China’s economic reform: Success, problems and challenges
1 Introduction
The rise of China is a major episode in world economic history. From the late 1970s, China pursued market-oriented reforms and open policy. During the past two decades, China experienced extraordinary growth. Since 1978, GDP growth rates have averaged 10 per cent a year, and 10.7 per cent in the 1990s, rivaling the record achieved by Japan and the ‘Four Tigers’ (South Korea, Singapore and Hong Kong and Taiwan province of China) in their fast growing period.
In a short span of time, China has experienced three historic transformations simultaneously. First, China is undergoing economic transition from a planned economy to a market economy. Second, China is undergoing economic development from a traditional agricultural economy to an industrialised economy. Third, China is changing from autarky to an important player in the arena of world economy and politics. China’s experience provides an ideal laboratory for economic research. The study of the Chinese economy can not only shed light on the causes and process of this massive growth surge, but also enrich our understanding of policy reform and institutional changes.
With China’s growth occurring at a bewildering speed and arising from complex processes, it is not surprising that there has been much debate among economists over the basic interpretation of China’s success. While some scholars tell us about ‘the China Miracle’ (Lin, Cai, and Li 1996), others claim ‘Growth without Miracle’ (Garnaut and Huang 2001). The experimentalist school highly praises China’s gradual, piecemeal reform and believes the hybrid institutions (such as township and village enterprises, or TVEs) reflect the distinctive Chinese social and cultural background and are a genuine innovation of the Chinese political leaders. The convergence school, on the other hand, believes that the institutional infrastructure that China needs for long-term growth has to converge to the best international practices in advanced economies (Sachs and Woo 2000).
China’s explosive growth challenges many widely accepted tenants of policy analysis. Private ownership, democracy, and the rule of law, which are seen by new classical economists as necessary to economic development, were notably absent, at least at the earliest stage of China’s reform. China is just like a student who never does his homework, but always outperforms his classmates in examinations. Why is the story of China unique? Is China showcasing a new type of economic system that is different from both socialism and market economy but is superior to both in stimulating economic performance, or are China’s experiments mainly the product of political constrains rather than economic optimisation? Do we have the confidence to say that past success can guarantee future prosperity? What are the major challenges and constrains that China is facing?
This paper does not have the ambition to answer all these questions, but provides a survey and a preliminary analysis of China’s economic reform. Section 2 provides a brief overview of China’s economic development from 1949 to the present. Section 3 analyses the economic reform of the early 1980s. The planned economy was not sustainable because the government found that it increasingly difficult to keep a high growth rate and fulfil the goal of full employment. The reform took a gradual approach and the rise of the non-state sector made a major contribution the China’s growth.
Section 4 discusses the formation of the triangle of the state-owned-banks (SOBs), the state-owned-enterprises (SOEs), and the government. We believe the equilibrium and dynamics among these three key players can largely explain the path and pattern of economic reform during the 1980s and 1990s. Section 5 provides another factor to explain China’s economic reform, namely, the central-local relationship. The competition and tension between the central and local government has a tradition of thousands of years in China and still plays an important role in the formation and evolution of China’s economic system.
Section 6 looks into the future and summarises the remaining tasks for China to accomplish in the near future in order to sustain high economic growth and social stability. We argue that China is facing an internal and external imbalance and a favourable policy package should help to maintain macroeconomic stability in the short term as well as pave the way for sustainable growth in the future. Section 7 tries to identify the key elements for a successful reform in China in the 21st century — what should be the strategic triggers for the reform, whether the current institutions are supportive to the reform, and how to find a potential institution which can act as a facilitator and ordinator for the reform.

2 Economic background
In the early 1950s, GDP per capita in China was less than 119 Yuan or US$ 40 (current prices). From 1953 to 1978, China’s annual growth rate of GDP averaged 6.1 per cent. In the 1960s, China’s growth rate was lower than that of Japan and the ‘Four Tigers’, but higher than the ASEAN countries. In the 1970s, China’s growth was lower than both the ‘Four Tigers’ and the ASEAN countries.
Although China’s economic growth rate was comparatively speaking fairly remarkable during this period, the growth was not stable. The growth process was frequently interrupted by political campaigns like the ‘Great Leap Forward’ in 1958 and the ‘Cultural Revolution’ from 1966 to 1976. Eckstein (1977) pointed out that China’s economic growth experienced a ‘policy cycle’. China’s economic policies changed so quickly that they hardly lasted for three years, which lead to the boom and bust of the Chinese economy.
In the late 1970s, China embarked on a major program of economic reform. The last two decades have witnessed the dramatic transformation of the Chinese economy. During this period, real GDP growth averaged 9.5 per cent a year. In 1980, per capita income in China was RMB 460 Yuan (less than US$ 150), and in 2004, this figure had reached RMB 10,128Yuan (or US$1,224), with major cities such as Beijing and Shanghai approaching US$ 2,500. Even taking inflation into consideration, the Chinese people’s living standards have risen almost sixfold in the last 20 years. If calculated on a purchasing power basis, the increase in the size of Chinese economy is even more impressive. The IMF found that on a purchasing power basis, the Chinese economy in 1990 accounted for just over 6 percent of world output, ranking third behind the United States and Japan (IMF 1993). More recent research by the World Bank suggests that based on purchasing power parity, China ranked the second largest economy in the world behind only the United States (World Bank 1997).
Before China launched its open door policy from the late 1970s, it was isolated from the world economy. China’s exports were only US$ 18 billion in 1978, its share of world trade was only 0.6 per cent. China was the 34th largest exporting country in the world. In the last two decades, China quickly transformed itself to an important trading power. Its foreign trade has increased almost 15 per cent annually in the past 20 years. In less than two decades, the total value of China’s exports has expanded more than twenty-fold. In 2005 China’s exports were US$ 762 billion, its imports were US$ 660 billion. Its trade dependence, measured by the ratio of the sum of imports and exports to GDP, was about 63 per cent.
In the late 1970s China was also a negligible participant in world capital markets. China scarcely had any foreign direct investment or foreign debt before the economic reform. This situation did not change much in early 1980s. Total foreign investment from 1979 to 1982 was less than US$ 12.5 billion, an average of about US$ 3 billion per year. In the early 1990s, China launched a new round of reforms and adopted more open foreign investment policies. After that, China experienced a dramatic increasing in foreign direct investment (FDI). Attracted by high expected returns and tax exemptions, FDI inflows increased by almost 50 per cent annually from 1992 to 1996. The trend has continued even after the Asian financial crisis. From 1993 China began to attract far more foreign direct investment than any other developing country. In 2005, the FDI flowing to China was US$ 72.4 billion, second only to the United Kingdom and the United States (Ministry of Commerce 2006).
From other indicators, the change in China is also very impressive. Life expectancy at birth from 1960 to 1965 was 36.3, the lowest in East Asia. During the past thirty years this figure has increased continuously. By the year 2005, life expectancy at birth was 70 for males and 74 for females (WHO, 2006). Around 80 per cent of China’s population was illiterate before 1949. By the mid-1990s, China had achieved virtually universal enrolment in primary education (Wang and Yao, 2001).
The widening income disparity in China has caught much attention recently. According to Chinese official statistics, the Gini coefficient in China rose from a low level of 0.33 in 1980, to 0.40 in 1994, and to 0.45 in 2002 (UNDP 2005). [REFERENCE PLEASE] China’s current income gap has surpassed that in India and Ethiopia and China is now one of the countries with the most unequal distribution in the world. The deteriorating trend for China’s income distribution is the result of the growing urban-rural gap and regional disparities. The income gap between rural and urban areas decreased at the beginning of economic reform, owing to substantial growth of rural household income. However, since the mid 1980s, the rural-urban gap has widened. The ratio of urban to rural income rose from 1.71 in 1984 to 3.23 in 2003. The uneven regional income gap between the coastal and inland areas has also expanded in recent years (Table 1).

3 The political economy of the 1978 reform
What was the impetus for market-oriented reform in China? Many papers hold that the inefficiency of the planned economy made it unsustainable. However, this theory cannot explain the timing of the reform. In our paper (Zhang and He 1998), we argued that the fiscal pressure faced by the government triggered market-oriented reform.
The relation between fiscal deficits and institutional change originated from Schumpeter (1918). He pointed out that ‘the method of studying fiscal conditions is especially useful to analyse the turning point of social development’. A first glance may lead to doubts as to whether this ‘Schumpeter’s’ Law applies to China. In the late 1970s, only in three out of eight years were there fiscal deficits (Table 2).
The deficit in 1976 was the largest, but accounted only for 3.8 per cent of total government revenue and 1.0 per cent of GDP.

However, in the planned economy, the government controlled the allocation of capital, so the financial account automatically balanced. The official figures on the government budget hid the real cost of the planned economy. In order to maintain their legitimacy, political leaders had to maintain high economic growth and achieve full employment. On the eve of economic reform, these two goals became more and more difficult, if not impossible. Without reform, a fiscal crisis as well as a legitimacy crisis would have eventuated.
First, in the late 1970s, the capital-output ratio increased sharply, reflecting that the government was injecting more and more money into the state-owned sector in order to sustain the previous growth rate. This put financial pressure on the government and gradually the growth rate declined, and so did people’s living standards. Thus the source for government revenue shrank and the discontentment of the people accumulated.
Second, in the planned economy, with the growth of population and the increase of labour supply, the government found it increasingly difficult to provide jobs for everyone. Because of the budget constraint, only a small proportion of the population could obtain welfare and other amenities. The fixed number of job positions was in sharp contrast to the growing number of new labourers, including the younger generation in the cities. Many high school and college students fell into unemployment the same day as they graduated.