s have since evolved into big cities. One good example of such towns was Wenzhou in Zhejiang Province. Indeed, since the start of reform in late 1970s, many small towns had developed rapidly to absorb the surplus rural labour. The number of administrative towns grew from 2,173 at the end of 1978 to 19,210 by the end of 1998. In total, these towns housed a population of 170 million. By the end of 2002, the number of administrative town increased further to 19,811 with a total population of 220 million (Wu 2005).

Also, the Chinese experience shows that planning for urbanization and industrialization need to be better coordinated to ensure the vigorous and orderly development of large, medium, and small cities and small towns as well business enterprises of different ownership forms and sizes. In other words, development should be well balanced to integrate the competitive advantages of villages, towns and cities in order to create and reap maximum benefits from the agglomeration effect generated by an integrated value chain. One particularly important link in this regional value chain is the small towns located near big cities. These small towns are the bridges between the rural areas and the big cities. They have the combined advantages of being near to both the source of an abundant supply of low cost labour (i.e. the rural areas) and the market (i.e. cities) for their products. More importantly, these small towns have room for rapid growth and have the potential to evolve into big cities with foresight and careful planning. Initially, the operations of enterprises located in these small towns can play a supportive role to the enterprises in the city. The low-skill labour intensive works can take place in these small towns while the big cities with limited space but better infrastructure and highly skilled and educated workforce could focus on higher value-add activities.

In short, the implementation of various measures by the early 2000s help to lay the foundations for accelerated transfer of rural surplus labourers to urban non-agricultural industries which underwent phenomenal growth as a result of China’s accession to WTO after the turn of the century.

5.4.1 Challenges in Overcoming the “Three Rural Problems”

Amidst the policy adjustment of increasing prices for agricultural products, agricultural production increased over the years until around mid-1990s when the overall shortages in the past turned into surpluses. The excess supply resulted in falling grain prices especially after 1992 when the government reformed the purchase, marketing, and pricing system of grain. Control over selling prices of grain was lifted in more than 98% of all counties and cities nationwide by the end of 1993. In 1995 and 1996, prices fell again as a results of bumper harvests and again. To protect the farmers, the central government raised the government purchasing price of quota grains by grain by 46.6% in 1994, 29.0% in 1995, and 5.8% in 1996. At the same time, the state grain department was ordered to increase their stockpiling of grain.

In August 1997, the State Council issued the Circular Concerning Unrestricted Purchase of Non-Quota Grain at Protective Price, stipulating the setting up of a grain protective price. According to the circular, the price for quota grain could be no lower than that of the previous year while the price for non-quota grain should be the base price for quota grain. In addition, besides fulfilling the usual commitments of quota purchase, all localities were told to purchase without restriction surplus grain from farmers at protective price. The implementation of this supportive policy resulted not only in increase in grain stock but also operation losses and unpaid bank credit. As of March 1998, outstanding grain loans nationwide were RMB 543 billion and grain operation losses amounted to RMB 214 billion (Zhang, Wang and Li, 1998). Despite government’s supportive efforts, grain prices still fell because of excessive supply. On a year-to-year basis, grain purchasing price dropped by 9.8% in 1997, 3.3% in 1998, and 12.9% in 1999.

Meanwhile, to help the farmers, policy makers continued to seek solutions which would not unduly increased the financial burden of the government. In June 1988, the State Council proposed the implementation of three policies. First, surplus grain would still be purchased without restrictions from the farmers at protective price. Second, the purchase grain would then be sold at a mark-up to ensure that the grain enterprises would not suffer a loss. Finally, purchasing funds lent by the policy bank to grain enterprises should “flow within a closed loop” to ensure that money would flow back to the bank after the sales of the grain stock. In November 1998, the State Council further dictated that grain dealers, distributors and processing enterprises were allowed to purchase grains only from state-owned grain purchasing and storage enterprises. All direct purchases from farmers were forbade. However, under the market economy, the policies could hardly be implemented within an environment of falling prices due to excessive supply. As a result, grain enterprises continued to suffer heavy losses.

The decade of 1990s for the agricultural sector was therefore ironically one of falling prices despite years of bumper harvests. The same patterns of increasing supplies and falling prices were seen in other crops, such as cotton, oil, and sugar too. The falling prices caused by excessive supply led to slower growth of farmers’ income and widening income disparity between urban and rural residents. The plights of the farmers were epitomized as the “three rural problems” (三农问题) – stagnant rural economy, poor rural residents, and backward rural society.

The stagnant rural economy was a result of falling prices. Efforts from the government centers around administrative measures of providing indirect subsidies through stipulating protective pricing and unrestricted purchases of farmers’ surplus grain stock. Despite so, prices continued to fall even in the late 1990s because of excessive supply. The problem of slower income growth was accentuated by rapid rises in tax burdens and expenses. The combination of slower income growth and higher tax burden and expenses translated into poorer farmers who found livelihood increasingly unbearable. Finally, focus on urban industrial sector also resulted in the neglect of the infrastructure development of rural sector, making the rural environment less conducive for expansion of industrial activities.

To improve the livelihood of the farmers in a more fundamental way, the government had to seek a comprehensive solution to the to the “three rural problems”. There were several challenges that needed to be overcome.

To begin with, the government had to find a way to liberalize the grain retail market while not hurting the interest of the farmers during the process. The administrative actions of price support and unrestrictive purchase of surplus grain stock proved not only unhelpful for the farmers but was also financially detrimental to the central government. Increasingly, the efforts of the policy makers gravitated towards marketization of the grain purchase and marketing system. One proposal to achieve the marketization of the system was to fully liberalize the grain purchase and marketing in major producing regions and doing away with the indirect subsidies of unrestricted grain purchase at protective prices. Instead, farmers in these regions could receive direct subsidies from the government.

Another challenge that the government encountered pertained to farmers’ land-use rights. Despite all the benefits of the brought by HRS, the system had its limitations. First, the contract did not offer farmers legal and permanent land-use right. In 1985, all farmers signed a contract lasting for fifteen year. As a result of this great uncertainty, farmers withheld making investments on the land. For example, Agricultural investment of collectives and individuals in rural areas decreased from 15.5% of the total rural investment in 1984 to 11.9% in 1987. In contract, nonagricultural investment rose from 84.5% to 88.1%. The low investment on the land led to declining productivity. Also, the ambiguous property rights restricted free transfer of land-use rights. As a result, larger scale agricultural operations could not be carried out through reorganization. In other words, land use could not be optimized. At the same time, again because of the unclear property rights, many farmers lost their land through forceful requisitions by local officials with no or little compensation. Without land, these farmers lost their means of making a living.

Besides the problems on the use of land, there was also the problem of weak bargaining power of the farmers. During the Cultural Revolution, the supply and marketing cooperatives and credit cooperatives were absorbed into the state sector. Even though the government had officially restored these cooperatives since the beginning of reforms, they had failed to recover their original functions because of changed market conditions. Hence the farmers were greatly disadvantaged when signing contracts to sell their produce to commercial companies which would then market the agricultural products as raw materials or primary products in the national markets. In 1998, for example, 38% of the companies that had contracts with farmers failed to keep to their promises of protective prices when purchasing farmers’ products. In many instances, contract formulation was even incomplete. The uneven negotiation power contributed to depressed earnings for the farmers who in turn became less motivated to increase production.

Finally, the government also needed to address the problems caused by migration of rural surplus labours to the cities. According to Wu (2005), one of the deep-rooted causes of the “three rural problems” was the shortage of agricultural resources, especially land, for the huge rural population. Once the surplus labour was liberated by the contract responsibility system and travelling to work in the cities was no more prohibited, migration of this surplus labour was inevitable. At the start of the reform in 1978, China had 82.1% of its population in the rural agricultural sector.

Migration from rural areas to the cities in search of job reached a historical high in the mid-1980s because of rapid growth of the TVEs. From 1984 to 1988, TVEs absorbed an average of 12 million farmers every year to work in the non-agricultural industries. The figure however dropped to five to six million annually after 1989 in the aftermath of the Tiananmen Incident. Also, the growth of TVEs was beginning to slow down by the late 1980s. Some TVEs were beginning to display ‘SOE symptoms’ as they grew larger and encountered weaknesses similar to these SOE counterparts. By the 1990s, the growth of many TVEs began to slow and many also ended in tight financial straits. The situation was exacerbated by the massive employment caused by SOEs’ layoffs of redundant labour in the second half of 1990s. Furthermore, as a result of the influx of migrants, many cities had been filled to the brink and social amenities had been overstretched to accommodate the new migrants. Hence, the migrants were evolving into not only an economic but also social problem and therefore had to be addressed urgently.

In responses to the various aforementioned problems relating to the rural agricultural sector, the Chinese government adopted various solutions.

In July 2001, the State Council issued the Opinion on Further Deepening Reform of the Grain Circulation System. The document stipulated the liberalization of the grain retail markets of eight provinces and municipalities of major consuming regions, including Zhejiang, Shanghai, Fujian, Guangdong, Hainan, Jiangsu, Beijing, and Tianjin. The administrative order pushed the grain circulation system closer to marketization.

At the same time, experiments of the direct subsidy reform, conducted in September 2002 at selected localities, showed positive results. Not only had the farmer’s income increased, the financial burden on the government was also alleviated. The unrestrained working of the grain market also greatly facilitated the structural adjustment of agricultural production and grain mix. In October 2003 during the Third Plenary Session of the 16^th CCCPC, the Resolution on Issues Regarding the Improvement of the Socialist Market Economic System was approved. The resolution put in official writing the requirements of improving the market system for agricultural products, liberalizing the grain purchasing market, and protecting the interests of grain farmers by direct subsidies instead of indirect subsidy through circulation (Wu 2005).

Next, to encourage farmers to invest in and make better use of the lands, the government extended the duration of the farmland contracts in 1993 for another thirty years. The Land Contract Law was passed in August 2002 by the National People’s Congress. Besides protecting the long term stability of the contract relations, the law stipulated that farmers had the right to transfer the use of the land, of their own free will, with compensation. In addition, farmers are entitled to compensation for lawful requisition of the contracted land. Despite the promulgation of the law, however, there was still frequent reporting of forceful requisition of land by local officials who would then make huge profits by putting the appropriated land to other commercial uses.

To alleviate the financial burden of farmers, the Chinese government also abolished various fees and taxes that worked out to a reduction amounting to 30% of the farmers’ total expenses. At the same time, to enable agencies at the grassroots level to operate with lower revenue collections, organizational reforms were carried out so that a simpler administration with better staffs could better serve the needs of the farmers. Rural democratic reforms were also accelerated to improve the quality of villager’ self-government. To address the issue of the farmers’ weak bargaining power vis-à-vis their commercial middlemen, it was decided during the Third Plenary of the 16^th CCCPC in 2003 that support be given to farmers to develop various market-oriented rural professional cooperative organizations. At the same time, the original supply and marketing cooperatives and credit cooperatives would undergo marketization reform so that a democratic management could be put in place to serve members, not the cadres.

Finally, to address the problem of massive migration of surplus rural labour into the cities, government also began to study issues relating to urbanization. Even though employment growth of rural surplus labour by the TVEs and SOEs was stagnating, activities in the private sector were picking up steam as the export sector expanded rapidly. FDI inflow was beginning to rise during the early 1990s after Deng’s Southern Tour. After 1997, the number of small and medium private enterprises also grew rapidly, encouraged by the aforementioned change in official position towards the non-state sector during the 15^th National Congress of the CPC and the subsequent Amendments to the Constitution of the People’s Republic of China protecting the rights and interests of private businesses. The growth of these non-state enterprises in the non-agricultural sector helped to absorb the surplus labour from the rural sector.

Also, drawing on the urbanization experience of developed countries, the Chinese government recognized that the transfer of rural surplus laborers to nonagricultural industries was not only a basic and inevitable component of industrialization, but also a fundamental approach to improve the living standard of farmers. For the farmers, the migration provides another means of generating non-agricultural income. For the national economy, the migration makes good sense as resources can now be better utilized. Historical experiences in developed countries stand testimonial to the benefits of increasing urbanization of its population. Agricultural population for the United States went down from 50% in 1870 to 30% in 1920 when industrialization was generally completed. By 1985, that figure decreased further to only 2.2%. Another industrial powerhouse, Japan, also had its agricultural population dropped from 70% in 1870 to 5.9% in 1995.

In short, the role of the government was to facilitate, not inhibit, the migration. Hence, the government stepped up efforts on the study of the various modes of urbanizations to find solutions that could be applied to the unique Chinese market and institutional environments.

To begin with, there are disagreements as to whether a bubble even exists.  This is also not the first time that doomsayers earnestly foretell China’s doom and gloom.

This time, however, the doomsayers are not economists backed by empirical data but are hedge fund managers who have enjoyed past successes in exploiting the excesses of irresponsible governments and are now convinced that the Chinese growth is not real but manufactured by the state.  Some have followed up their prediction with the launching of ‘distress China funds’ in anticipation of a possible meltdown of the overheated Chinese economy.

Perhaps, China’s emergence as the world’s second largest economy in 2010 is a more telling indication of how overheated the Chinese economy really is . Given the huge Chinese population, it is not surprising that China’s economy outsized Japan’s. What is shocking is the short span of only five years China took to more than double its economy from 18.3 trillion yuan in 2005 to 39.8 trillion yuan in 2010, especially when the world was embroiled in a major financial crisis followed by a recession during two of those years.

Chinese government had wanted to act as early as 2007 to reduce the economy’s overdependence on investment to drive growth. The outbreak of the global financial crisis, however, not only delayed economic reforms but also worsened the structural imbalances. With the fall in interest rate to 5.31 percent by December 2008 followed by the unleashing of the 4 trillion yuan stimulus, money supply spiked.

Three-quarter of the money for the stimulus came from state banks. Officially, loans amounting to 9.95 trillion yuan and 7.95 trillion yuan were issued in 2009 and 2010 respectively. In reality, actual credit created was much larger as banks evaded credit control by developing a shadow banking system that kept dealings off-balance sheet. In the end, the total social financing which includes loans from all other non-bank sources hit about 15 trillion yuan in 2010, almost double that of total official new lending.

With tight capital outflow controls in place, the credits created could only be used for domestic investments which inevitably led to asset inflation in the housing and stock markets. At the same time, the decline of net export had to be compensated by government investments in order to achieve the growth target of at least 8 percent. An estimated $1.7 trillion have been reportedly loaned, for example, to local state entities. Worse, many of the loans are for projects that may not be commercially viable and are backed by collateral comprising of land with inflated values, raising worries over rising non-performing loans.

In addition, policymakers also have to face with mounting inflationary pressures. While GDP recovered to 10.3 percent by 2010, fixed asset investment also rose by 23.8 percent in 2010 to reach 27.8 trillion yuan or about 70 percent of GDP, fueling inflationary pressures. The inflationary situation was also aggravated by the re-pegging of yuan to the US dollar in 2008, causing China to lose some degree of monetary independence. Its interest rates were kept low, albeit higher than that of the US, and its currency weak. While the undervalued yuan and the relatively higher interest rates attracted inflow of hot money, the high economic growth attracted FDI. Coupled with a sizable net trade surplus, the high capital inflow caused foreign exchange reserves to swell 23 percent in 2009 to reach US$2.4 trillion and another 18.7 percent in 2010 to reach US$2.85 trillion, fueling further concerns over excessive liquidity.

Having said that, while there is truth in the talk that Chinese economy has been put on life-support system since the advent of the Global Financial Crisis, a quick meltdown is far from imminent.

The risk is concentrated particularly in the banking sector because of the relatively underdeveloped financial market. An analyst from Fitch Ratings, for example, estimates that China faces a 60 percent risk of a banking crisis by mid-2013. Chinese regulators, on the other hand, maintain that risk is manageable because home mortgages are backed by sufficient downpayments and the total lending volume is limited. Stress-tests conducted by Chinese regulators show that most banks can withstand up to a 30% drop in housing prices. The non-existence of a loan derivative market also greatly reduces the likelihood of a disaster that parallels the US subprime mortgage crisis.

Meanwhile, tight control over inflows limits the impacts of hot money inflows. Most of the capital inflows are FDIs which cannot be easily withdrawn. What remaining liabilities in the international investment position can be covered more than adequately by China’s foreign exchange reserves. Strict capital outflow controls also reduce the likelihood of capital reversal which has been a key factor triggering crises among the emerging economies.

More importantly, Chinese policymakers are planning or have begun implementing several important structural reforms. To start with, instead of focusing on M2, policymakers plan also to look at total social financing which will allow policymakers to better monitor overall liquidity conditions and curb inflation. Next, interest rate controls are being liberalized so that cost of capital can more accurately reflect market forces as well as borrowers’ risks. To broaden the financial market and provide additional funding sources for enterprises, Chinese policymakers are also encouraging the growth of a bond market which will also help to diversify risks away from the banking sector.

In addition, as part of its efforts to internationalize yuan, China has allowed international trades to be settled using the Chinese currency. Capital outflow controls have also been relaxed to support overseas direct investment efforts of enterprises going global. Meanwhile, Shanghai’s stock exchange plans to start an international board to allow cross listings by foreign companies. Besides allowing foreign companies to raise funds in China, the move also enables Chinese residents to invest directly overseas.

Among other things, these new measures help to deepen and broaden the financial system, diversify risk, moderate excessive liquidity, and ease inflationary pressures.

As for the overheated property market, the effects of recent administrative measures to curb speculation are beginning to show. Many property agents in major cities have downsized as interests in resale properties dissipate. In addition, the injection of 36 million units of subsidized public housing over the next five years will go a long way in moderating prices and cooling speculation in the property market.

More pertinently, even though bubbles may exist in asset markets especially in some first-line cities and that industrial overcapacity looms, the real economy is far from being a bubble and will over time be driven increasingly by internally-driven growth underpinned by rising pace of urbanization. The real challenge is in controlling inflation while allowing rebalancing and restructuring to proceed uninhibited.

In recent years, to nurture the nascent domestic hedge fund industry, Chinese regulators have begun introducing tools such as short selling, margin trading, and stock index futures. However, allowing foreign hedge funds unrestricted access is quite another. To begin with, foreign speculators’ room to maneuver may already be limited. Chinese equity markets are relatively closed to foreign investors who have access to probably only less than 1% of Chinese market capitalization.

Furthermore, China is unlike other emerging economies many of which have only limited means. The Chinese government also has more power than most others in influencing its domestic markets through their control over the local governments, state banks and state-own enterprises. This explains, to a certain extent, why the Chinese government succeeded in pulling a fast recovery when the US government failed.

One should never underestimate the resolve of the Chinese policymakers in defending China’s national interests. Allowing foreign speculators to benefit at the expense of China’s misfortune will put the government in extremely bad light in the eyes of its people. Therefore, expect the already well-honed and crises-seasoned Chinese policymakers to do whatever it takes, including the dishing out of temporary anti-market measures, to constrict destructive market activities. In the end, ‘distress China’ fund managers’ hope of a quick windfall may just fall through.

Perhaps, a surer and welcomed way to profit from China is to find more constructive ways to contribute to the Chinese economy. Opportunities still abound despite the talks of bubbles. The US hedge fund and buy-out group Fortress Investment, for example, plans to team up with a local partner in China to provide housing for the Chinese elderly which will number 260 million by 2020.

Short of that, it’s hard to see how foreign hedge fund managers can have their field day even if their zealous prediction of a Chinese economic meltdown materializes.

Note: An edited version is published in Business Times on April 2, 2011.

1990s was a decade in which many regulatory changes were put in place for the development of the non-state sector as part of the efforts to establish a modern enterprise system. These changes include the passing of the Company Law and Accounting Law in 1993, Partnership Law in 1997, Provisional Guidelines for the Development of Urban Employee Shareholding Cooperatives in 1997, Contract Law in 1999, and Securities Law in 1999.

In the rural non-agricultural sector, conditions became less conducive for the rural enterprises than in the 1980s. For example, as a result of the shift in developmental focus in the 1990s, rural tax burdens were increased substantially while charges for basic services, such as education and health were also raised (Huang, 2008). At the same time, credits for private entrepreneurs were curtailed. Through such measures, resources were diverted from the rural sector to support high-growth development in the urban sector. As the policy environment turned less conducive for the development of rural private enterprises, large number of peasants became available and many began to migrate to cities in search of jobs. The situation faced by the peasants was accentuated by land grabs by local officials in the name of development. 1990s therefore saw a great influx of migrant workers to the cities in search of jobs. The abundant supply of the migrant labourers weakened their bargaining power and many were poorly paid or exploited.

As Huang (2008) professed, in the 1980s, rural entrepreneurs went to the cities and were rewarded for their entrepreneurship. In contrast, in the 1990s, rural laborers flooded the cities in search of jobs and were compensated for their labour. The result was an urban boom epitomized by the rapid buildup of skyscrapers and urban amenities in cities like Beijing and Shanghai. To many observers, a visit to these cosmopolitan cities was enough to convince them the great stride China has made on its road of economic reform. 1990s is a period when Chinese policy makers switched strategy and opted for urban-based state-led growth underpinned by massive inflow of FDI and persistently high state-led fixed investment. While the urban sector flourished, the rural sector languished. The plights of the peasants were succinctly summarized as the “three rural crises” (三农问题) — the crisis of agriculture, the crisis of rural governance, and the crisis of the peasantry.

Nevertheless, despite the change in policies making conditions unfavourable for rural entrepreneurship, growth of rural industrialization continues in the 1990s, with one difference from that in the 1980s. The phenomenal rural industrialization since the early 1980s has been widely portrayed as being led by rural collectives. In the 1990s, the rural private enterprises played a growing role. The number of rural collectives declined from 1.57 to 1.07 million from 1985 to 1998 while that of rural private enterprises climbed from 10.7 to 19 million. During the same period, the share of the rural collectives in the work force, value-added, and sales of all rural enterprises (i.e. rural collectives and rural private enterprises) dropped from 59%, 74% and 60% to 41%, 45%, and 43%, respectively.

Politically, despite frequent criticisms of market-oriented reforms from the conservative statesman and theorists, policy makers continued to make adjustment on government’s position on private enterprises in recognition of the private sector’s growing contribution to the national economy. Among other things, reform-minded political leaders argued that the essence of socialism was the realization of common prosperity, not absolute and total state ownership. China’s character of socialism was not determined by the share of the state sector in its economy. In short, China should totally break away from the Soviet model expounded in the textbook of Political Economy.

More importantly, the views of the reform-minded prevailed over the conservatives during the 15^th National Congress of the CPC in 1997. The Congress adopted a resolution that pronounced keeping public ownership as the mainstay of the economy and allowing diverse forms of ownership to develop side by side as part of the basic economic system in the primary stage of socialism for at least one hundred years. The new resolution removed ideological impediments and laid down the political foundation for the development of non-state sectors. In 1998, the fundamental change was incorporated into the Amendments to the Constitution of the People’s Republic of China. For the first time, the lawful rights and interests of the individual business sector and private sector were protected by the state.

The change in government’s position on state ownership in effect helped to improve the business environment for the private sector. As the guidelines of the 15th National Congress of the CPC was implemented, readjustment of the layout of the state sector meant that the state was withdrawing from many industries that were non-critical. This in effect, left more room for private enterprises to grow.

Indeed, since 1998, the share of non-state sectors in the national economy has grown rapidly. Government’s support for development of non-state sector was growing partly because of the more than ten million SOE employees laid off every year as a result of the withdrawal by the state sector from non-critical industries. The employment situation was aggravated by the hundreds of millions of migrant workers seeking employment in the non-agricultural industries. To prevent social unrest, new jobs had to be created quickly. The State Council made prompt decisions to implement measures that support the development of small and medium non-state enterprises which were the main engines of new job creation. (See Table 5.1).

Table 5.1 : Employment By Ownership (%)

Year	State	Non-State	Collective	Nonpublic
1997	53.1	46.9	13.9	33.0
1998	41.9	58.1	9.1	49.0
1999	38.2	61.8	7.6	54.2
2000	35.0	65.0	6.5	58.5
2001	31.9	68.1	5.4	62.7
2002	28.9	71.1	4.5	66.6

Extracted from Wu (2005, p.199).

By the end of the twentieth century the non-state sector had becoming the largest sector driving the national economy. Not only were the non-state enterprises huge in size, they were also superior in performance. Regions where non-state sector accounted for a larger share also experienced faster GDP growth rate. A number of TVEs had also grown rapidly, despite market competition, to become leaders in their respective industries.

As for the foreign sector, with the lessons learned during the experimenting phase in the 80s, China’s policymakers also began improving the regulatory environment governing FDI. For example, in 1991, China granted more preferential tax treatment for Wholly Foreign Owned Enterprises and contractual ventures and for foreign companies that invest in selected economic zones or in high-priority projects encouraged by the state, such as those relating to energy, communications and transport. They also further relaxed the restrictions on the establishment of joint ventures, provided assurances against nationalization, and allowed foreign partners to chair joint venture boards.

FDI growth in China slowed briefly after the events at Tiananmen Square in June 1989, but resumed and quickly grew in the 1990s. The real pick up in FDI came in 1992 after Deng Xiaoping’s tour of Southern China when policies of openness and market-oriented reforms introduced earlier were reaffirmed (See Figure 5.2). From US$4 billion in 1991, FDI inflows increased sharply to US$11 billion in 1992 and US$28 billion in 1993, with growth rates of over 150% in both years. FDI growth, however, began to moderate by late 1990s because of government policies to cool down overheating in the Chinese economies after the high growth in the early 1990s. FDI inflows leveled off in 1998 and dipped slightly in 1999 also because of the Asian financial crisis.

Figure 5.2 : China’s FDI Inflows (1984 – 2006)

During this phase, foreign investments also began to overflow into the centers of China’s (state-owned) heavy industry manufacturing and finance. Of these, Shanghai and the neighboring provinces were the clear beneficiaries and they become the next-largest recipient area by 1995.

Notably, investments by large Western and Japanese MNCs constituted only a small portion of total FDI flows into China during much of the 1990s. As in 1980s, a significant portion of FDI flows into China originated from small and medium enterprises (SMEs) operating simple and labour-intensive production and assembly processes. They were typically from China’s neighbouring regions, such as Hong Kong, Macao, and Taiwan and other Southeast Asian countries all of which are predominantly ethnically Chinese economies.

By the turn of the twentieth century, China looked increasingly unstoppable, having successfully surmounted various obstacles including challenges from remaining remnants of the old-guards to slow down or turn back reforms as well as the Asian financial crisis.

In addition to the changes in the five subsystems, there was also a major shift in approach on how the state enterprises could be reformed. Prior to this, the most commonly used reform policies towards the SOEs were either delegating power or contracting the operation to the management in the hope of providing incentives to raise productivity and profitability. This approach reflected government’s strategy of invigorating every state-owned enterprise. The outcome had not been favourable because, without proper monitoring and control measures in place, these policies encouraged the management to engage in short-term thinking and illicit activities, such as distributing funds as bonuses instead of investing for future growth, making loans with no repayment plans, embezzling public property, and engaging in high risk stock market and property market speculation use company’s fund. These activities were detrimental to the enterprise in the long term. In recognition of the weaknesses of the old approach, during the Third Plenary Session of the 14^th CCCPC in 1993, the overall strategy changed from invigorating all SOEs to one of “letting go of small enterprises” either by restructuring them into shareholding cooperative enterprise or selling them to collectives or enterprises. Wu (2005), for example, recounted the experience of Shunde County of Guangdong Province that started in 1993. By the end of 1994, the Shunde County succeeded in transforming 896 SOEs and TVEs into 2 listed joint stock companies, 7 unlisted joint stock companies, 32 joint ventures, 124 joint state-private enterprises, 431 public-owned private-run enterprises, 78 shareholding enterprises with shares held by employees, and 22 enterprises sold through auction. More importantly, the transformation improved the performance of the enterprises and some emerged as flagship enterprises within their industries a few years later.

In 1994, the Chinese government announced a new strategy of “grasping the big ones and letting go of the small ones” in its effort to establish a modern enterprise system. The strategy meant concentrating effort on the large and medium-sized SOEs that were essential to the national economy while releasing and invigorating small and medium SOEs by means of merger, leasing, contracting, offering for sale, or bankruptcy.  In 1995, out of a total of 87,900 industrial SOEs with independent accounting, 72,200 were considered small according to the standard of National Statistics Bureau (Wu 2005).

During this period, however, the increasing dominance of the non-state sector led to the emergence of a hot debate regarding ownership structure. The debate lasted till 1997. The process of “letting go of small enterprises” did not gain momentum until the second half of 1995 and the new strategy was only formally endorsed by the 15th National Congress of the CPC three years later in 1997.

Notably, when responding to the criticisms of the conservative statesmen and theorists, the reform-minded policy makers maintained that “whether a country has the character of socialism is not determined by the share of the state sector in its economy. . . . As long as the party has correct policies to prevent the polarization between the rich and the poor, China’s socialist character is securely guaranteed.” They further professed that China should totally break away from the Soviet model expounded in the textbook Political Economy and that the essence of socialism was the realization of common prosperity, not absolute and total state ownership. The state should therefore withdraw from ordinary competitive industries and focus on strategic industries. During the process, the state should accept that a decline in the share of state-sector in the national economy would not alter the socialist character of China.

The debate eventually led to the jettisoning of the traditional socialist position “the higher the proportion of the state sector in the national economy, the better” during the 15^th National Congress of the CPC in 1997. Instead, a resolution was adopted which pronounced keeping public ownership as the mainstay of the economy and allowing diverse forms of ownership to develop side by side as part of the basic economic system in the primary stage of socialism for at least one hundred years. The mainstay status of public ownership referred to the fact that state-owned and collective-owned assets dominate in assets of the whole society, the state sector controlled the most vital part of the national economy and played a leading role in the development of the economy. The new resolution removed ideological impediments and laid down the political foundation for the development of non-state sectors. In 1998, the fundamental change was incorporated into the Amendments to the Constitution of the People’s Republic of China. For the first time, the lawful rights and interests of the individual business sector and private sector were protected by the state.

At the same time, in line with the strategy of “advancing in some areas while retreating from others”, the central government would reduce the scope of the state sector by retreating from non-critical industries while advancing to control key industries vital to the national economy and security. Policy makers embarked on a process of readjusting the ownership structure of the national economy in two ways: the strategic layout readjustment of the state sector, underpinned by the strategy of “grasping the big ones and letting go of the small ones”, and the promotion of the healthy development of non-state sectors (Wu 2005, P. 191).

According to estimates by the Development Research Center of the State Council in 1997, state assets committed in production and business sector amounted to 3,000 billion, spreading over 291,000 enterprises in a whole range of industries. That averaged out to only RMB 10 million for each enterprise, a grossly inadequate amount for achieving economies of scale and for building sustainable core competency through innovative research and development. The state could choose to increase investment in all state enterprises to strengthen their operations but doing so required at least RMB 2,000 to 2,500 billion, not to mention the trillions needed for replenishing the pension funds. During those days, these were astronomical sums. The viable alternative is therefore to restructure the state sector by withdrawing from non-critical industries so that resources could be better focused on strategic industries. This entailed strengthening state enterprises to be retained, merging those that have the potential to grow and become profitable, divesting those that are in non-critical industries, and closing down remaining that are unprofitable.

In the following years, during the process of letting go of small enterprises, some malpractices emerged that resulted in what many economists claimed as the loss of state assets. The key issue was in the valuation and transfer price of the enterprise’s property. In many cases, the management decided on the transfer price without the valuation from a fair third party. As a result, many state enterprises were sold at very low price either to the management (i.e. seller and buyers are the same party), or to friends or relatives. The root of the problem was that the capital market was not yet fully developed, making it difficult to determine the true value of the enterprise through open market competition.

By the mid-1990s, significant progress in establishing a macroeconomic control system and adjusting the ownership structure had been made. With the continued growth of the non-state sector, the state sector no longer monopolized the whole economy. Its share in the national economy was significantly reduced. The non-public sector’s share of the GNP exceeded that of the state sector by 1997. By year 2000, the non-public sector accounted for 46.2% of the GNP (See Figure 5.1). In terms of national total industrial output, the SOE share had also fallen from 77.6% on 1980 to 28.5% by 1996 (SSB, 1997: 413).

Figure 5.1 : GNP By Ownership (%)

*Non-public sector include all non-state and non-collective enterprises, such as individual businesses, private enterprises, and foreign-invested enterprises.

Extracted from Wu (2005, p.66).

From 1978 to 1993, while the total number of industrial enterprises increased from 1.2 million to 10 million, the total number of state-owned industrial enterprises increased only from 83,700 to 104,700. Most of the new enterprises were formed outside the state sector. Non-state enterprises, especially those that are the private ones were increasing at a higher rate. Overall, it is indisputable that the developmental pace of the SOE sector in the 1990s still lagged behind that of the non-state sector. State enterprises were losing out not only in terms of number but in profitability as well. According to a World Bank (1997) report, about half of industrial SOEs made a loss in 1996, up from one-third in 1994. (Lin 2001, P. 35)

Moving into the twenty-first century, a socialist market system based on a mixture of ownership forms gradually began to take shape. There was no dispute that a market economy had developed in China.

 

Architect of Reformation of the Urban Sector

One key person whose contributions dramatically change the economic facade of China in the 1990s is Zhu Rongji. After succeeding Jiang Zeming as the mayor of Shanghai, Zhu won respect for the tremendous changes he brought to Shanghai. Among other things, his achievements included the development of Pudong as well as build-up of the city’s telecom, urban construction and transport sectors.

In 1991, Zhu became vice-premier of the State Council and director of the State Council Production Office. He job included tackling tough economic problems in industry, agriculture and finance. As the Governor of the central bank, Zhu was also instrumental in fighting inflation. He adopted the most direct way to cool economic activities: ordering the banks to cease lending. By 1996, bank credit disappeared and inflation fell below 8%, amid falling growth rate.

As an acclaimed reformer, Zhu was not afraid of making fundamental wrenching changes that China desperately needed.

In the 1990s, regulatory changes continued unabated as policymakers strived to improved the regulatory framework for the working of a market economy. Shanghai Stock Exchange began trading in 19 December 1990. Regulations pertaining to issuance of shares were introduced in April 1992 for enterprises to issue tradable and non-tradable shares and test sites for enterprises were established. For example, trials for joint-stock companies with listed shares were conducted in enterprises located in Shanghai and Shenzhen while those involving joint-stock companies with non-tradable shares were carried out in Guangdong, Fujian and Hainan. In addition, there were also experiments on shareholding by employees in many different locations.

However, as late as 1993, key issues relating to state sector still had not been resolved. Most scarce resources were still in control by government and SOEs even though the state sector accounted for less than half of GDP. For example, the sector consumed more than 70% of bank loans. This dominance of the government agencies and SOEs translated into a complex web of vested interests, thus accentuating the problem in reforming the sector and the economy.

Changes to fix these issues arrived progressively in October 1992 during the 14th National Congress of the CPC when the target of establishing a socialist market economy was set. In November 1993 at the Third Plenary Session of the 14th CCCPC, the Resolution on Issues Regarding the Establishment of a Socialist Market Economic System was adopted. Many important breakthroughs were made at the session. Guided by a new reform strategy of “combining overall advance with key breakthroughs“, it was decided that reform should firmly extend from the hitherto development in the non-state sector to the state sector so that an overall advance could be achieved. It was hope that a socialist market economic system would take shape by the end of the twentieth century.

To achieve the overall advance, major breakthroughs must be secured in five subsystems, namely the fiscal and taxation system, the banking system, the foreign exchange control system, the enterprise system, and the social security system.

First, the establishment of the fiscal and taxation system called for transforming the existing central-local fiscal responsibility system into a “tax-sharing system” based on a rationalized division of power and responsibility between the central and local governments. Through the 1980s and the early 1990s, the central government implemented a series of reforms to decentralize its fiscal system in order to provide more incentives for local government to promote economic growth (Lin and Liu, 2000). However, this fiscal decentralization led to widening fiscal disparity and shrinking central government revenues (World Bank, 2002). The introduction of this tax-sharing reform in 1994 was therefore meant to boost the central revenues and enhance intergovernmental transfers. At the same time, on the corporate side, a uniform enterprise income tax rate (33%) was adopted and a value-added tax (17%) was imposed on all industrial and commercial enterprises to replace the previous system of varied income tax rates for different types of enterprises.[1] The standardization of the taxation system not only greatly simplified the tax structure but also put in place an equitable system that would help to promote fair competition.

Second, for the improvement of the financial and banking system, the 1993 resolution stipulated the setting up of a central bank system to carry out monetary policy independently under the leadership of the state council.[2] In addition, the state-owned commercial banks would be kept as mainstay and diverse forms of financial institutions are allowed to develop side by side. To achieve that, the existing state-owned specialized banks would be commercialized and their policy policy-related businesses would be taken over by the newly set up policy banks. This separation of policy-related banking from commercial banking would help to establish a unified and open system of financial markets with orderly competition and strict regulation.

Third, for reforming the foreign exchange control system, the central government decided to abolish the dual exchange rate system in domestic and foreign enterprises. After the merging of the two exchange rates, the convertibility of RMB would be managed under the current account, with the objective of eventually abolishing controls over capital flow to make RMB a fully convertible currency at an opportune time.

Next, the 1993 resolution ordered the transformation of the operation mechanism of SOEs in order to establish a modern enterprise system characterized by clearly established property rights, well defined power and responsibility, separation of enterprise from government, and scientific management. In December the same year, the Company Law [3] was passed with the explicit goal of instituting a new governance structure for all newly established or reorganized enterprises. It was to take effect on July 1, 1994. The law discards the existing ownership labels and regroups economic organizations into two categories: limited liability companies and limited liability stock companies. Although the old classification still remained in effect, it would be phased out gradually and eventually, the Company Law would become the cornerstone of China’s “modern enterprise system” (RMRB, August 8, 1997).

Finally, the 1993 resolution announced the setting up of a new multi-layer social security system that include social insurance, social relief, social welfare, special care and placement, social mutual aid, and private saving security. The system would combine social pooling funds with individual accounts to provide old-age pension and medical insurance for urban workers.

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[1] Before the implementation of the unified tax rate in 1994, the official tax rate for state enterprises was up to 55%, much higher than the ceiling of 35% for the other enterprises. In reality, of course, the official rate was not necessarily strictly adhered to. According to an estimate by the State Tax Bureau (GWYYJSKTZ 1994: 17), in 1991 the actual average rate for state enterprises was 33.39% while urban collectives and private enterprises paid 28% 29.7% respectively, all lower than the official rates.

[2] Earlier in 1993, Vice Premier Zhu Rongji was made the head of People’s Bank of China which was became the central bank in 1983.

[3] Besides the Company Law, a growing number of related laws and regulations were also introduced progressively as part of the institutional framework for the modern enterprise system. Among these were Accounting Law in 1993, Partnership Law in 1997, Provisional Guidelines for the Development of Urban Employee Shareholding Cooperatives in 1997, Contract Law in 1999, and Securities Law in 1999.

In the aftermath of the political disturbances in 1989, another resurgence of conservative thinking occurred, led by the conservative statesmen and theorists who had all along been uncomfortable with the pace and direction of reforms. This bout of conservatism held sway until 1992 until Deng’s 1992 Southern Tour to revitalize the reform process and opening up.

	1990s
Model / Guiding Ideology	Establishment of the socialist market economic system (社会主义市场经济) – “Combining overall advance with key breakthroughs” strategy (93 – Third Plenary Session of the 14th CCCPC) Reforms to be firmly extended to state sector to achieve overall demand Breakthrough in five subsystems: fiscal and taxation system, the banking system, the foreign exchange control system, the enterprise system, and the social security system. Establishment of a modern enterprise system underpinned by Company Law. Strategies to reform SOEs “Letting go of small enterprises” (93) “Grasping the big ones and letting go of the small ones” (抓大放小)(94) “Keeping public ownership as the mainstay of the economy and allowing diverse forms of ownership to develop side by side as part of the basic economic system in the primary stage of socialism for at least one hundred years.” (97 – 15th National Congress of the CPC) Readjusting the ownership structure of the national economy (97) “Advancing in some areas while retreating from others” – Strategy for reform of the state sector and the promotion of the healthy development of non-state sectors Jiang’s “Three representatives” （三个代表) first proposed in 2000 and formally endorsed in 2002.
Main Events / Efforts / Initiatives	Opening of Shanghai Stock Exchange (90) Trials for enterprises to issue tradable and non-tradable shares conducted at various locations. (92) Deng’s Southern Tour Rapid Growth of FDI after 1992 Adoption of the Resolution on Issues Regarding the Establishment of a Socialist Market Economic System (93 – Third Plenary of the 14th CCCPC) Debates about declining role of state sector. (95 – 96) Adoption of new definition of state ownership (97 – 15th National Congress of the CPC) Amendments to the Constitution – Lawful rights and interests of the individual business sector and private sector were protected by the state for the first time. (98) Debates about loss of state assets (95 – 96)
Key Regulatory Changes	Industrial / Commercial  Regulation on issuances of shares (92) Company Law (93) Accounting Law (93) Provisional Guidelines for the Development of Urban Employee Shareholding Cooperatives Partnership Law (97) Contract Law (99) Securities Law (99)