Justin Yifu Lin: How China avoided transition collapse
The price of its success and the lessons for others
Pekingnology today presents 中国在过去40年间向市场经济的转型之路 China’s transition to market economy in the last four decades by Justin Yifu Lin.
Professor Lin, formerly Senior Vice President and Chief Economist of the World Bank, 2008-2012, is Dean of Institute of New Structural Economics, Dean of Institute of South-South Cooperation and Development, and Professor and Honorary Dean of National School of Development (NSD) at Peking University.
The article, recently made public in Chinese on the website of the NSD, is excerpted from the 2022 book 《中国与西方：当前经济、政策与应对》published by 中信出版集团 CITIC Publishing Group. The Chinese book is translated from China and the West, edited by Jan Svejnar, a professor at Columbia University, and Lin. It was published by Edward Elgar Publishing.
For a well-rounded discussion of why China was able to avoid the collapse and stagnation that happened in other transition economies, what price China paid for its success, and what lessons are to be learned for others, this article is not lengthy. Let’s get right into it.
China’s transition to market economy in the last four decades
China celebrated the 40th anniversary of transition from a planning economy to a market economy in 2018. The economic performance since that transition started has been a miracle in human history. In 1978, China was one the poorest countries in the world, her per capita GDP was $156, less than one-third of the average of $490 in Sub-Saharan African countries. Like other poor countries, 82 percent of her population lived in rural areas, and 84 percent was living below the international poverty line of $1.25 a day. China was also an inward-looking economy, with trade consisting of merely 9.7 percent of its GDP. From that humble starting point, China achieved an average annual GDP growth rate of 9.4 per cent and trade growth rate of 14.8 per cent during the period 1978–2018. In 2010, China overtook Japan to become the second largest economy in the world and overtook Germany to become the largest exporter. China became the largest trading country in the world in 2013 by overtaking the USA, and the largest economy, measured by purchasing power parity, in the world in 2014 again by overtaking the USA. More than 700 million people in China have gotten out of poverty, contributing to more than 70 percent of the global poverty reduction in this period. Moreover, China is the only emerging market economy in the world that did not suffer from a homegrown financial crisis. In 2019 China’s per capita GDP reached $10,400. It is most likely that China will cross the threshold of $12,700 and become a high-income country around 2025. If the above prediction is realized, China will be the third, following South Korea and Taiwan, to successfully grow from low-income to high-income economy among nearly 200 developing economies after World War II.
In this chapter, drawing on Lin (2012a), I would like to explore why it was possible for China to achieve such an outstanding performance in 1978, why it was impossible to have a similar performance before 1978, why China was able to avoid the collapse and stagnation that happened in other transition economies, what price China paid for its success and what lessons are to be learnt.
HOW CHINA AVOIDED TRANSITION COLLAPSE
After World War II, all the socialist countries and most other developing countries, inspired by the same modernization dream and guided by the prevailing structuralism, also adopted a similar strategy and government interventions to accelerate the development of advanced, capital-intensive industries and had a poor economic performance similar to that in China. When China started the transition from a planned to a market economy, many other socialist and developing countries embarked on a similar transition. China achieved stability and dynamic growth, whereas other countries suffered from economic collapse, stagnation and frequent crises (Easterly 2001).
The reasons are twofold and related to differences in their transition strategies.
First, other socialist countries and many developing countries followed the Washington Consensus of privatization, marketization and liberalization, inspired by neoliberalism. This strategy derived from the argument that socialist countries and other developing countries had not done well because excessive government intervention caused misallocations of resources. This argument led to the recommendation that, to improve their economic performance, these socialist and developing countries should immediately remove all distortions and end government interventions, so as to allow markets to function. However, the purpose of all of these distortions was to protect large-scale capital-intensive industries. If the government eliminated those distortions immediately, these large-scale industries would be bankrupt and large numbers of workers would lose their jobs, undermining social and political stability. Without social and political stability, economic development is impossible. As a result, after Washington Consensus shock-therapy reform many countries reintroduced subsidies and protection for the purpose of preserving jobs.
Moreover, many of these large-scale industries were basic needs or defense related. Even after the privatization, governments continued to subsidize them to stay in operation. As a result, whether it was for reasons of social stability, basic needs or national defense, after the privatization, liberalization and marketization, the government reintroduced new types of subsidies and distortions. These distortions were yet more inappropriate and even more inefficient than the explicit subsidies and protections that had been swept away.
Before privatization, the managers were state employees. If there were difficulties, they would ask the government for protection and subsidies. If the government were to provide assistance, the managers could at most increase their on-the-job consumption. Putting money into their own pockets, however, was corruption and punishable. After privatization, owners of those large enterprises also asked for subsidies. In this case subsidies could simply be turned into their own wealth, and there was an incentive to ask for yet higher subsidies and assistance. As a result, reform led first to chaos, followed by stagnation and frequent crises.
China managed to maintain stability and dynamic economic growth in the transition. The main reason is that China adopted a pragmatic approach. The government provided transitory protection and subsidies to the existing sectors to maintain stability. However, the Chinese government also liberalized and facilitated entry into new labor-intensive and small-scale traditional industries, which were consistent with China’s comparative advantages. In the past, the government discriminated and repressed those sectors. To make those labor-intensive industries competitive, China also needed to provide adequate infrastructure and a good business environment. The infrastructure in China was extremely poor when the transition started. Although it was desirable to improve infrastructure for the whole nation, the Chinese government lacked financial resources to do so, and so it set up special economic zones (SEZs), industrial parks and export processing zones, improving infrastructure in a limited number of areas. China’s business environment was also very poor due to the distortions needed to protect existing industries. In SEZs and other economic zones, however, the government eliminated all of these distortions. In addition, the government provided one-stop service and other incentives to the firms in SEZs or industrial parks. As a result, new industries consistent with China’s comparative advantage quickly became China’s competitive advantage.
It was for these reasons that China maintained stability, achieved dynamic growth, and China’s exports rose rapidly in the last four decades. As China grew and accumulated capital, its comparative advantages gradually upgraded from labor-intensive to capital-intensive industries. During the upgrading process, China could benefit from the latecomer’s advantage.
WHAT PRICE DID CHINA PAY FOR ITS SUCCESS?
Although the economic performance during the transition in the last four decades was extraordinary, however, China also paid a very high price for its success. In addition to environmental degradation and food safety issues, which have attracted many public complaints and are the results of rapid industrialization and lack of appropriate regulations, the main issue during the transition is widespread corruption and the worsening of income disparities. Before 1978, China had a rather disciplined and clean bureaucratic system and an equalitarian society. According to the Corruption Perception Index published by Transparency International, China ranked No. 79 among all the 176 countries or territories in 2016; and based on the estimates of National Statistical Bureau and various scholars’ research, China’s GINI coefficient has exceeded 0.45, higher than the international warning level, after 2000 (Li and Sicular 2014). These problems were related to China’s pragmatic, dual-track transition strategy.
On the one hand, the government provided transitory protection and subsidies to the nonviable state-owned enterprises (SOEs) in the old, capital-intensive sectors to maintain stability and, on the other hand, liberalized and facilitated the entry to the new, labor-intensive sectors which were consistent with China’s comparative advantages to achieve dynamic growth. One of the most important costs of investment and operation for the old capital-intensive sectors was the cost of capital. Before the transition in 1978, the government used fiscal appropriation to pay for investments and cover working capital, so SOEs did not have to bear any cost for capital. After the transition, the fiscal appropriation was replaced by bank loans. The Chinese government set up four large state banks and a stock market to meet the capital needs of large enterprises. To subsidize SOEs, the interest rates and capital costs were artificially repressed.
When the transition started, almost all firms in China were state-owned. With the dual-track transition, private-owned firms grew and some of them become large enough to get access to bank loans or list in the equity market. As interest rates and capital costs were artificially repressed, whoever could borrow from the banks or list in the stock market were therefore subsidized. These subsidies were paid for by the low returns to savings in the banks or in the stock market made by individual households. Those people providing the funds were poorer than the owners of the large firms they financed. The subsidization of the operation of the rich’s firms by poorer people was one reason for increasing income disparities. Moreover, the access to bank loans and equity market generated rents, leading to bribery and corruption of the officials who control the access.
Similarly, before 1979 natural resources mining was operated free of concession fees by large-scale state-owned mining companies and the outputs were provided to other SOEs at very low prices. The government allowed private firms to enter the mining sectors in 1983 and liberalized controls over output prices in 1993. Concession fees and output taxes were kept low as a measure to compensate for state-owned mining enterprises’ social policy burden of employing redundant workers and covering the pension of retired workers (Lin and Tan 1999). New private mining companies did not have such burdens. Acquiring a concession promised them overnight enrichment and became a source of income inequality and corruption.
In addition, some natural monopoly industries, such as power and telecommunication, were operated by state-owned enterprises. The government liberalized the entry to those industries gradually. Those monopoly rents were also sources of inequality and corruption.
For coping with corruption, President Xi Jinping launched an anti-graft campaign after taking office in 2013. However, the root of the widespread corruption was the rents arising from the distortions of the dual-track transition, which protected and subsidized the large-scale SOEs in comparative-advantage defying, capital-intensive industries. In the 1980s and 1990s China was a poor country and capital was scarce. After four decades of rapid economic growth, capital becomes relatively abundant and comparative advantages in China evolved accordingly. Many capital-intensive industries turned from defying China’s comparative advantages to becoming consistent with China’s comparative advantages. As a result, firms in those industries became viable and should have been competitive and profitable in domestic and global markets as long as they had good management. The nature of subsidies and protections to the recipient firms changed from a necessity for survival to a pure rent.
It was, and still is, imperative to eliminate all remaining distortions and protections, so as to complete the transition to a well-functioning market economy and to uproot the causes of corruption and income disparity. Indeed, this was exactly the intention of the comprehensive reform agenda adopted in 2013 by the third plenary session of the 18th party congress of Communist Party of China.
THE LESSONS FOR OTHER DEVELOPING COUNTRIES AND FOR ECONOMICS?
What, finally, are the implications for other developing countries? The analysis in this chapter suggests, first, that every developing country has the potential to grow dynamically and continuously for 30 or more years and to eliminate poverty and become prosperous, if they develop their economy according to their comparative advantage. With the government’s facilitation in a market economy, countries can turn their comparative advantages into competitive advantages. Competitive industries can be profitable, accumulate capital and engage in processes of industrial upgrading that tap into the potential advantage of backwardness, enabling them to grow much faster than high-income countries, maintaining growth rates of 7 percent or more for several decades, as in the case of China in the last four decades. Although there is potential for every country to grow, they need to have the right development strategy in order to tap into their potential.
Second, most countries inherit many distortions from previous interventions. Those distortions cause misallocation of resources and rent seeking. Removing those distortions is desirable. However, distortions exist for certain reasons, and are, in economic terms, largely endogenous. Unless the causes of a distortion are removed first, the attempt to eliminate the distortion can do more harm than good. A country embarking on reform should, therefore, be pragmatic employing transitory and transitional protection as China was over the last 30 years.
A careful liberalization of entry into new sectors, of a country’s comparative advantages and of government facilitation of growth in those sectors, can allow it to grow dynamically and preserve stability while preparing the ground for the removal of the distortions. A pragmatic approach to step-by-step development, according to a country’s evolving comparative advantage, is of great value to developing countries.
At the same time, pragmatism is required in the transition itself. The final goal is the establishment of a well-functioning market economy, but it should be a process managed by the government paying attention to the needs of all sectors and providing business opportunities for them.
The analysis in this chapter shows that it is important to examine the reality of the situation in developing countries and to develop new ideas and theoretical understandings based on their experiences. In recent years, reflecting on the weakness of structuralism and neoliberalism, I advocate New Structural Economics (Lin 2012b), which is generalized from the successes and failures of China and other developing countries’ development and transition. From the perspective of new structural economics, the secret of China’s success is its use of both the “invisible hand” and the “visible hand”, forming an organic integration, complementation and mutual improvement of the functions of the market and the state. The applicability of a theory generalized from one country to another depends on the similarity of pre-conditions in those countries. I hope that the New Structural Economics will provide useful insights for developing countries in overcoming development challenges in their roads ahead.
Easterly, William, (2001). ‘The Lost Decades: Developing Countries’ Stagnation in Spite of Policy Reform 1980–1998’, Journal of Economic Growth. 6: 135–57.
Li, S. and T. Sicular, (2014). ‘The Distribution of Household Income in China: Inequality, Poverty and Policies’, China Quarterly. 217: 1–41.
Lin, Justin Yifu, (2009). Economic Development and Transition: Thought, Strategy, and Viability. Cambridge, UK: Cambridge University Press.
Lin, Justin Yifu, (2012a). Demystifying the Chinese Economy. Cambridge, UK: Cambridge University Press.
Lin, Justin Yifu, (2012b). New Structural Economics: A Framework for Rethinking Development and Policy. Washington, DC: World Bank.
Lin, Justin Yifu and Guofu Tan, (1999). ‘Policy Burdens, Accountability, and the Soft Budget Constraint’, American Economic Review: Papers and Proceedings. 89: 426–31.
World Bank (on behalf of the Commission on Growth and Development), (2008). The Growth Report: Strategies for Sustained Growth and Inclusive Development. Washington, DC: World Bank.
(This article is excerpted from the book 《中国与西方：当前经济、政策与应对》published by 中信出版集团 CITIC Publishing Group in 2022. The Chinese book is translated from China and the West, edited by Jan Svejnar and Justin Yifu Lin, and published by Edward Elgar Publishing.)