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
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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
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Theoretical vs. empirical studies of institutions
• Divorced theoretical and empirical studies of institutions
– Theoretical literature (e.g. Coase, North, Hurwicz-MaskinMyerson, 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
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
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problems in today’s China
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
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Stylized Governance Structure of China
This governance structure is evolved over a long history
Central Gov't
Central Adm Function
Personnel
Finance
Agriculture
Territorial Control
Industry
Personnel
Province A Province B Province C
Finance
Agriculture
Industry
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Stylized Governance Structure of
China in 14th Century (Ming-Qing)
is similar to today’s RDA regime
Emperor
Central Adm Function
Personnel
Finance
Justice
Territorial Control
Industry
Personnel
Province A Province B Province C
Finance
Justice
Industry
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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
RDA as the institutional foundation for
regional 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
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); …
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
Characteristics of China’s RDA Regime
Compared with Other Regimes
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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 13of
resolving local incentive and coordination problems
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
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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
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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
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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
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• New incentive problems in solving multi-task problem
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
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important fundamental reforms that China should take further
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;19
violations should be punished heavily
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 20
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
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