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China in the
World Economy

THE DOMESTIC POLICY
CHALLENGES

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SYNTHESIS REPORT

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China in the World Economy:
The Domestic Policy Challenges

SYNTHESIS REPORT

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which came into force on 30th September 1961 , the Organisation for Economic Co-operation
and Development (OECD) shall promote policies designed:

- to achieve the highest sustainable economic growth and employment and a rising
standard of living in Member countries, while maintaining financial stability, and thus
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Foreword

To reap the full benefits of further integration in the world economy, the Chinese
economy must undergo fundamental adjustments. A substantial reallocation of
resources among economic sectors and a major restructuring of the business sector
will be needed to correct widespread inefficiencies. The government will face
demands from society to ease the pressures created by this historic transition.

Many OECD Member countries which have undergone similar economic
upheavals have found that international co-operation in the framework of the OECD
can provide valuable support in designing institutions and policies that maximise
the benefits of liberalisation while minimising its costs. This landmark study grew
out of what the OECD perceived as a strong interest by the Chinese authorities in
sharing the collective knowledge and experiences of economic development that
OECD Member countries have accumulated through this process.

Since 1995, China and the OECD have engaged in a fruitful dialogue on many
policy issues of common interest in the framework of a comprehensive programme
of co-operation managed by the Centre for Co-operation with Non-Members.

This study takes stock of the results of these activities and develops the analy-
sis of the policies that will have to be adjusted in order to meet the challenges of
further trade and investment liberalisation. It is published under my responsibility.

1 hope that this work can provide the Chinese authorities and people with
tools and encouragement to continue their momentous undertaking.

Donald ). lohnston
Secretary-General
OECD

About the synthesis report

This is the synthesis report of a large study undertaken by the OECD Secre-
tariat. It was written by Charles Pigott, Senior Economist, Economics Department,
OECD, on the basis of the 22 chapters of the full study. The full study (see below)
will be available in a separate volume.

About the study

This study has been undertaken in the framework of the ongoing OECD-China
programme of dialogue and co-operation, managed on the OECD side by the Centre
for Co-operation with Non-Members. Policy issues covered under the programme
include tax policy, statistics, environment policies and indicators, agriculture, com-
petition, enterprise reform, corporate governance, financial sector reform, insurance,
education, and science and technology. Although the study draws on the under-
standing gained from several years of dialogue with a number of Chinese Ministries
and Agencies, this remains an independent study of the OECD Secretariat.

Acknowledgem ents

This study has been produced by a cross-Directorate team led by Charles Pigott (Senior
Economist for China in the Economics Department) under the supervision of Silvana Malle
(Head of the Non-Member Economies Division) and has been co-ordinated by Frederic
Langer (Head of the China and Asia Unit of the OECD Centre for Co-operation with Non-
Members).

OECD Contributors: |on Blondal, Peter Borkey, Sang Mok Choi, Andrzej Kwiecinski,

Christina Tebar-Less, George Holliday, Marie-France Houde,
Bernard Hugonnier, Xiande Li, Marie-Ange Maurice, Krzysztof
Michalak, Elena Miteva, Makoto Nakagawa, Young-Sook Nam,
Stilpon Nestor, Charles Pigott, Anders Reutersward, Udo Pretschker,
Sally Van Siclen, John Thompson, Peter Whiteford, Terry Winslow,
Aki Yamaguchi, Gang Zhang.

Outside Contributors: Chunlai Chen, Hunter Colby, Sylvie Demurger, Gerry Dickinson,

jean-Frangois Huchet, Scott Jacobs, Gilles Lelong, Shantong Li,
Wayne Morrison, Albert Park, Scott Rozelle, |ian-Guang Shen,
Qihong Sun, Cunzhi Wan, Wei Wang, Shiqiu Zhang, Zhujian Zhou.
Research support: Chuen-Mui Wu Final copy editor: Kathleen Gray

The CCNM wishes to thank the experts from OECD Member countries and China who
participated in the informal seminar under the auspices of the Economic and Development
Review Committee on 10 December 2001 in Paris, contributing important comments on the
draft study results. Experts from China, who took part in their personal capacity, were
Mr. Wen Hai, Deputy Director, China Centre for economic research, Beijing University, Mr. )un
Han, Director General, Research Department on the rural economy, Development Research
Center of the State Council (DRC), Mr. Kang |ia, Director, Institute of Fiscal Science, and
Mrs. Shantong Li, Director General, Department of Development Strategy, DRC.

©OECD 2002

Synthesis of the Main Findings of the Study

China’s progress during the economic reform era that began in 1978 has been
one of the great economic success stories of the post-war era. China has become
the world’s seventh largest economy and second largest recipient of foreign direct
investment. Only Japan and Korea achieved a comparable record of sustained
rapid growth during the latter half of the 20th century. China’s performance is all
the more remarkable in that its reforms have been gradual and its development
has occurred despite extensive, though declining, state ownership and interven-
tion in the economy.

The accession of China to the World Trade Organisation (WTO) marks an
important milestone along the reform path China has been following for more than
twenty years, rather than a new direction. China has been liberalising its interna-
tional trade and investment policies since the mid-1980s and is now as open as
some present WTO members. Although China stands to gain significantly from the
opening of its export markets under the terms of its accession, the depth and
breadth of its commitments to liberalise access to its domestic economy are
acknowledged to be more extensive than those agreed to by previous adherents
to the WTO. This willingness reflects the fact that opening to international markets
promotes market discipline, access to technology, and other qualities that have
been important goals of domestic economic reforms. In this respect, WTO entry is
a complementary aspect of the next phase of China’s reforms.

This report synthesises the main findings and recommendations of the OECD
horizontal study of the domestic economic policy challenges posed by China’s fur-
ther trade and investment liberalisation (TIL). The study comprises 22 detailed
reports prepared by nine OECD directorates covering the adjustments and policy
challenges facing the key sectors of the real economy over the next decade, and
their implications for the policies that will be critical to success in meeting these
challenges. The study represents an OECD perspective drawn from the experiences of
its Member countries with economic transformations, and from the work of the OECD
with China and other emerging economies over the past decade. The basic question
the study addresses is: how can China best reap the benefits of its opening and other
economic reforms over the next decade in order to meet its basic development objec-
tives? The reports analyse the current problems impeding China’s economic 5 I

China in the World Economy: Synthesis Report

development and identify key priorities and objectives, along with some suggested
specific steps, in order to maximise the benefits of China's opening and other
reform efforts. These analyses highlight the interdependence, and increasing
need for co-ordination of policies in different areas.

Messages

The studies document the impressive progress China has made in transforming
its economy during the reform era. At the same time, they indicate that the important
engines that have driven China's growth in the past are losing their dynamism. The
main reason is that China's economy has become badly fragmented and segmented,
and this has led to increasing-under and inefficient utilisation of resources. Trade and
investment liberalisation, although it will require difficult adjustments by some seg-
ments of the economy, will stimulate other segments and bring positive net benefits
to the economy as a whole over the longer-term. However by itself, trade and invest-
ment liberalisation is unlikely to solve the basic problems now impeding China's eco-
nomic development.

As it has throughout the reform era, the realisation of China’s economic potential,
including the full benefits of trade and investment liberalisation, rests on its success
in continuing and strengthening its domestic economic reforms. However China's
economy has reached a stage that calls for some important changes in the way eco-
nomic reforms are carried out. As the economy has become increasingly exposed to
market forces and the scope for self-contained development of individual sectors has
declined, economic problems have become more and more interdependent. Condi-
tions in particular segments of the economy, such as rural labour markets, industry, the
financial system, and regional development, now depend as much or more on devel-
opments in other areas of the economy than on developments or policies in that spe-
cific segment. Economic distinctions among various parts of the economy that have
been accorded different treatment are breaking down. This interdependence has led
to several "vicious circles" in which problems in a number of areas interact in a mutu-
ally reinforcing fashion to impede progress in the overall reform process. Particularly
difficult is the vicious circle involving the weak performance of many of China’s enter-
prises and the problems of the banking system that is described in the next section.

In China's present situation, the outcomes of particular reforms depend increas-
ingly on the interaction among measures taken by the economy’s key actors -
government, enterprises, workers, and the financial system - acting in markets whose
functioning is shaped by key framework conditions such as competition, property
rights, and corporate governance. Rather than emphasising particular sectors, reforms
now need to focus more on economy -wide policies to promote more efficient allocation
of resources and to bolster the effectiveness of markets. The study highlights three
objectives as the key to the success of China's overall reforms over the next decade.

Synthesis of the Main Findings of the Study

• The first and most immediate is to lay the foundation for improving the util-
isation of China’s resources, by removing present obstacles to business sec-
tor restructuring and by achieving better integration among various
segments of the economy that have been developed separately under dif-
ferent sets of rules.

• The second is to improve competition law, property rights, enterprise gov-
ernance and other frameworks that are essential to efficient market func-
tioning so that resources are efficiently allocated in the future.

• And the third is to improve the capacity of the government to support eco-
nomic development, by strengthening the effectiveness of macroeconomic
policies while refocusing the role of regulatory policy on establishing and
enforcing rules for market behaviour.

In achieving these objectives, reforms need to be both concurrent and care-
fully sequenced. Individual reforms to address particular problems need to be
accompanied by complementary reforms in other areas in a comprehensive and
co-ordinated fashion that is mutually reinforcing. Preferential development of
individual sectors to "lead" the overall economy is likely to have much lower pay-
offs than in the past, and pose greater risks of negative outcomes. At the same
time, reforms cannot be made all at once and care needs to be taken to establish
the pre-conditions needed for follow-up measures.

Both principles will be particularly important to the achievement of three
objectives which the study identifies as needed to break through the vicious circles
now impeding reforms and establish the pre-conditions for sustained progress in
the future. These are to:

• restore solvency to the financial system;

• bolster market based mechanisms as the dominant force for restructuring of
the business sector;

• and establish public finances on a sound and sustainable basis.

Taking stock: the progress that has been made and the problems that need
to be overcome

China’s economy has undergone extensive transformations over the past twenty
years (Table 1 ). The characteristic feature of the government's economic strategy has
been to create separate channels for development outside the state sector,
operating under different rules and conditions, in order to progressively
increase the scope for market forces while phasing out central planning. This
process, which has been termed "growing out of the plan”,' has been highly
successful but it has become increasingly apparent that its ability to push
China's economic development further is coming to an end. Structural problems in

China in the World Economy: Synthesis Report

Table 1. The transformation in China’s economy

1980

2000

GDP per capita 1

168

72 72

Percentage of population in urban areas

Share of GDP (per cent) in:

Agriculture

Industry

Services

Share of employment in:

Agriculture

Industry

Services

Trade/GDP (%)’

1. In constant 1995 US$.

2. Figure is for 1998.

3. Exports plus imports as share of GDP.

Sources: World Bank, World Development Indicators, 2000; China Statistical Yearbook, 2000; IMF, International Financial Statistics.

Figures for shares in GDP and employment for 2000 are from Chapter 1 , Table 1.1.

Figure 1. Real GDP growth

3 year moving average

Synthesis of the Main Findings of the Study

the real economy have worsened progressively during the 1 990s, leading to growing
under-utilisation of labour and a protracted slowdown in real growth (Figure 1).
These structural problems are substantially attributable to a lack of integration
in factor markets, among business segments, and among regions.

Obstacles to resource utilisation in the rural economy 2

China's agriculture employs about 50 per cent of the country's workforce and
is characterised by relatively scarce land in relation to labour and small-scale pro-
duction using little mechanisation. As in Japan and Korea, output per unit of land
is high by international standards but output per worker is low. Land-intensive
crops, notably wheat, corn, soybeans, and cotton are produced mainly in the
northern part of the country while most of China's rice and sugar crops are pro-
duced in the southern half. Cultivation of vegetables, which are labour-intensive,
is concentrated in coastal provinces and in areas adjacent to cities. Meat produc-
tion is more evenly dispersed and largely carried out in small "backyard" facilities.
Agriculture supplies less than half of total rural income. Per-capita incomes of rural
households are 40 per cent of those in urban areas and, due largely to greater
access to off-farm jobs, are highest in coastal areas.

Policy toward the rural economy continues to be carried out under frame-
works and institutions distinct from those governing other parts of the economy.
The Ministry of Agriculture is responsible not only for agricultural activities but
also for general oversight of township and village enterprises (TVEs). The property
rights regime in rural areas, in which village collectives formally own agricultural
land, is distinct from that applying in urban areas. China’s population registry sys-
tem (fiukou) includes provisions that impede migration of rural-born workers by
preventing them from becoming legal residents of cities. Education resources per-
capita and the average level of schooling are significantly lower than in urban
areas. Pensions and other social benefits provided in urban areas are largely
unavailable to the rural population.

Limits on integration with the rest of the economy did not prevent the rural sec-
tor from providing two key sources of China's development during much of the
reform area. The first came from a major transformation in the policy environment in
agriculture in the early 1980s. The tightly-controlled commune system of pre-reform
times was replaced by a household based system in which individual farmers
lease their land from the collectives, are largely autonomous in their production
decisions, and bear the profits or losses from their operations. Market forces have
largely replaced government plans and targets. And with the important exception
of grains, 3 government intervention in the production, pricing, and marketing of
agricultural products is now limited.

China in the World Economy: Synthesis Report

These policies have been instrumental in raising agricultural productivity and
living standards during the reform era. The increase in agricultural productivity
provided the first major impulse to the take-off in China’s growth during the first
half of the 1 980s. However, the physical constraints on China's land and environ-
mental resources make it difficult to increase productivity further within the exist-
ing pattern of production. Fertiliser use is already exceptionally high and the
scope for increasing the use of pesticides is limited by their adverse environmen-
tal impacts. Water shortages and other environmental problems pose increasing
barriers to higher agricultural productivity.

Fundamental improvements in agricultural productivity depend on substan-
tial reallocation of resources away from land-intensive products toward labour-
intensive products. However, the scope for reallocation is limited by certain gov-
ernment agricultural policies, the most of important of which is the grain procure-
ment system. The policy has also had adverse consequences for macroeconomic
performance in recent years: grain surpluses and falling market prices have
depressed agricultural incomes and contributed to a marked slowdown in rural
consumption growth.

The changing role of agriculture within the rural economy has provided a sec-
ond major source of China's growth and development. In 1980, agriculture
employed virtually the entire rural workforce and supplied nearly all of its income.
However, rising productivity within agriculture was accompanied by the large-
scale exit of workers from agriculture to industry.

In order to employ the workers coming from agriculture, local governments
were encouraged to foster the growth of rural non-agricultural enterprises (REs) ,
commonly known as TVEs. 4 These REs have been the main vehicle for absorbing
this exit of workers from agriculture. REs are small and medium-size enterprises
(SMEs) in rural areas that specialise in labour-intensive products, and along with for-
eign funded enterprises produce most of China's exports. Exemption from central
planning restrictions, backing from local governments, business relations with state-
owned enterprises (SOEs), greater exposure to market discipline compared to
SOEs, and access to cheap rural labour, led REs to flourish beginning in the mid-
1980s. They were the largest contributor to growth in aggregate GDP and employ-
ment from the mid-1980s through the early 1990s, and by 1996 employed
131 million workers, or 28 per cent of the rural workforce. The development of REs in
turn has transformed rural income generation, with more than 40 per cent of rural
incomes now coming from non-agricultural activities (Table 2). The overall effect has
been to increase the interdependence between the rural and urban economies,
even though the traditional administrative distinctions have largely remained.

The large-scale shift of workers from lower productivity occupations in agriculture
to higher productivity jobs in industry has been an important engine of China’s

Synthesis of the Main Findings of the Study

Table 2. Rural household incomes by source

Net income per capita, per cent

Year

1985 1990 1995 1998 1999

Total income (monetary and in-kind)

Of which: farming and related activities 2
Memoranda:

Total annual income in 1999 RMB 3
Annual real growth rate, percent'

1. Average growth rates for the periods between indicated years.

2. Including animal husbandry, forestry, fishing, hunting and gathering.

3. RMB amount deflated by the consumer price index.

Source: Figures are taken from Chapter 16, Table 16.4, which gives additional details. Data come from China Statistical

Yearbook 2000, Tables 10-14 and 10-15. The data are derived from official household budget surveys using partly
different definitions in urban and rural areas. Wages are assumed to be paid entirely in money.

100

311

1 370

1 718

2 132

2 210

0.9

4.6

7.5

3.7

growth, as it has been for other rapidly developing countries in the past. However,
in China the bulk of the shift has taken place within the rural economy rather than
through migration from rural to urban areas, due to government regulations that
have impeded migration from rural to urban areas. These impediments, which
amount to disincentives to migration rather than outright barriers, derive primarily
from two sources. The first is related to the fiukou, and has effectively denied ser-
vices, other benefits, and most formal sector jobs in urban areas to rural migrants.
The second impediment arises from the rural land tenure system, under which
farmers who are absent for prolonged periods of time from their rural residences
risk losing the land-use rights that are their primary old-age insurance.

Moreover, the shift of agricultural workers into REs has also been quite
uneven. These industries have developed mostly in coastal provinces and have
much less of a presence in the interior provinces, particularly those in the west.
Even during the most dynamic phase, the growth of REs has not been sufficient to
fully absorb the exit of workers from agriculture. The result has been the develop-
ment of a substantial surplus of under-employed rural workers. A large portion of
these workers - as many as 100 million - have become "floating" migrants who
have taken up unregistered informal sector employment in urban areas.

The impetus to aggregate growth from REs has also waned in recent years.
Since 1996, RE performance has deteriorated sharply, and employment has fallen
by nearly 2.5 million. The slowdown in China’s export growth after the 1997 Asian
crisis can explain only a small part of this deterioration, which is rooted in funda-
mental structural problems. China’s REs are suffering from financial problems and
operating inefficiencies nearly as severe as those afflicting the SOE sector. The

China in the World Economy: Synthesis Report

exemption from central planning restrictions and sponsorship by local govern'
ments, which gave REs an advantage in the past, have become less important as
constraints on SOEs have been relaxed. The disadvantages of REs, in terms of dis-
tance from infrastructure and other facilities that benefit businesses in urban areas
and which limit the scale of operations REs can achieve, have become more prom-
inent. The degree to which these disadvantages are offset by access to lower cost
but also lower skilled labour is unclear.

China's further opening to international markets offers opportunities to revive
the growth forces from the rural economy but does not ensure the opportunities
will be exploited. China’s undertakings in agriculture under the WTO include tariff
reductions and higher import quotas, elimination of the privileged position of
state-trading enterprises (STEs), and increased scope for private traders in the
marketing of agricultural products. The opening to international markets implies a
shift of resources away from land-intensive products, notably grains (except rice)
and cotton, and an increase in resources in labour-intensive products such as veg-
etables and horticultural products. However, several policies not covered by
China's WTO accession agreement, notably government control of grain procure-
ment prices and distribution, will need to be changed if this reallocation is to
occur to more than a limited degree.

Nor does opening appreciably alter the scale of the challenge of employing
China's rural workers. Estimates suggest that, even with no further opening, nearly
70 million additional workers will exit agriculture between 2000 and 20 10. 5 WTO
itself is expected to add only 2 to 3 million further to this decline. The analysis in
the chapter on rural industries indicates that, even under optimistic assumptions
about how much their performance can be improved, REs are unlikely to be able
to take up more than a fraction of the rural workers who will need to find jobs out-
side the agricultural sector. This further underscores the fact that the development
of the rural economy is increasingly dependent on conditions and policies affecting
the economy as a whole.

Structural impediments to further industry development *

Two related structural changes have provided much of the impetus to China's
industrial development during the reform period. The first is the shift from a
wholly state-owned industrial sector at the beginning of the reform period toward
one increasingly dominated by "non-state" enterprises, starting with TVEs and
other collectively owned businesses, followed by foreign-funded enterprises, and
more recently by private domestic enterprises. Enterprises either wholly owned
or controlled by government entities now account for less than 30 per cent of
industrial output, although they still employ nearly half of the urban workforce in
I 12 the formal sector.

©OECD 2002

Synthesis of the Main Findings of the Study

This transformation of industry ownership contributed to growth in at least
two ways. First, it fostered a shift of resources toward enterprises that have been
more efficient and more effective in responding to changing market forces than
most SOEs. The fact that non-state enterprises have faced harder budget constraints
than many SOEs partly accounts for this superior performance.

Second, ownership transformation helped to spur growth by increasing com-
petition. The entry of non-state enterprises engendered particularly fierce compe-
tition in export industries and industries supplying foreign goods, where the state
has allowed relatively free access. Competition has been increased further by the
curtailing of central planning mechanisms and freeing of prices: nearly 90 per cent
of retail prices are now completely market determined, the main exceptions being
energy and other utility prices. Increased competition has helped to raise the
overall profit orientation of industry. The advance of competition has, however,
been uneven. Protected industries reserved entirely or mainly for SOEs include
major utilities such as electricity and petroleum/gas extraction, but also mineral
extraction, steel and other metallurgical industries, automobile production, basic
chemicals, and tobacco.

The second structural change is the progressive opening of the Chinese
economy to foreign trade and investment. China’s average tariff rate has fallen
from above 40 per cent in the early 1990s to 15 per cent in 2001. Since 1979,
China has received a cumulative total of US$ 350 billion in foreign direct
investment (FDI) and in recent years, foreign investment has averaged 4-5 per
cent of GDP (Table 3). The performance admittedly has been uneven: the bulk
of foreign direct investment has come from Chinese Taipei, Hong Kong, China,
and other Asian countries with large ethnic Chinese populations, while China
has been less successful in attracting foreign direct investment from OECD
countries. 7 Foreign direct investment has been largely concentrated in coastal
provinces, mainly because most of the special economic zones (SEZ) granting
preferences to foreign investment have been established in those regions.

The opening to international trade and investment has increased competi-
tion, spurred the growth of domestic labour-intensive industries, especially REs,
and helped to develop China’s exports. Foreign-invested enterprises (FIEs) in
China have also been instrumental in developing China’s export industries, partic-
ularly in recent years as foreign direct investment inflows have shifted toward cap-
ital- and technology-intensive export sectors. Foreign investment has also helped
to raise industry productivity and to improve industry technology, know-how and
the skills of workers.

As in agriculture, the dynamism to industry imparted by structural shifts
seems to be weakening. Industry financial performance has deteriorated sharply
since the early 1990s. Profits fell to nearly zero in 1998, with more than one-third of

China in the World Economy: Synthesis Report

Table 3. Ratio of foreign direct investment inflows to China's GDP
and gross capital formation

Total foreign direct
investment
inflows
(US$ billion)

China's

GDP

(US$ billion)

Ratio of total
foreign direct
investment inflows
to China's GDP
(%)

China's

domestic

GCF 1

(US$ billion)

Ratio of total
foreign direct
investment inflows
to China's domestic
GCF 1
(%)

1983

0.916

300.375

0.31

101.483

0.90

1985

1.661

305.254

0.54

1 15.300

1.44

1990

3.487

387.723

0.90

134.705

2.59

1995

37.521

700.278

5.36

285.928

13.12

1996

41.725

816.490

5.1 1

323.148

12.91

1997

45.257

898.244

5.04

343.285

13.18

1998

45.463

958.990

4.74

356.964

12.74

1999

40.319

989.621

4.07

368.446

10.94

1 . GCF refers to gross domestic capital formation.

Source : The Table is adapted from Chapter 1 0, Figure 10.2. Data come from various issues of the China Statistical Yearbook.

enterprises making losses, and despite noticeable improvement during 1999-2001,
financial performance remains weak in many sectors. Growth in industry employ-
ment and capital spending has declined markedly. The deterioration has been
pervasive and not simply confined to SOEs. The performance of collective enter-
prises has worsened nearly as much as that of SOEs; and the SME sector generally
is in particularly dire straits.

The poor industry performance can be traced in part to the accumulation of
policy burdens arising from the long-standing use of enterprises to accomplish
social policy goals. These burdens, which amount to government resource extrac-
tion through regulation, include excess labour, high debt loads, and responsibili-
ties for public pensions, housing, education, and other social benefits that in other
countries are the responsibility of government or individuals. Policy burdens are
heaviest on SOEs but they are also borne by REs. Authorities have made signifi-
cant progress in recent years in reducing excess labour and excess capacity and in
reducing debt burdens of larger SOEs. However less progress has been made in
reducing other policy burdens, and there has been much less improvement for
other SOEs or non-state enterprises.

The biggest problem impairing industry performance is widespread ineffi-
ciency in enterprise operations. Presently, much of industry operates with inade-
quate resources that are poorly managed by the firms that control them and
which are misallocated across firms, in contrast to formerly centrally planned
economies in Eastern Europe, China's industry is characterised by widespread
sub-optimal scale in production facilities, fragmentation and duplication. There

Synthesis of the Main Findings of the Study

are 200 separate producers of automobiles, most of which complete only a few
thousand units per year. Much of the plant and equipment is outmoded. Economies
of scope are also poorly exploited, as illustrated by the nearly 8 000 independent
cement firms in China compared to 110 in the United States, 51 in Russia, 58 in
Brazil, and 1 06 in India.

Inadequate technology and limited capacity to innovate are particular weak-
nesses of much of Chinese industry. Technology standards for a large portion of
domestic firms are below international standards. China devotes proportionately
fewer resources, and produces less scientific outputs such as patents, than OECD
countries, as well as other large developing countries such as India. Industry also
plays a relatively smaller role in technology development and innovation. More-
over, the technology transferred by foreign enterprises to Chinese firms seems to
have been limited in both amount and scope.

These inefficiencies are attributable to a range of factors at the firm level, in
the external environment, and in the relation between government and busi-
ness. The poorly skilled and insufficiently profit-motivated management that
characterises much of domestic business has neglected technology. Weak finan-
cial discipline, which has effectively presented firms and their government back-
ers with a zero cost of capital, has been a major impetus to the development of
unproductive and redundant capacity. The pre-reform policy of encouraging
regional self-sufficiency together with low capital mobility has left a legacy of
limited regional specialisation in production. The resulting inefficiencies have
persisted and accumulated because key corrective market mechanisms have
been severely impaired. Exit via bankruptcy and liquidation has been relatively
rare, although it is becoming more common; and regional protectionism and
other administrative barriers have severely restricted the scope for value-
enhancing mergers and acquisitions (M&A). These factors have become a mutu-
ally reinforcing vicious circle (Figure 2). Government interference leads to poor
SOE management and inefficient operations, which foster low profits and high
debt; this in turn makes it more difficult to restructure to improve efficiency and
prompts government interventions that spread the problem by extracting
resources from stronger enterprises to prop up those that are failing.

Industry problems have become acute at a time when the traditional dis-
tinctions among ownership forms are becoming less and less meaningful in
functional terms. Smaller SOEs and REs are blending into the broader universe
of SMEs. Non-state enterprises are moving closer to enterprises formally rec-
ognised as private. The blurring of distinctions among ownership classes has
not, however, appreciably levelled the playing field among enterprises even
though it has modified the boundaries. The different ownership classes are
still subject to distinct legal and regulatory frameworks. Differences in treat-
ment - among smaller versus larger enterprises, among enterprises in competitive 15 I

China in the World Economy: Synthesis Report

Figure 2. The vicious cycle of poor enterprise performance

Source: OECD Secretariat.

versus sheltered sectors, and among enterprises that receive backing from
central or local governments versus those that do not - remain and in some
cases have increased.

The contrast in performance among industry segments has likewise become
starker. Large SOEs remaining under government control receive preferential
treatment from the government and are often sheltered from competition, but
their performance is often lacklustre and their flexibility is constrained by gov-
ernment intervention in their management and by various policy burdens. A
contrasting segment includes less favoured SOEs and collectives that have
become highly competitive in national, and in some cases international, mar-
kets, in large part because they have been freer of government interference,
more exposed to market discipline, and better managed as a result. Within this
group are enterprises in consumer goods and other labour-intensive industries
that have been tempered by fierce competition and have successfully integrated

Synthesis of the Main Findings of the Study

into international production chains. Between these groups lie a large portion of
(mainly) SMEs in poor financial condition and in dire need of restructuring, but
whose ability to restructure is circumscribed by limited access to financing and
other impediments.

China's further opening to international markets will force substantial adjust-
ments in industry. 8 Studies indicate that production of textiles, particularly lower
value-added segments, could more than double once the Multi-Fibre Agreement
(MFA) is phased out in 2005. Other labour-intensive industries are expected to
gain, although not as dramatically. Domestic firms in a number of capital or technol-
ogy intensive industries are expected to lose ground, at least initially, to foreign com-
petition. These include automobiles along with segments of the chemical and
metallurgical industries. Foreign direct investment is also expected to rise substan-
tially, by as much as two-fold annually by 2005 compared to the level that would oth-
erwise prevail. Higher foreign direct investment will create jobs but will put
competitive pressure on current domestic enterprises, even in sectors where China
has a comparative advantage.

Trade and investment liberalisation is unlikely by itself, however, to restore
dynamism to China's industry. To take full advantage of trade and investment lib-
eralisation, the real economy will require extensive restructuring of firms,
improvement in their governance and management, and reallocation of resources.
The benefits of trade and investment liberalisation to particular industries will
depend not only on their theoretical comparative advantage but also upon their
ability to restructure and upgrade operations to meet the challenges of world
markets that in important respects have become more difficult over time. For
example, higher end segments of the textile industry will need to improve tech-
nology and quality if they are to keep up with competitors in other emerging
Asian economies. Firms producing labour intensive products will need to inte-
grate into international production chains if they are to be successful in export
markets. Trade and investment liberalisation should help to improve some of
the mechanisms needed to accomplish the necessary restructuring, by increas-
ing competition, expanding opportunities for alliances between foreign and
domestic firms, and spurring government officials to take measures to improve
the business environment. However, key obstacles that now exist to improve-
ment in industry performance, such as continued government interference in
enterprise management, poor financial discipline, and restrictions on exit and
other modalities for re-deploying resources, need to be addressed if the poten-
tial benefits of trade and investment liberalisation are to be realised. Further-
more, a more comprehensive and effectively enforced competition law will be
needed to prevent incumbent firms and governments from erecting new protec-
tionist barriers to subvert trade and investment liberalisation and the adjust-
ments it will necessitate.

China in the World Economy: Synthesis Report

Figure 3. Equity market capitalisation: ratio to GDP in selected countries, 2000

Indonesia
Thailand
China
Germany
Korea
Japan
Australia
Chinese Taipei
Malaysia
United States
United Kingdom
Singapore
Hong Kong, China

0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0

Note: Figure is from Chapter 15, Figure 1 5.1 .

Source: International Federation of Stock Exchanges and OECD Secretariat Estimates.

Growing constraints from the financial system 1

China's financial system has made important progress in recent years. The stock
market has expanded impressively since its inception in the early 1990s, reaching a
market capitalisation of more than 50 per cent of GDP by 2001 (Figure 3). The past
decade has also seen the creation of new nation-wide banks, significant expansion
of the insurance sector, development of a domestic money market, and the more
recent emergence of consumer and housing finance. The financial supervisory and
regulatory structure has also been thoroughly reorganised and rationalised along
lines consistent with international best practices.

Despite this progress, the financial system still performs inadequately in car-
rying out several of its basic functions in the economy. Although savings appear to
be mobilised reasonably effectively, 10 credit is inefficiently allocated. SOEs
receive the bulk of funds allocated by the formal financial system, while non-state
enterprises receive a much lower share than warranted by their importance in the
overall economy." Non-commercial considerations, such as the need to sustain
loss-making SOEs, continue to influence bank lending. These distortions, together

©OECD 2002

Copyrighted r

Synthesis of the Main Findings of the Study

with the limited ability to vary interest rates to reflect risk, mean that the effective
cost of credit varies widely among borrowers of comparable credit worthiness.
There is limited diversity in financial outlets and capabilities. The interbank mar-
ket and other available facilities provide only limited scope for transferring funds
among financial institutions or regions. Insurance companies and other institutional
investors are underdeveloped even compared with other emerging market econo-
mies such as India and Brazil. The government and other bond markets are small,
fragmented, and illiquid, and the stock market, despite its rapid growth, is subject
to limitations on access and trading that impair its effectiveness. Financial instru-
ments to deal with liquidity fluctuations, manage risk, and provide for other speci-
alised needs are limited.

The external discipline provided by the financial system has also been a
major weakness. Years of government-mandated lending together with weak con-
tract enforcement and bankruptcy regimes created a distorted credit culture in
which banks have had limited incentives - and even less ability - to maintain
strict lending standards and enforce loan contracts. Government mandates and
weak lending standards created “soft budget constraints” for many enterprises
that were a major factor in the over-investment that occurred during 1992-94, and
whose legacy of excess and inefficient capacity now afflicts the Chinese economy.
The overall weakness in discipline has been aggravated by its unevenness across
enterprises. Due in part to the limited development of capital markets, but also to
government intervention in enterprise operations, the financial system lacks
means to support enterprise restructuring, re-deploy resources, and provide a
market for corporate control.

These weaknesses in the financial system are partly a reflection of the fact
that China is still a developing country. However they also reflect the fact that evo-
lution of the financial system has lagged that of the real economy. Despite the
substantial growth of the non-state sector in the real economy, the financial sys-
tem remains virtually entirely state-owned (Table 4), with only a single privately
owned domestic bank. The four major state-owned commercial banks (SOCBs)
established in the early reform period to finance SOEs, and which are still heavily
oriented toward this enterprise segment, dominate the financial system, account-
ing for nearly three-quarters of domestic lending. Credit facilities are segmented
between the cities and rural areas. Operations of most commercial banks, with the
exception of the SOCBs and 13 newer joint-stock banks, are restricted to their
home city.

These structural features reflect the heavy past involvement of the govern-
ment in lending decisions to support central planning mandates in the real econ-
omy and to use bank lending as a substitute for government spending to promote
various non-commercial objectives. The latter practice was spurred in part by the
steady decline in government tax revenues from the early 1980s through the

China in the World Economy: Synthesis Report

Table 4. State ownership of banks

State owned or controlled banks:
share of banking system capital

1998 1994

China

100

Other emerging economies:

Hong Kong, China

India

Indonesia

Malaysia

Philippines

n.a.

Singapore

Thailand

Russia

n.a.

Argentina

Brazil

Chile

Mexico

Peru

South Africa

OECD countries:

Australia

Canada

n.a.

France

O 2

n.a.

Germany

Italy

17'

n.a.

Japan

United Kingdom

n.a.

United States

Czech Republic

Hungary

81 3

Poland

1. 1999.

2. The government has a controlling interest in several financial institutions that
provide services similar to those of commercial banks.

3. 1990.

Sources : Chan-Lee, James with Sanghoon Ahn (2000), Measuring the quality of financial

systems in 29 market economies: an indicators approach with an extension to East Asia,
Asian Development Bank Institute, July; Barth, James R., Gerard Caprio Jr.,
and Ross Levine (2001 ), The regulation and supervision of hanks around the world: a new
database, World Bank, February; national sources and secretariat estimates.

mid-1990s (see Chapters 18 and 22 on tax policy and macroeconomic issues
respectively). The resulting substitution of government mandates for sound credit
I 20 standards is substantially responsible for the massive accumulation of non-

Synthesis of the Main Findings of the Study

performing loans by banks and other financial institutions. Government
involvement, and the perception that financial institutions will ultimately be
backed by the government regardless of their performance, has also inhibited
the development of a commercially oriented internal culture focused on the main-
tenance of sound lending standards and rigorous management of risks.

Beginning in the mid-1990s, the pace of financial reform has accelerated
sharply in an effort to address the system's weaknesses. The banking law enacted
in 1996 led to a significant tightening of bank lending standards by improving
internal controls and strengthening accountability by holding bank loan officers
and their management responsible for new problem loans. This step, together
with the earlier establishment of three "policy banks", was intended to free com-
mercial banks from government mandates. In 2000, authorities transferred
RMB 1.3 trillion (about US$ 150 billion) of SOCB non-performing loans (NPLs),
amounting to nearly 18 per cent of their total loans, to bank asset management
companies (BAMCs). New joint-stock banks with nation-wide scope have been
established since 1995 in order to create more diversity in the financial system.
Authorities have also sought to reduce restrictions on the joint-stock banks to encour-
age their development and are planning to introduce governance reforms for SOCBs.

However, while important, these steps have not proved sufficient to remedy
the weaknesses in financial system capabilities. Credit quality has improved but a
large portion of SMEs now face a virtual credit crunch. While many of these enter-
prises are in poor financial condition, surveys suggest that lack of access to fund-
ing has become a key impediment to SME restructuring. Financial discipline has
become if anything more uneven than before, as large SOEs with government
backing continue to have good access to bank credit and have been the main ben-
eficiaries of the additional financing provided by the stock market. Government
intervention in lending decisions has been reduced but the continued provision
of working capital loans to poorly performing SOEs suggests it has not disap-
peared. Furthermore, while the tightening of lending standards helps to contain
new non-performing loans, it is unlikely to be sufficient to foster the managed risk-
taking characteristic of commercially oriented financial institutions, and which will
be increasingly needed in China to facilitate the adjustments to trade and invest-
ment liberalisation.

Financial weakness has made these problems all the more difficult to deal
with. Despite the carve out of non-performing loans in 2000, the SOCBs along with
many other financial institutions almost certainly would have negative capital if
their loan portfolios were valued realistically, non-performing loans remaining with
the SOCBs after the transfer of loans to BAMC were nearly 27 per cent of total
loans in mid 2001 according to official figures, and would probably be higher if the
international accounting and loan classification standards China is gradually intro-
ducing were fully applied. Joint stock banks also have high non-performing loans 21 I

China in the World Economy: Synthesis Report

and rural credit co-operatives are widely acknowledged to be in especially bad
shape. Moreover, financial institutions have little cushion to write down non-per-
forming loans: capital adequacy ratios are barely at the BIS minimum in the best
cases and Ministry of Finance restrictions have left loan provisions at levels that
are quite low by international standards. Bank profits have fallen steadily through
the 1990s to very low levels that would probably be close to zero, or even nega-
tive, for SOCBs if international accounting standards were applied.

In a proximate sense, the ongoing problems of financial institutions reflect the
poor condition of their enterprise customers. A severe vicious circle has devel-
oped (Figure 4). Poor enterprise performance contributes to bank non-performing
loans and lowers bank profits by eliminating much of their core market. By them-
selves, financial institutions themselves cannot hope to restore their financial sol-
vency unless and until enterprise performance improves substantially. But high
non-performing loans make it difficult for banks to provide the funds for the enter-

Figure 4. The vicious circles of bank and enterprise problems

Government Interference

I 22 Source: OECD Secretariat.

Synthesis of the Main Findings of the Study

prise restructuring needed to improve their performance. While common to countries
in financial distress, this vicious circle is aggravated in China by behaviours
derived from the traditional relations among financial institutions, SOEs, and the
government that reforms have not yet decisively transformed. Limited govern-
ment revenues to facilitate SOE restructuring and its consequences continue to
require bank lending to sustain loss-making SOEs. This in turn weakens efforts to
improve the internal credit culture and commercial orientation of the banks, while
blunting incentives of SOEs to improve their own governance and management.

The combination of financial weakness and inadequate governance of financial insti-
tutions and enterprises also creates risks that inhibit the development of healthy cap-
ital markets as alternative financial outlets.

As in other areas, trade and investment liberalisation offers opportunities but
cannot itself guarantee that domestic problems will be appreciably reduced, and
it presents some risks if these domestic reforms are not effective. Trade and
investment liberalisation in principle allows much greater scope for foreign banks,
insurance companies and securities firms to participate in the domestic market.
Concerns within China that domestic banks will lose a substantial market share to
foreign banks appear to be overstated, however. Foreign banks are likely to be
very selective in their activities and to largely avoid lending to domestic enter-
prises until their performance improves substantially . 12 As argued in the chapter
on the banking sector, the development of China's domestic banks depends on
the success of reforms to improve their capabilities and governance and to facili-
tate restructuring of their enterprise customers. Given success in these areas, for-
eign entry into banking and other financial services should help to develop the
financial system, and ultimately benefit Chinese firms that succeed in improving
their capacities to operate effectively. Trade and investment liberalisation is also
likely to increase foreign investment in China's capital markets. This is likely to
help develop these markets over the long-term, but it may put near-term pres-
sures on Chinese equity markets, where domestic shares appear overvalued com-
pared to those on international markets. Opening of the capital markets to foreign
participation on any sizeable scale implies liberalisation of the capital control
regime - which will require substantial improvement in financial discipline and
supervision if risks to financial stability are to be contained.

Emerging weaknesses in macroeconomic performance 13

China's macroeconomic performance has been enviable in many respects.
Impressive growth in real GDP has been accompanied by even more rapid growth
in foreign trade and investment that have made China one of the more open of the
world's largest economies . 14 The external balances have remained healthy. China
has undergone several episodes of overheating and inflation during the reform 23 I

China in the World Economy: Synthesis Report

period, but has avoided the prolonged bouts of very high inflation suffered by
many other developing countries.

In recent years, however, several signs of a weakening in China's macroeco-
nomic performance have emerged. The first is the slowdown in real growth noted
earlier. Real GDP growth since 1996 has averaged slightly above 8 per cent, nearly
2 percentage points below the pace of the prior fifteen years. Fiscal stimulus,
which contributed nearly 1 percentage point to growth during 1998-2000, pre-
vented an even greater slowdown. Employment growth has fallen even more
sharply (Figure 5), to below the rate needed to absorb new entrants into the
labour force plus those laid off from SOEs and other activities. The result has been
a marked rise in urban unemployment - which by some estimates is over 1 0 per
cent - and a further increase in under-employed rural workers.

The slowdown is not fundamentally cyclical. China was hit only moderately by
the 1997 Asian crisis and growth has remained low by past standards even as
Asian countries recovered. Nor does the slowdown seem to reflect the natural
decline in potential growth that occurs as countries run out of opportunities to
transfer labour from low productivity to higher productivity occupations and to
absorb readily available technology and know-how from abroad. The labour sur-
pluses and widespread inefficiencies in industry suggest that these processes

Figure 5. Aggregate employment growth

Per cent

3.5 _

Per cent

_ 3.5

3.0 3.0

L2L

Source: China Statistical Yearbook, 2000 .

©OECD 2002

Copyrighted materiel

Synthesis of the Main Findings of the Study

have been slowed by structural distortions but are not exhausted. Rather the
growth slowdown is more plausibly viewed as the result of the drag on aggregate
demand engendered by the problems of banks and enterprises, together with
structural problems in the rural economy.

The slowdown in real growth also poses challenges to authorities as they seek
to foster the adjustments needed to alleviate the structural problems. Adequate
growth is needed to generate the demand, profits, and government revenues
required to finance industry upgrading, facilitate reallocation of resources among
sectors, and support workers displaced by the transition. Achieving full employ-
ment of the labour force is likely to require an extended period of growth above
China's potential rate at some future point.

Efforts to support growth through macroeconomic stimulus have underscored
the limits on monetary and fiscal policy instruments. As has happened in OECD
countries during periods of banking stress, expansionary monetary policy has had
only a limited impact because of the credit crunch resulting from banks' reluctance
to risk incurring new problem loans. Although the central bank interest rate has
been lowered progressively, to below 1 per cent currently, bank-lending rates
have been allowed to fall by less in order to avoid further aggravating the weak
profitability of the banks.

As a result, fiscal policy had had to supply most of the macroeconomic stimu-
lus. Official figures suggest that China’s fiscal position is healthy and that there is
ample scope for fiscal expansion. While the general government deficit rose to
nearly 3 per cent of GDP in 2000, domestic and foreign government debt together
still amount to only about 32 per cent of GDP. 15 However, this picture is misleading
because it is widely acknowledged that the government will need to take on debt
obligations not yet explicitly recognised. The main obligation, the funds needed
to restore solvency to financial system, could more than double the government
debt ratio initially. 16

China's debt-carrying capacity is probably less than its GDP might suggest
because government revenues are relatively low. Tax revenues fell steadily rela-
tive to GDP between 1980 and 1996 and, although they have recovered some-
what, are still less than 15 per cent of GDP. General government revenues,
including ''extra-budget" fees collected by local governments and contributions
to social insurance funds, are about 21 per cent of GDP, a relatively low level
compared to OECD countries as well as a number of emerging market econo-
mies (Table 5).

The relative scarcity of government revenues has had broader consequences.
Government spending on education, research and development, and other social
purposes have been low by international standards. The imposition of policy bur-
dens on enterprises and the use of bank lending as a substitute for explicit 23 I

China in the World Economy: Synthesis Report

Table 5. Government on-budget revenues as share of GDP

Figures for 1999

Percentage share

China

20.4

OECD average

37.8

United States

31.0

European Union

45.0

Japan

37.6

Other emerging market economies

Brazil

31.7

India

18.8

Indonesia

17.3

Russia

29.8

Source. OECD Secretariat compilations and estimates based on national sources.
Date include payments to social insurance funds.

government spending is due at least partially to the scarcity of government
revenues. Limited revenues at the local government level, due in part to distor-
tions in the present fiscal federalism arrangements, have encouraged the wide-
spread imposition of unsanctioned ad hoc charges and other forms of resource
extraction on enterprises and rural residents. These distortions account for a
striking paradox in China’s fiscal system. Government financial resources to facil-
itate economic reforms and meet other key social needs are limited: yet the bur-
den of government resource extraction is heavy for most segments of the real
economy - including those that appear to receive preferential treatment in the
formal tax system.

The macroeconomic consequences of China’s WTO entry are difficult to pre-
dict . 17 Much will depend on the success of the economy in making the necessary
microeconomic adjustments and on the degree to which economic reforms allow
the potentially large dynamic gains from trade and investment liberalisation to be
realised over the long term. Adjustment to trade and investment liberalisation will
stimulate some sectors but engender deflationary pressures from sectors that lose
ground. Macroeconomic policy is likely to have to deal with a shifting balance
between these positive and negative forces over time. Recent commentaries
point to the possibility that the current exchange rate parity may need to be
changed at some point as trade and investment liberalisation proceeds - but they
differ as to the direction. These considerations suggest that greater flexibility will
be needed in macroeconomic demand management instruments and in the
I 26 exchange rate regime and capital control regimes.

©OECD 2002

Synthesis of the Main Findings of the Study

Growing imbalances in regional development 18

China's growth during the 1990s has been accompanied by growing inequality
among its regions. Incomes and living standards have risen in nearly all areas, but
growth has been most rapid in the coastal provinces, followed by provinces in the
central region, and least rapid in the western regions (Table 6). Geographic dispar-
ities in income have been rising steadily since the late 1980s.

Table 6. Per capita GDP and real GDP growth by province

Per capita GDP
RMB/capita

Rank in the

year

Change
of rank

Growth rate
of GDP

1980

1999

1980

1999

1980-99

1980-90

1990-00

Eastern

Beijing

1 582

19 803

8.8

10.9

Tianjin

1 392

15 932

7.3

1 1.5

Hebei

427

6 913

1 1

-1

9.2

12.8

Liaoning

768

9 958

8.4

9.4

Shanghai

2 738

30 805

7.4

12.2

Zhejiang

468

1 1 981

-5

1 1.1

15.0

Jiangsu

544

10 699

11.6

14.0

Fujian

343

10 969

-1 1

11.4

15.4

Shandong

405

8 648

-5

10. 1

19.6

Guangdong

473

1 1 739

-3

12.8

14.6

Guangxi

281

4 264

-1

7.2

1 1.6

Hainan

278*

6 227

-12

11.7

12.5

Central

Shanxi

437

5 1 17

8.7

9.4

Inner Mongolia

345

5 400

-3

10.6

9.8

Jilin

384*

6 302

-3

9.5

10.4

Heilongjiang

685

7 660

6.9

8.4

Anhui

285

4 710

-4

9.9

12.2

Jiangxi

342

4 673

8.8

1 1.7

Henan

317

4 899

-4

9.6

1 1.5

Hubei

428

6 511

9.2

1 1.9

Hunan

365

5 227

-1

7.8

10.5

Western

Chongqing

4 852

Sichuan

315

4 356

8.1

10.0

Guizhou

219

2 463

-1

9.5

8.7

Yunnan

367

4 444

-3

1 1.8

9.3

Tibet

259

6.4

9.2

Shaanxi

335

4 107

10.0

9.1

Gansu

388

3 595

8.8

9.4

Qinghai

475

4 707

7.1

8.2

Ningxia

409

4 477

1 1

9.7

8.5

Xinjiang

405

6 653

-3

11.1

9.7

Source : China Statistical Yearbook, 2000.

©OECD 2002

China in the World Economy: Synthesis Report

The divergences in growth rates and increasing gaps in living standards
among China's regions, and between urban and rural areas, are fundamentally
reflections of their poor integration. Transportation and communication infrastruc-
ture within China's interior provinces, and that linking the interior with the coast, is
generally much less developed than in the coastal provinces. Segmentation has
been accentuated by differences in market rules and conditions across regions,
and in the way government policies are applied. The scope for non-state enter-
prises has been considerably less in interior provinces than on the coast, and the
heritage of SOE dominance and past central planning is greater. Capital mobility
has been limited, due in part to the limited outlets for transferring savings among
regions and to protectionist barriers to business establishment across regional
jurisdictions. Largely as a result of the pre-reform policy of regional self-sufficiency
together with limited capital mobility, there is relatively little regional differentia-
tion in industrial production structures, suggesting that regional comparative
advantages are not adequately exploited. There are several competition bodies
and conditions governing business establishment often differ among provinces.
Until recently, interior provinces were given much less freedom to offer preferen-
tial treatment to attract foreign direct investment compared to the coastal prov-
inces, and in some cases have been further disadvantaged by the closure of their
resource sectors to foreign participation. As discussed in Chapter 9, the relatively
inefficient distribution system has increased costs of marketing products nation-
wide and has fostered regional segmentation in some product markets.

Government policy to favour the development of coastal provinces has
increased their integration with the international economy to a degree that in
some respects exceeds their integration with the rest of the domestic economy.
While the policy is intended to catalyse the development of the economy as a
whole, the spillover benefits are limited by the poor integration of the coast with
the interior. The focus in the current five-year plan is to continue to rely on the
coast to lead China's growth while improving infrastructure in the interior, mainly
western, provinces and allowing their governments to offer financial and other
preferences to attract foreign direct investment and domestic capital. These
efforts are intended to provide a foundation for the much longer-term goal of
reducing disparities in growth and, eventually, in living standards. Apart from
these measures, explicit regional policy has largely been left to provincial authori-
ties. Financial and other key reform policies at the national level have few explicit
regional dimensions.

China's approach to regional policy presents a marked contrast to the experi-
ence of the European Union. From the beginning, EU policy emphasised the inte-
gration of its internal markets in parallel with liberalisation of its international
trade and investment regimes. The example of the United States, which has
I 28 enjoyed a high degree of internal integration for many years, has been a motivating

Synthesis of the Main Findings of the Study

factor behind this emphasis. Internal integration in the EU has been an explicitly
broad based effort to allow free movement of goods, services, capital, persons,
and businesses. In order to create comparable conditions for business operations
across member countries, the European Commission is assigned responsibility
under the Treaty of Rome for enforcing competition law, and has undertaken com-
plementary initiatives toward greater harmonisation of tax and other policies
affecting the business environment. The motivation for this move to a "single mar-
ket” has been that internal integration can have benefits at least comparable to
those from external integration, and indeed is necessary to fully realise the bene-
fits of external trade and investment liberalisation.

Trade and investment liberalisation is widely expected to increase pressures
for divergences among China's regions - despite the initiatives being taken under
the western economic development programme. Although governments in interior
provinces are making strong efforts to attract foreign investment, most foreign
direct investment is expected to go to coastal provinces. The labour-intensive
industries that will benefit most are also concentrated in coastal provinces. Their prox-
imity to international markets and their infrastructure also favour coastal producers of
vegetables and other labour-intensive agricultural products. Without further policy
efforts, income inequalities among regions are expected to grow, and could even
accelerate with trade and investment liberalisation.

Improving the utilisation of China’s resources

China's economy is clearly operating below its productive potential. Human,
capital, land, and other resources are under-employed, misallocated among eco-
nomic sectors, and inefficiently used. Achieving better resource utilisation is the
most basic challenge China faces in seeking to meet its development objectives.

As discussed in this section, better integration among the various segments
China's economy is likely to be essential if resource utilisation is to be improved.

Many of the priorities and suggested steps outlined below, and summarised at the
end in Box 2, will need to be supported by complementary policies to improve
market framework conditions and to strengthen the capacity of the government to
support economic development.

Raising labour utilisation 19

The task of achieving full employment of China’s workforce is daunting. Rough
projections indicate that China’s aggregate labour force will increase by more than
70 million over the next decade. To absorb these new entrants along with the mil-
lions of workers expected to leave agriculture, while making progress toward
reducing the number of under-employed, will require substantially more rapid
employment growth in industry and services than has been attained in recent years. 29 I

China in the World Economy: Synthesis Report

Given the widespread structural distortions in the economy, macroeconomic policy,
although it has an important complementary role to play, can do little in the
medium-term if inflation is to be contained. Instead, achieving better labour utili-
sation is fundamentally a structural challenge. Labour market reforms are a neces-
sary pre-condition to achieve this goal, but broader reforms discussed later will
also be required.

The key priority for improving the capacity of labour markets is "... to overcome
an inherited pattern of labour market segmentation and establish a national labour market ". 20
This is necessary because, whatever purposes they may have served in the past,
impediments to rural-urban migration and other impediments to mobility have
become major obstacles to absorption of excess labour and improvement in
labour productivity. Removal of labour mobility constraints is necessary not only
to allow workers to find jobs but also to reduce other distortions. In particular,
access to a wider array of jobs should improve incentives for rural workers to
increase their human capital. Increasing the supply of labour to urban areas
should stimulate development of urban businesses. Integrated labour markets
should foster business location to areas offering the greatest comparative advan-
tages in terms of access to resources, suppliers, and markets.

An essential step toward creating a national labour market is to begin to pro-
gressively phase out the constraints on migration to urban areas and other barriers
to the recruitment of non-local workers by urban enterprises. Reform of the hukou
is necessary to reduce these impediments and has recently been endorsed in
principle by the Chinese authorities. Several local experiments with its relaxation
are underway. The step has broader implications that condition its timing: in par-
ticular, the phase-out might begin with medium-sized cities followed later by
larger cities. Furthermore, to genuinely improve labour mobility and integration,
hukou relaxation needs to be accompanied by reforms of the rural land tenure sys-
tem if rural migrants are not to face a prohibitively large loss of their land assets.
Reform of land tenure, whose terms vary widely, is also necessary to ensure that
migration incentives are comparable across regions.

While a key step, elimination of hukou-re\ated constraints on rural-urban
migration and land tenure reform are only first steps. Other complementary mea-
sures need to be taken, beginning in the near-term and extending over a longer
period, to improve labour market flexibility and to ensure that improved mobility
results in greater and higher productivity employment in the economy as a whole.
Local preferences and other measures within and between urban areas that
inhibit migrants from seeking education or finding jobs in the formal sector also
need to be eliminated in a timely fashion. Development of the unemployment
insurance system to replace the transition arrangements being used to help laid-
off SOE workers should help to improve incentives for efficient job-search. OECD
experience suggests that unemployment insurance reforms can be reinforced

Synthesis of the Main Findings of the Study

through the establishment of a modern employment service that works with busi-
nesses to improve collection and dissemination of information - but which does
not seek to interfere with hiring decisions.

Over a longer period, development of SMEs in or near cities in interior prov-
inces needs to be fostered along with the expansion of existing cities and creation
of new cities in areas where they are economically viable. This will be necessary to
ensure that rural migrants from these provinces can find jobs without a mass exo-
dus to coastal cities, and the attendant excessive congestion and negative exter-
nalities such an exodus would likely create.

Improved labour market performance also depends importantly on broader
reforms to social programmes. Achieving higher educational standards in order to
improve human capital is a key priority in this regard, particularly in rural areas
where education expenditures and attainment lag those in urban areas consider-
ably. A longer-term goal suggested by OECD experience would be to raise the
average duration of formal education from the current 9-10 years to 12 years, and
to increase the portion of students that complete the first level of higher educa-
tion (i.e. 16 years) to 25 per cent.

Better integration of the markets also depends on reforms to increase the
coverage and portability of pensions and other social benefits. While achievement
of these objectives is necessarily a longer-term goal, more attention needs to be
paid in the medium-term to relieving distortions that arise from the unevenness in
financing burdens for the government-run first tier of the pension system. These
distortions are greatest between rural and urban enterprises, and between the
informal and formal sectors within the urban sector, and are due to the currently
limited and uneven coverage of pension benefits. These differences have wors-
ened as required contribution rates for enterprises subject to the formal pension
system have increased. A first step would be to reduce disparities that now exist
among urban areas, possibly by pooling financing of the first tier of the pension
system at the provincial government level, rather than at the municipal level as is
now the case. Over the longer-term, coverage will need to be extended to rural
workers and those now in the informal sector in cities, but with flexibility to allow
some local variations in contribution and benefit rates.

Making better use of land and environmental resources 21

The key to improving productivity in the agriculture sector is to "... foster
cropping patterns and other agricultural decisions based on emerging market
opportunities and regional comparative advantage, rather than on the traditional
yardstick of increasing grain output in all areas at any cost’’. 22 As indicated in the
last section, land and other resources now devoted to grain production need to be
shifted toward more labour-intensive crops if China is to be able to exploit its

China in the World Economy: Synthesis Report

comparative advantage under trade and investment liberalisation. To achieve this
goal, the current system of government control over grain procurement prices and
the related interventions should be phased out as import restrictions are elimi-
nated. This is likely to be needed in any case to contain fiscal burdens on the
government.

This step will have greater benefits if accompanied by other complementary
policies. These include development of information systems concerning output
and input prices and improved marketing channels. Improvement in product stan-
dards and quality that are consistent with international norms is particularly important
if China is to fully benefit from the opening of foreign markets to agricultural products
in which it has a comparative advantage. Infrastructure investment to better link
farmers with their markets is also important, particularly in interior provinces. As
the experience of European transition economies has underscored, restructuring
in agriculture, and in the rural sector as a whole, requires adequate financing.
Improvement in the functioning of the rural credit co-operative network and its
better integration with the rest of the financial system is basic in this respect.
Development of other micro-financing and informal credit channels, provided they
can be structured and supervised to prevent abuse, could be particularly effective in
the small-scale and low-income farming environment in China.

Reallocation of agricultural production will help to promote an important
environmental goal, which is the severe shortage of water and degradation of
water quality in Northern China. Water use has expanded sharply over the past
twenty years due to increasing use of irrigated land and to growing demands from
rural industries and urban centres. Reduction of land-intensive grain crops should
release water resources to accommodate urbanisation or other uses. The recent
adoption of a more market-oriented water pricing policy, based in part on actual
supply costs, should also help to promote more efficient use of water resources.

China’s other major environmental problems are extensive air and water pol-
lution. Nearly one-third of the country suffers from acid rain, urban air pollution is
quite severe in larger cities, and there are growing pressures on solid waste dis-
posal facilities. These problems can be traced to a variety of factors, including low
energy efficiency and the reliance on soft coal in energy generation, the increased
use of fertilisers in agriculture, urbanisation, and the explosion in the automobile
population in urban areas. The trend away from heavy toward lighter and generally
less polluting industries has moderated these forces somewhat, but not enough to
prevent a continuing deterioration in environmental quality.

China’s government has been making strong efforts to alleviate pollution
problems. Environmental standards have been tightened substantially and the
authorities have been encouraging more efficient energy use and a shift away from
I 32 coal toward oil and other less polluting sources. Local governments have been

Synthesis of the Main Findings of the Study

shutting down enterprises that are in violation of pollution standards. These and
other steps have substantially established the legal and regulatory framework needed
to achieve China's environmental goals. However, as in many other areas, the effec-
tiveness of the framework is limited by implementation problems.

Trade and investment liberalisation will potentially contribute to alleviating
China’s environmental problems by spurring the shift toward more labour-inten-
sive industries. However the extent to which the environmental benefits are rea-
lised depends on reducing three main barriers that are limiting the effectiveness
of current policy. The first is better enforcement of environmental regulations, par-
ticularly of national standards that are often evaded or ignored at the local level.
The power of courts to interpret environmental laws and to adjudicate disputes
between legal and regulatory provisions needs to be strengthened. Second, sub-
sidies, price distortions, and other adverse incentives that encourage pollution
and inefficient energy use need to be phased out. And third, there needs to be
better co-ordination among government agencies to develop a more comprehen-
sive environmental strategy and to redress the significant gaps and "responsibility
vacuums" in environmental policy formulation and enforcement at all levels.

Bolstering the capacity of the business sector to productively employ resources 23

Labour market reforms can improve the conditions under which labour is sup-
plied but improvement in the capacity of the business sector to productively
employ both labour and capital is equally critical. An important longer-term goal is
to foster the development of China’s service sectors, particularly labour-intensive
services, but the pace at which this occurs will depend on further increases in
urbanisation. The more immediate priority is to restructure China’s industrial
enterprises through consolidation and reorganisation to achieve a more efficient
structure of industry as a whole. Technology also needs to be upgraded and indus-
try’s capacity to innovate and to absorb new technology strengthened.

China’s government has long been heavily and directly involved in industry
restructuring. Since the 1980s, authorities have sought to develop large enterprises
and enterprise groups as "national champions” to compete in international markets
with multinationals from more advanced economies - although these efforts have met
with little success. More recently, the government has intervened extensively and
directly to reduce excess labour and other policy burdens of SOEs, to lower surplus
capacity, and to manage SOE restructuring. While these efforts have had important
benefits, they have also distorted the restructuring process, for example by requiring
stronger enterprises to merge with weaker firms. Much of the government involve-
ment reflects its continued intervention in SOE management. Government efforts
have also been focused on large SOEs destined to remain under state control.

China in the World Economy: Synthesis Report

A key message of the study is that market mechanisms need to be strengthened so
that they play the dominant role in China’s business restructuring. Fundamental improve-
ment in the performance of China's industries will involve extensive reallocation of
resources, and changes in ownership and control extending across thousands of
enterprises in both the state and non-state sectors. SMEs are critical to this effort
and their importance will further increase as the economy shifts toward more
labour-intensive activities. These changes will need to come about primarily from
market driven processes in which individual enterprises reorganise to maximise
the long-term value of their operations. While trade and investment liberalisation
offers opportunities to large Chinese enterprises, success in international markets
has come to depend less on the scale of a multinational’s operations than on the
sophistication of its management and the effectiveness of its governance -quali-
ties over which government can have little direct control. Given these conditions,
government policies to promote restructuring need to focus on establishing condi-
tions that support market restructuring processes, such as improving competition
and clarifying property rights, while limiting direct interventions to matters, such
as the disposition of SOE assets, where market processes alone are insufficient to
accomplish the task.

The most pressing need is to remove obstacles that now exist to market
driven business restructuring. Two sets of policies are most essential to accom-
plish this objective. The first is financial system reform, as discussed further in the
next sub-section, it will not be possible to shift resources toward enterprises that
can use them most efficiently unless credit allocation is much more firmly based
on strict commercial criteria than is now the case. For this to happen, banks and
other financial institutions will need to have greater capacity and better incentives
to lend to productive outlets. Financial markets need to be more flexible and
open if they are to facilitate transfers of ownership and create a market for corpo-
rate control. OECD experience also offers lessons for improving access to external
financing for creditworthy SMEs, as part of broader efforts to develop this key
enterprise segment.

The second key step is to end government interventions that constrain enter-
prises' ability to reorganise, distort their incentives to do so, and which block their
exit when needed. SOEs particularly need to be given autonomy to choose the
partners and terms for mergers and acquisitions based on their long-term eco-
nomic value, without being burdened by non-commercial requirements imposed
by government authorities. SOEs also need to have clearer claims and control
over their assets if they are to be able to restructure their operations in a produc-
tive manner. Regional barriers to capital mobility and to cross-provincial business
location also need to be curtailed. Policies that have the effect of creating cartels
or price floors (including rules that define pricing below industry average cost as
"predatory”) should be avoided wherever possible since these tend to limit

Synthesis of the Main Findings of the Study

incentives for restructuring and to slow exit. Equally important are reforms to facil-
itate and accelerate exit, since large numbers of China's present enterprises are
not competitively viable and will need to leave the market if industry is to
become more efficient.

While such measures are essential first steps, their ultimate payoff depends
on reforms in other areas. These include measures to eliminate external condi-
tions that would tend to distort restructuring decisions, such as unequal social
benefit burdens and incentives that encourage regional protectionism. Equally
important are reforms to corporate governance and other framework conditions
discussed in the next section that are needed to ensure that enterprises have the
capacity and incentives to exploit value-enhancing restructuring opportunities. In
light of experience and the more demanding international market environment,
authorities might also review the current policy of developing national champions
and consider narrowing its focus to areas where China’s current advantages give it
a better chance of success than in the past.

The technology challenges facing Chinese industry further underscore the
importance of strengthening market forces while improving the quality of govern-
ment intervention. Meeting these challenges involves more than simply making
more technology available to the market. Other key objectives are to foster the
improvement of capacities at the firm level to innovate and to use and absorb
technology; to improve technology diffusion; and to enhance the technological
pay-off from foreign direct investment. Explicit technology policies cannot achieve
these objectives by themselves without broader reforms. In particular, bolstering
firm abilities and incentives to keep up with market technology standards
requires improvements in management and governance, competition, and other
framework conditions necessary to ensure that firms are adequately profit-oriented.

Equally important are reforms to improve protection for intellectual property
rights to encourage technology sharing and the development of venture capital
facilities. Further opening of knowledge-based service sectors to foreign participa-
tion would also help to foster technology transfer from abroad.

The government has an important role to play in improving China's technologi-
cal capabilities but there needs to be a change in emphasis. The government is
likely to have to supply much of the resources to bring funding for basic science up
to levels more comparable to international norms. OECD experience suggests that
China's government can contribute to technology diffusion by providing support to
regional university and other research centres, for example. There is also a need to
embed government technology policies in a broader framework that exploits com-
plementary relations with other industrial policies. This is likely to require greater
co-ordination between the Ministry of Science and Technology, which has been
largely responsible for technology policy, and other Ministries responsible for pro-
grammes concerning financing for SMEs and other industrial policies. 33 I

China in the World Economy: Synthesis Report

Box 1 . Improving technological capabilities -
Some potential lessons from OECD experience

OECD experience offers some lessons for fostering the development, diffu-
sion, and absorption of technology. It shows that successful new technology-based
firms - which are responsible for an increasing share of innovations - require not
only superior governance and management capabilities but also an enabling infra-
structure of business services.

The experience of OECD countries indicates that effective implementation of
technology diffusion programmes requires organisational improvements and stra-
tegic changes in firms, the building of interactive relations between different play-
ers, exploitation of existing resources and a local presence. To accelerate
technology diffusion, OECD governments are focusing on addressing market and
systemic failures through four types of operational strategies:

• Supply-driven initiatives that transfer technologies developed under govern-
ment sponsorship to the private sector. An example is the Canadian Space
Agency’s Space Station Program, which involves competitive bidding of private
firms for contracts to develop and commercialise dual-use space technologies.

• Demand-driven programmes seek to diagnose and enhance the technological
absorptive capacity of firms. The Manufacturing Extension Partnership in
the United States assists smaller manufacturers to implement appropriate
technologies and improve their business practices.

• Network-Building initiatives develop bridging institutions and inter-firm partner-
ships to facilitate information flows. Innovation Centres in the Netherlands
strengthen both vertical and horizontal network links at the regional level.

• infrastructure-building programmes upgrade the technology diffusion infrastruc-
ture at the national level. Korea adopted various schemes of spreading new
technology and promoting network links as part of the country’s develop-
mental strategy.

Absorption of technology is a long-term process in which acquiring firms need to
develop long-term partnerships and trust with technology providers. Case studies of
the electronic and semiconductor industries in Korea and Chinese Taipei suggest that
it is important for domestic firms to engage in progressively more advanced forms of
technology transfer with foreign partners over time (for example, from subcontracting,
to technology licensing to OEM, to ODM, to joint product R&D and strategic alliances).

Despite its impressive performance, there is significant room to improve
China's foreign direct investment performance in both quantitative and qualita-
tive terms. The strengthening of intellectual property rights protection under
China’s accession agreement should help to attract more foreign direct invest-
ment from developed country businesses, which have sometimes been reluctant to

Synthesis of the Main Findings of the Study

invest in the domestic market out of concern that their advanced technologies
and production techniques will be inadequately protected. Given the worldwide
trend toward the use of M&A in cross-border investment, establishment of mar-
ket based mechanisms for domestic M&A would also help to attract investment
from more advanced economies. Adoption and effective enforcement of a com-
prehensive competition law, and reduction in administrative and other barriers
beyond those required by the WTO, would encourage more foreign investment
aimed at the domestic market. Further opening of protected industries, for
example by allowing more foreign participation in extractive activities, would
also help to attract foreign direct investment as well as increase efficiency.

Other measures could help to improve the pay-off to the domestic economy
from foreign investment. Improved competition and better enforcement of con-
tracts would encourage more local sourcing of inputs, such as packaging materials,
used by resident foreign enterprises. Reduction of government interference in the
operations of domestic enterprises could help to foster more fruitful partnerships
with foreign firms possessing advanced technology.

Improving the effectiveness of the financial system 24

Improvement of the capabilities of the financial system to promote efficient
resource utilisation is fundamental to the restructuring of industry, achieving better
integration among regions, bolstering macroeconomic performance, and allowing
China to open its financial markets to the world without undue risk to financial sta-
bility. As noted earlier, despite the important steps taken over the past five years,
the fundamental capabilities and incentives of the financial system to allocate
credit efficiently remain impaired.

As discussed in the previous section, the problems of the financial system are
closely linked to those of the real economy and to the shortage of resources effec-
tively available to the government. As emphasised in the chapter on the banking
sector, China's banks are unlikely to become fully healthy and effective until the
performances of their enterprise customers improve substantially. Nevertheless,
international experience strongly indicates that timely and decisive reforms of the
financial system are essential to break through the vicious circle China now faces.
Three key objectives need to be achieved if the financial system is to become an
effective support, rather than obstacle, to the broader reform process.

The first and most pressing objective is to restore capital adequacy to financial insti-
tutions within the near-term , through direct government financial support as needed.
International experience suggests there are a range of specific modalities that
could be used to accomplish this objective, but that three important principles
need to be observed if the benefits are to be realised.

China in the World Economy: Synthesis Report

• First, the rehabilitation needs to be thorough, comprising measures to deal
with non-performing loans (through removal from banks' balance sheets of
non-performing loans that cannot be dealt with out of provisions or through
write-downs) and increases in capital, to at least the BIS minimum initially.

• Second, the clean up should complete the financial rehabilitation of SOCBs,
and address the non-performing loans of other commercial banks and
credit co-operatives that are also in distress.

• And third, the clean up and its aftermath should also involve strict condi-
tions on the financial institutions, under which management is held
accountable for, and given the requisite autonomy to improve, future per-
formance. For example, authorisation for banks to enter new lines of busi-
ness could be made conditional on their maintenance of adequate capital
and adherence to prudential standards.

While a necessary precondition, balance sheet clean up cannot itself guaran-
tee sustained improvement in the effectiveness of the financial system. Perhaps
the most basic lesson from other countries’ experiences with financial distress is
that clean up needs to be accompanied by stringent measures to correct the con-
ditions that led to the stress. In China's context, measures to establish and
strengthen the governance of financial institutions as commercial entities and fur-
ther improve their internal systems for credit assessment and management of risk
are essential, along with the strengthening of the independence and capabilities
of bank supervisors. These are particularly necessary given the inevitable diffi-
culty of ensuring that government-owned financial institutions, particularly large
ones, are truly commercially oriented,

Nevertheless, international experience strongly suggests that breaking the
vicious circle China is now in requires early intervention to restore financial sys-
tem solvency as other measures to improve conditions in the real economy that
require more time are undertaken. Inadequately capitalised financial institutions
tend to have weak incentives to maintain sound lending standards or manage
risk . 25 Indeed, financial weakness can spur perverse incentives to hide loan prob-
lems or to take excessive risks ("gamble for redemption"), in China's case, stronger
balance sheets are necessary to allow other reforms to improve the fundamental
health of financial institutions to proceed. These include the ability of banks to
restructure to meet increased foreign competition and to access external funds to
bolster their capital. Moreover, given their low profitability, China's financial insti-
tutions are unlikely to be able to achieve capital adequacy out of their own
resources within a reasonable time. In fact, balance sheet clean up is probably key
to their longer-term ability to improve their profitability.

While the current rapid pace of loan growth might suggest that banks could
"outgrow” their high non-performing loans rates given sufficient time and continued

Synthesis of the Main Findings of the Study

rapid growth in the real economy, such a strategy carries important risks. It would
leave banks in even worse shape if loan or deposit growth were to slow. It could
also pose a difficult dilemma between improvement in banking system conditions
and fostering the growth of alternative financial outlets which might divert busi-
ness from banks. As the experience of other countries, most recently )apan, has
underscored, relying on real sector recovery to restore the health of financial insti-
tutions is more likely to impede real recovery, allow financial problems to get
worse, and increase the ultimate cost of their resolution.

There has been concern that a government sponsored clean up will under-
mine financial institutions' incentives to sustain a strong credit culture. Against
this must be set the fact that only SOCBs benefited from the first non-performing
loans programme, and the widespread perception within and outside China that
the government will always back the solvency of the SOCBs in order to prevent a
financial crisis. Delay in restoring solvency is more likely to increase and prolong
expectations of multiple and open-ended bailouts. A second concern is whether
China’s government can afford the cost of a thorough financial system clean up,
given the limits on its fiscal resources. The cost is likely to be high, on the order of
those facing other Asian countries that experienced severe banking problems in
the aftermath of the 1997 crisis. 26 However, as argued in the last section of this
summary, the cost should be affordable provided that government revenues con-
tinue to rise relative to GDP, social benefit programmes are established on a sus-
tainable basis, and further non-performing loans are kept to minimal levels. China
does not now face an intractable dilemma between cleaning up the financial sys-
tem and maintaining the sustainability of its fiscal accounts. But further delay,
since the ultimate costs are likely to rise, increases the risk that such a dilemma
will develop in the future.

Restoration of solvency will also help to promote the second, if longer-term,
objective, to create a more diverse and balanced system in which financial outlets other than SOCBs
have a much greater role. The SOCB orientation toward SOEs is likely to continue, as they
become "lead banks" for the large firms that will remain under state control. This,
together with their size and potential ability to tap domestic and international
financial markets, gives them a strong comparative advantage in serving multina-
tional and other larger enterprises. The other commercial banks and credit co-
operatives probably have stronger comparative advantages and incentives to
lend to SMEs, but their ability to expand their market share is circumscribed by
regulatory and other limits on their access to funding. Accordingly, relaxation of
policies that restrict the ability of joint stock and other smaller institutions to
expand, as part of broader efforts to create a more level playing field among commer-
cial banks, are necessary first steps toward greater diversity in the financial system. A
more active longer-term policy to restructure the SOCBs along regional or functional
lines would also help to promote greater diversity and to increase competition.

China in the World Economy: Synthesis Report

Greater diversity would also help to improve the commercial orientation of the
financial system as a whole. Although strong efforts are being made to develop a more
commercially oriented credit culture in the SOCBs, the task is inevitably difficult given
the traditional role of these banks in central planning, their continued strong ties to
the government, and, not least, their "too big to fail" status. The joint-stock banks
enjoy more autonomy from government mandates, are generally better managed and
more commercially oriented. Increasing the importance of these banks would help to
make the overall banking system more responsive to market forces.

The third key objective to improve financial system capabilities is to foster the
development of China’s capital markets. The government bond market needs to be able
to absorb the large increase in public debt that is likely to occur in the next sev-
eral years. Capital markets are also necessary to allow enterprises to achieve a
better debt and capital structure and to provide the instruments for retirement
savings that will be needed as the second and third tiers of the pension system
develop. However, China’s capital markets are not yet capable of adequately car-
rying out these functions. Most listed companies are SOEs and only about one-
third of their shares are actively tradable. The market has been prone to manipu-
lation and overvaluation. The bond, as well as money, markets are behind the
stock market in their development and lack liquidity and breadth. As argued in
Chapter 15, the markets as a whole will need further strengthening to accommo-
date new financial instruments, greater foreign participation and increased expo-
sure to international financial markets at acceptable risk.

As in other areas, the priorities for improving the capital markets start with sev-
eral near-term steps to remove obstacles to their effective functioning and develop-
ment. These steps have been endorsed by the authorities (or at least raised by
senior officials), but in some cases their implementation has been delayed.

• The first is to increase the share of SOE equity that can be traded within the
three year time-period authorities have specified, following a pre-announced
timetable.

• The second is to open stock market listing to all firms, including collectives
and private firms, based on their ability to meet the supervisory require-
ments - thereby ending the preferential treatment large SOEs still receive in
this area. This, together with the first step, is basic to improving the discipline
offered by the stock market and to creating a market for corporate control.

• The third step is to integrate the equity markets by eliminating the distinc-
tion between ("A") shares that can be held by Chinese citizens and the ("B” )
shares that can be held by foreigners within the near term. This step does
not depend upon achievement of capital account convertibility, but it will
need to be carefully timed to avoid disruptions arising from the now consider-
able differences in share valuation across the segmented markets.

©OECD 2002

Synthesis of the Main Findings of the Study

These near-term steps should open the way for, but also need to be rein-
forced by, other policies to promote the development of the capital markets over
the medium and longer-term. These include policies to improve corporate gover-
nance and to allow foreign financial institutions to enter the capital markets, and
implementation within the medium-term of official plans to improve the govern-
ment bond market. Frameworks for mortgage bond and mortgage-backed bond
markets will need to be established in order to facilitate the increased demand
for real-estate credit as housing reforms proceed.

Achieving better integration among China’s regions 27

Better integration among China’s regions is not simply important on equity
grounds. Lack of integration is becoming an impediment to other development
goals and is likely to become a greater obstacle over time if not addressed. With-
out greater integration, coastal and a few interior cities are likely to bear the brunt
of the migration of workers who will need to find jobs in cities. The resulting pres-
sures on urban land, the environment, and other resources could lead to sharply
diminishing returns from agglomeration, and thereby degrade the advantages that
have given these urban areas their vitality. Greater integration is needed to make
full use of China's land and agricultural resources - which cannot be transferred to
the coast. Continued segmentation among regions limits the productivity gains
from regional specialisation and restricts the ability of enterprises to achieve ade-
quate economies of scale and scope.

To achieve better integration, China needs a much broader and comprehen-
sive regional development strategy focused on the creation of national markets for
products and productive factors. This implies a shift in emphasis, away from the
granting of selective exemptions from government regulations and tax prefer-
ences, in favour of measures to allow greater scope for national market forces and
to improve the ability and incentives of local governments to respond to those
forces. OECD experience underscores several pitfalls in regional development
strategies that are potentially relevant to China, including:

• over-reliance on government interventions to develop specific areas or sec-
tors (“growth poles") to catalyse regional development, a strategy which
tends to be quite expensive and has proved to not be very successful;

• the launching of major infrastructure projects without taking realistic
account of regional demand; and

• maintenance of direct assistance to declining sectors in order to protect
local economic activities.

In addition to infrastructure development, a comprehensive regional devel-
opment strategy for China involves three basic objectives. The first is to ensure
that common framework conditions for competition, property rights, business

China in the World Economy: Synthesis Report

establishment, and taxation apply to all regions and localities. As the experience
of the EU suggests, this is likely to require a sustained and broad initiative from
the central government. The principle that sub-national governments may not
impose barriers to domestic trade, which is contained in current law but lacks
enforcement provisions, needs to be strengthened. This might be accomplished
(as in the European Union and Russia) partly through the application of national
competition law provisions.

The second objective is to improve the mobility of capital among regions.
Development of national capital markets and improvement in the commercial ori-
entation of financial institutions are the ultimate keys to promoting a more effi-
cient geographic allocation of capital over the longer-term. In the near-term,
administrative burdens on local business need to be reduced and transparency in
regulations increased if provincial governments in the interior are to be competi-
tive in attracting foreign direct investment as well as domestic capital. Reduction in
administrative barriers and local protectionism that impede cross-border business
establishment and mergers and acquisitions is also important. In the medium term,
further development and liberalisation of the money markets and expansion in the
geographic scope for city bank operations in the interior would facilitate the ability to
transfer savings among regions. Opening of protected resource sectors to foreign
investment would also help to attract foreign direct investment to resource-rich cen-
tral and western provinces.

Regional integration also depends on a third objective, reform of central-local
government fiscal relations. The current system contributes to the unevenness in
tax burdens among regions. As discussed in the last section of this synthesis, the
allocation of government revenues and division of responsibilities for spending
need to be realigned among government levels in accordance with need rather
than the economically arbitrary administrative criteria. China needs not only to
raise the total amount spent nationally on education but to give equal priority to
increasing resources for education in rural areas, particularly those in the interior,
where standards are now low but the potential payoff in terms of improved human
capital is relatively high.

Realisation of the benefits of greater integration also depends on promoting
greater balance in urbanisation by fostering market-driven creation and develop-
ment of new cities in interior provinces. City building along with the exit of work-
ers from agriculture will help to equalise strains on urban resources and provide
an impetus to regional growth as agglomeration economies are exploited. Expan-
sion of existing medium-sized cities by accretion of bordering rural townships that
are already experiencing rapid growth of new enterprises should also help to
invigorate growth. Creation of new cities, however, is a complex process in which
the most productive role of government is to foster conditions conducive to their
I 42 formation. These include access to financing and sufficient flexibility in labour

Synthesis of the Main Findings of the Study

Box 2. Key priorities for improving resource utilisation

Problem

Priority objectives

Some suggested steps

Labour market segmentation

Create a national labour

a ) Beginning in the near term,

is preventing full employment

market by removing

progressively phase out hukou

of human resources

impediments to labour

related restrictions

mobility

on migration and reform rural
land tenure

b ) Continue to develop the
unemployment insurance
system and reduce disparities
in social benefit burdens over
time

Government policies impede

Foster cropping patterns

In the near term, phase out

a shift away from land-intensive

in line with market forces

controls on grain procurement,

toward labour-intensive crops

and regional comparative
advantage

prices and distribution

Environmental problems impair

Improve enforcement

Strengthen the powers of courts

efficient resource allocation

and achieve better

to interpret and enforce

co-ordination

environmental laws and

of environmental policies

regulations; eliminate distortions

among government agencies

that encourage pollution and
inefficient energy use

Business sector restructuring

Foster market-based

a) In the near term, remove

is hampered by lack of market

mechanisms as the primary

government imposed obstacles

mechanisms

vehicle for restructuring

to enterprise restructuring
b) Develop capital markets over
the longer term

Technology is sub-standard

Develop a comprehensive

c) Improve protection for

and capabilities

framework to foster

intellectual property rights;

for innovation, diffusion,

technology capabilities

increase government resources

and absorption are weak

of enterprises

devoted to basic R&D

Credit allocation is inefficient,

a) Restore financial system

a) Restore capital adequacy

financial discipline is weak,

solvency

to financial institutions in the

and financial facilities

b ) Improve diversity in

near term subject to strict

to support business sector

financial institutions

performance requirements.

restructuring are limited

and develop money

b) Remove regulatory barriers

and capital markets

impeding the functioning and
development of money and
capital markets as soon as
possible

c) Over a longer period, foster a
greater role for joint-stock and
other smaller com mercial
banks; foster development of
capital markets, in part by
liberalising access of foreigners
to the capital markets

©OECD 2002

China in the World Economy: Synthesis Report

Box 2. Key priorities for improving resource utilisation (cont.)

Problem

Priority objectives

Some suggested steps

Regional fragmentation

Develop a comprehensive

a) In the near term, eliminate

is becoming an obstacle

regional development strategy,

administrative and other

to broader development needs

focused on the creation of more
uniform framework conditions
and improving internal
capital mobility

regional protectionist barriers

b ) Reform central-local
government fiscal relations
within the medium-term

c) Promote development

of national money and capital
markets

markets to attract essential labour skills, along with sufficient autonomy for
regional and city planning authorities to formulate and implement development
strategies based on local resources and comparative advantage.

Strengthening the institutional frameworks for market functioning

The success of the steps to break down barriers to resource reallocation and
to ensure that resources are efficiently used in the future depends critically upon
governance, property rights, competition, and other frameworks essential to effec-
tive market functioning. Considerable effort has been made over the past several
years to strengthen several of these frameworks, but their impact has been
blunted by the more limited progress made in complementary areas. Fundamen-
tal ambiguities in the property rights framework have not been resolved; market
discipline is still inadequate; and while organisational structures and many of the
basic laws have been established, their effectiveness has been limited by inade-
quate enforcement. This section outlines the priorities for strengthening the
frameworks; these are summarised in Box 3 at the end.

Strengthening enterprise governance 28

Establishing governance structures so that enterprises behave as autono-
mous profit-seeking commercial entities has been a key goal of China’s eco-
nomic reforms since the early 1990s. 29 The difficulties facing China in accomplishing
this task are hardly unique. OECD countries have experimented for several
decades with various modalities for ensuring that publicly-owned companies

Synthesis of the Main Findings of the Study

perform adequately - but with only limited success. The difficulties in China are
likely to be even greater, given the close ties between the government and
SOEs.

Since 1999, corporate governance reform focused on SOEs has become a key
priority in China. The strategy has sought to create governance structures pat-
terned on best practices derived from OECD-country experience. 30 One compo-
nent of the strategy is the conversion ("corporatisation") of SOEs into legally
independent joint-stock companies and the establishment of boards of directors
and supervisors together with laws defining their responsibilities and those of
managers. With this, the authorities have sought to curtail direct government inter-
vention in enterprise management by creating separate organs to manage state-
owned assets. The second component, which has been given increasing emphasis,
is to list corporatised SOEs and diversify their ownership in order to provide further
discipline on the boards and managers. Nearly half of SOEs have so far been corpo-
ratised. Authorities plan to corporatise the SOCBs within the next several years.

The tangible results of the governance reforms have fallen short of expecta-
tions, however. Actual corporate governance practices deviate considerably from
OECD standards, and surveys indicate that China is still seen as comparing
unfavourably to its Asian competitors in this regard. 31 Weaknesses in the struc-
tures themselves are one reason for the limited success of the reforms. The
boards of directors and supervisors mandated by corporatisation do not yet have
sufficiently distinct identities within the enterprise and their independence is lim-
ited. Top managers continue to be appointed by local authorities or political offi-
cials. The boards tend to function more as an extension of management than as its
monitor, and are effectively bypassed in exercising genuine oversight. The auton-
omy of managers is weakened by their dependence on government or political
authorities for their position, their low salaries, and their lack of a direct stake in
the firm's profit performance.

Two related steps needed to improve the functioning of the existing corpo-
rate governance framework are to strengthen the independence and powers of boards of
directors and to foster greater accountability and professionalism among managers. Greater use
of qualified independent directors, including outside directors, should be part of
this effort. With this, the scope for political participation in enterprise governance
should be limited to advice and consultation. These steps would help to lay the
foundation for development of a market for managers, which is now lacking, and
for the more widespread adoption of performance-based compensation.

The greater obstacles and necessary solutions to the present weaknesses in
corporate governance lie outside the corporate governance structures themselves.

Much of the difficulty in creating SOEs that are autonomous, profit-oriented, and
accountable to their state owners can be traced to the ambiguities in the property 4; I

China in the World Economy: Synthesis Report

rights framework discussed further below. Partly as a result, SOEs have gained
only limited autonomy as the result of corporatisation, and have continued to be
subject to government restrictions on their ability to lay off workers, dispose of
assets, and engage in mergers and acquisitions.

As in other countries, stronger market discipline is critical in establishing a
firm and lasting foundation for effective corporate governance. In China, competi-
tion is often limited in sectors in which the current listed SOEs are concentrated.
Apart from the continued weakness in discipline from financial institutions, lim-
ited access to the market and the withholding of the majority of listed SOE shares
from trading effectively prevent the stock market from carrying out the disciplining
role it has been assigned in the overall corporate governance reform strategy. The
impact of ownership diversification has so far been blunted by the fact that nearly
all of the minority shareholders are other public entities, whose own profit-orien-
tation is often weak. 32 Strengthening external disciplines is particularly important
because once the basic legal structures are established, their functioning depends
most critically on market incentives for enterprises to maintain effective gover-
nance. 33

Finally, corporate governance issues in China do not simply involve SOEs.
Collective enterprises have multiple owners and stakeholders and their internal
control, allocation of residual claims, and ties to local governments are also
ambiguous and of limited transparency. Many collectives seem to be evolving into
forms equivalent to joint-stock companies but without being required to adopt
the governance structures of the latter. The need to establish a good credit stand-
ing and business reputation should create incentives for larger collectives to
adopt governance norms more in line with those required of corporate firms. The
degree to which this will be true for other collectives is less clear.

Reforming property rights and insolvency mechanisms

Property rights and their embodiment in contracts have been one of the
major gaps in China's frameworks for market functioning. An essential step toward
remedying this gap was taken in 1999 with the enactment of a Unified Contract
Law to replace the formerly scattered collection of laws, by-laws, and regulations
based on numerous and not always consistent legislative provisions. The new law
creates clearer and more even rules of the game for contractual transactions
among businesses of all types and establishes a national framework to which local
authorities are subject. The law also reduces the scope for regulatory restrictions
on contract provisions that are not sanctioned by other legislation.

The key remaining objective is to develop a coherent framework clarifying
property rights and ensuring their equal application to all economic segments.
Property rights remain highly ambiguous due to the unresolved status of state

Synthesis of the Main Findings of the Study

assets and the relation between public and non-public ownership. Different sets
of rules apply to private, collective, and state-owned property. SOEs cannot freely
dispose of their land or of rights to its use.

Lack of clarity about the effective owners of SOEs is a major obstacle to their
restructuring and improvement in their governance. SOEs are effectively owned
by a collection of ministries and agencies at all government levels with unclear
and often conflicting claims that are not adequately defined by existing law or reg-
ulations. This creates a situation that has been characterised as "agents without
owners'', 34 in which multiple owners have limited incentives to monitor the enter-
prises or to hold their managers and boards accountable. It also produces conflicts
that slow and distort business restructuring and exit. 35

Ambiguous property rights are also impeding restructuring in other parts of
the real economy. Apart from the potential barrier to labour mobility posed by
the rural property rights regime, the uncertain status of state assets poses obsta-
cles to the development of private enterprises. Private enterprises are unlikely
to realise their full potential until the rules for acquiring state assets are better
defined.

There is thus a pressing need to develop a coherent framework and support-
ing laws clarifying rights to property and to ensure their equal application to all
segments of the economy. Explicit protections for private property, and better
definition of the rights of the enterprise as a legal entity vis-a-vis holding groups,
regulatory agencies, and political bodies, are key elements of this framework.

Ambiguous property rights are also an impediment to China's insolvency
mechanisms. Although bankruptcies and liquidations have increased markedly in
recent years, they have occurred mainly among smaller firms and those in the pri-
vate sector. Passage of the reformed comprehensive bankruptcy law that was first
drafted in 1994 will be an important step toward establishing uniform rules apply-
ing to state and non-state enterprises and in defining the rights of debtors, credi-
tors and shareholders. But further efforts are likely to be needed to improve the
independence of bankruptcy courts and the professional skill of judges so that
they can more effectively implement the legislation.

More also needs to be done to clarify the rules if insolvency mechanisms are
to be able to accommodate the large-scale re-deployment of assets from nonvia-
ble enterprises that will be needed in coming years. Presently, exit is often
blocked by legal and administrative barriers to disposal of claims of banks, bank
asset management companies, social benefit funds, and agencies responsible for
supporting displaced workers. The government agencies that are ultimately
responsible for these bodies need to be held liable for these claims so that they
do not prevent the liquidation of insolvent firms.

China in the World Economy: Synthesis Report

Improving the competition framework 36

By some standard indicators, China’s product markets appear to be reason-
ably competitive: market concentration at the national level is relatively low; and
there has been substantial entry of new firms. Economic rivalry is fierce in many
sectors. These measures are deceptive, however, because the limits to competi-
tion in China are manifest in other ways. Government restrictions are more promi-
nent as barriers to competition. Limited transport facilities, local protectionism,
and other barriers to geographic integration allow enterprises to exercise monop-
oly power in local markets to a degree that is not apparent in national concentra-
tion ratios. Moreover, as noted earlier, competition is uneven across sectors.

The main weaknesses in the competitive environment in China can be listed
as follows.

• As has happened in other countries, established enterprises and local gov-
ernments often seek to prevent entry by newcomers and thereby extract
monopoly rents. Product market competition is limited in some cases by
overt barriers, by distortions in the tax code and distribution system, and,
probably most importantly, by locally imposed restrictions on outsider's
ability to establish or acquire a local business. 37

• The different legal and regulatory frameworks applying to state-owned, col-
lective, private and foreign enterprises, along with complex and opaque
requirements for business establishment and business scope, often limit
competition. Examples include the high minimum capital required of pri-
vate limited companies and their need to undergo an elaborate regulatory
approval process to make even modest changes in their lines of business. 38

• While prices are reasonably free to vary for most products and markets,
they continue to be restricted in some, notably energy and tobacco. The
temporary price floors imposed in industries with excess capacity also limit
competition as well as impede exit.

• A substantial number of key sectors are wholly or mainly reserved to SOEs,
including not only natural monopolies but, as noted earlier, automobile and
steel production. Authorities plan to reduce the role of SOEs to "strategic
sectors” but have not specified what those sectors will be.

The present competition law framework rests on the 1993 Unfair Competition
Law and the 1999 Price Law, together with various specific regulations and decrees
banning certain regional protectionist practices. These laws are enforced by the
State Administration for Industry and Commerce (SAIC) and the State Develop-
ment Planning Commission (SDPC). Together these laws outlaw some overt anti-
competitive practices, such as price fixing, and prohibit unauthorised actions by
local government agencies or officials that prevent competition. However these

Synthesis of the Main Findings of the Study

laws do not constitute a comprehensive legal framework for competition. In partic-
ular, existing Chinese law does not clearly prohibit other practices, such as monop-
oly abuses, cartels, or restrictive distribution arrangements, that effectively prevent
entry and restrict competition. Current prohibitions on anti-competitive practices by
government agencies lack sanctions and have had little if any practical effect.

Given this situation, the key objective is to establish a national competition
framework to ensure that laws and regulations support rather than interfere with
market competition. Adoption of such a framework is particularly important since
incentives to engage in anti-competitive practices are likely to increase with trade
and investment liberalisation. An essential first step is to enact and implement a
comprehensive competition law along the lines of that now being drafted by the
State Economic and Trade Commission (SETC) and SAIC. This law should include
effective sanctions against the maintenance of "administrative monopolies” by
government agencies. As in OECD countries, China’s government could usefully
apply competition principles to identify existing and proposed laws and regula-
tions that interfere with competition, with a view to eliminating those that are oth-
erwise unwarranted. Special scrutiny should be given to laws that restrict entry
based on the legal form or ownership of an enterprise. Competition policy princi-
ples should also be incorporated in the design of natural monopoly regulation.

Beyond these measures, steps need to be taken to reduce the incentives for
anti-competitive behaviour, particularly that fostered by government entities. In
this respect, reforms to social security, the financial system, and other conditions
that encourage government entities to extract resources through anti-competitive
behaviour are ultimately important to ensure a competitive environment.

Developing financial regulatory and supervisory capabilities 39

The financial regulatory and supervisory (FRS) framework is key to the suc-
cess of the steps discussed earlier to improve the capabilities of the financial sys-
tem and to allow its further development without creating unacceptable risks to
financial stability. China's financial regulatory and supervisory authorities face espe-
cially great challenges given the adverse incentives inherent in extensive state own-
ership of financial institutions.

Important steps have been taken since the mid-1990s to provide a modern
institutional base for financial regulation/supervision comparable to that of OECD
countries. In 1999 the People's Bank of China (PBC) was reorganised into nine
regional branches in order to reduce local government interference in its opera-
tions and to provide a platform for more effective bank supervision. The PBC now
has responsibility for all depository financial institutions, including the rural credit
co-operatives. The previously fragmented responsibility for regulation and super-
vision of the stock exchanges, bond markets, and securities and investment

China in the World Economy: Synthesis Report

companies has been consolidated in the China Securities Regulatory Commission
(CSRC), while responsibility for insurance companies has been lodged with the
China Insurance Regulatory Commission (CIRC).

The key objective now is to strengthen the autonomy of financial supervisory
authorities and to endow them with the necessary physical and human resources
to accomplish their tasks. China's financial regulators face a particularly daunting
task in maintaining prudential standards in state-owned financial institutions sub-
ject to other, sometimes conflicting, government mandates. As the essential start-
ing point, supervisors need to have the authority and independence to exercise
surveillance over supervised institutions solely in the interest of prudential
soundness and in a way that is not constrained by other government objectives.
Supervisors need to be able to require prompt corrective action by institutions
subject to their jurisdiction when problems are found. While their authority has
been strengthened in recent years, supervisory authorities still lack full control
over some basic prudential standards, such as the power to impose realistic
norms for bank provisioning and loan write-offs . 40 Financial supervisors will also
have to continue to acquire the necessary physical and human capital to accom-
plish their tasks. Adaptation of internationally accepted supervisory norms and
practices to Chinese circumstances is an important means to these ends - and one
which will also provide a foundation for the ultimate opening of the financial sys-
tem to international markets.

Supervisory structures and responsibilities also need to be further refined to
keep up with the development of financial markets. The concentration of authority
over capital markets in the CSRC and expansion of its institutional capacity have
been essential steps toward ensuring effective oversight of the markets. However,
the authority of the CSRC to investigate abuses and order remedies needs to be
further strengthened, and accounting, disclosure, and audit standards should be
aligned more closely with international practices. Newer financial vehicles, nota-
bly investment funds that take money from the public, need to be brought within
a formal regulatory framework, preferably one based on models provided by
major financial markets outside of China. The CSRC and supervisory authorities
responsible for the insurance and pension fund sectors need to co-ordinate their
efforts to ensure a level playing field for institutional investors.

Ultimately, the effectiveness of financial supervision in China, as elsewhere,
rests on its success in ensuring that market participants have adequate internal
incentives and capabilities to maintain prudential standards. Supervision needs to
progressively increase the responsibility of market participants for in-house compli-
ance with prudential standards, risk management, and adherence to industry stan-
dards. Effective corporate governance of all financial market actors is crucial to these
goals. To this end, efforts to strengthen shareholder rights and to raise standards of
I 50 corporate governance are an essential element of the supervisory process.

©OECD 2002

Synthesis of the Main Findings of the Study

Improved transparency in the operations of all enterprises is essential for effec-
tive regulatory oversight and effective monitoring by investors and stakeholders.

Several steps now underway should help greatly to improve transparency once they
are completed. These include the implementation of new accounting standards for
financial institutions that are more in line with international norms; and the exten-
sion to all non-financial enterprises of the modernised accounting standards that
have been required of listed SOEs. Transparency needs to be accompanied by
improved disclosure and measures to ensure the accuracy of the information
reported. To this end, enterprises need to be further encouraged to bring in inde-
pendent outside auditors to assist in preparing their annual reports. This should be
facilitated by the increased scope foreign auditing firms are scheduled to receive
with trade and investment liberalisation. Supervisory authorities, together with the
relevant professional associations, need to make further efforts to increase the inde-
pendence of auditing firms and their compliance with regulatory standards.

Improving the enforcement capacity of the judicial system

Weak enforcement of improved legal and regulatory frameworks has been a
recurrent theme of China’s economic reforms, ranging from enforcement of con-
tracts, commercial codes, competition law, and environmental codes. The Chinese
authorities are committed under their WTO agreements to improve judicial
enforcement of contracts and other business codes, including those governing
intellectual property and counterfeiting.

However, there has been little fundamental change in the judicial mechanisms
for enforcement. Neither the independence of the courts nor their jurisdiction is
adequately established. Although the Chinese constitution states that judicial pro-
ceedings are to be free of interference from other government and political entities,
judges, courts, and other judicial organs remain under their supervision and depen-
dent on them for funding. The legal obligations of other government entities to
enforce or obey court decisions are not adequately established, and court decisions
are often ignored as a result. The relations among courts are also unclear, which
makes it difficult to reconcile conflicting rulings in different jurisdictions or to build a
body of case law. Enforcement is further hampered by the limited experience of
China's courts (which traditionally have been devoted to criminal matters) with civil
law proceedings, and the limited training of judges and other judicial personnel.

To improve enforcement the key objective is to strengthen the independence and
clarify the jurisdiction of courts , particularly with respect to government bodies. The Supreme
People's Court has developed a plan for independent funding of the judiciary to
curtail its dependence on local governments. For this to be effective, however, the
process of appointing judges will need to be made more professional and less
subject to political influence. 51 I

China in the World Economy: Synthesis Report

Box 3. Key priorities for improving frameworks for effective
market functioning

Problem

Priority objectives

Some suggested steps

Corporate governance
reforms have had limited
success

Address remaining weaknesses
in governance structures
while clarifying
property rights and
strengthening market
incentives

a) In the near-term, improve
independence and
accountability of managers
and boards of directors

b ) Remove restrictions on trading
of SOE shares as soon as
possible and take other steps
over the longer-term to improve
financial market discipline

Ambiguous property
rights hamper corporate
governance and mechanisms
for business sector restructuring

Develop a coherent framework
and supporting laws ensuring
that property rights are well
defined and apply equally
to all economic segments

In the near term, clarify
and strengthen SOE rights
to property and other assets;
clarify rules governing use of
and acquisition of state assets
by non-state entities

Bankruptcy and other insolvency
mechanisms are too weak
to allow resources to be
re-deployed from firms
that are not competitively viable

Establish a more uniform
framework for insolvency
and strengthen the autonomy
and enforcement powers
of bankruptcy courts

In the near term, enact
a comprehensive bankruptcy
law with uniform rules and clear
rights of debtors, creditors, and
shareholders; clarify responsibility
for debt of failing enterprises to
banks and social benefit funds
so that they do not block exit

Competition is uneven across
sectors; anti-competitive
practices and in some cases
legal/regulatory frameworks
impede entry or limit
competition among incumbents

Develop a comprehensive
framework for fostering
competition nationwide
with clear definition
of the responsibilities
of government agencies

a) In the near term, enact

a comprehensive competition
law; and establish a clear code
of conduct sanctioning
anti-competitive practices
by government entities

b) Except for natural monopolies,
open sectors now reserved
for SOEs to other enterprises

Weak financial discipline
encourages misallocation
of resources, weakens
incentives of enterprises
to operate efficiently, and poses
risks to financial stability

Strengthen the independence
and capabilities of financial
regulators/supervisors; improve
the ability and incentives
of financial institutions
and markets to provide
discipline

a) In the near term, restore
solvency to financial institutions
while continuing to improve their
accountability for maintaining
sound prudential standards

b) Move rapidly to strengthen
enforcement powers

of financial supervisors

c) Improve transparency and

remove restrictions on financial
markets that inhibit discipline

Laws and regulations
are poorly and unevenly
enforced

Strengthen the independence
of the judiciary and clarify its
jurisdiction

a ) In the near term, reduce
the judiciary's financial
dependence on government
and political authorities and
strengthen the jurisdiction of
courts over government agencies

Synthesis of the Main Findings of the Study

Improving the government’s capabilities to support economic development

The need to periodically redirect the role played by government as the
economy develops is not unique to China. OECD countries have gone through a
comparable process during the post-war period, in building, restoring, and
maintaining sound public finances, in seeking to develop tax structures that
impose as little distortion as possible on the real economy and in undertaking
regulatory reforms to improve market functioning. As discussed further below
and summarised in Box 4, improvement in the ability of China's government to
foster a successful adjustment to trade and investment liberalisation and to pro-
mote its longer-term development rests on the achievement of three key goals.

The most immediate is to bolster public finances to establish a sustainable fis-
cal position in which adequate revenues are raised to meet the development
needs of the economy. Reform of central-local government fiscal relations is an
important element of this effort. The second goal is to strengthen and increase
the flexibility of the policy instruments needed to maintain macroeconomic sta-
bility in the face of the diverse shocks the economy is likely to experience in
coming years. And the third goal is to establish a comprehensive framework for
regulatory policy to promote effective market functioning.

Bolstering public finances'"

The strains on China's public finances are manifest in the under-funding of
research and development, education, and other areas important to the econ-
omy's development, the difficulty of finding adequate government revenues to
facilitate restructuring of SOEs and to expand social benefits, as well as the prolif-
eration of ad hoc fees and charges imposed by local governments. As noted earlier,
demands on public finances will grow substantially even in the medium term. The
scale of these demands has led at least one prominent scholar to warn that China's
fiscal position may be heading for a crisis. 42 However a crisis should be avoidable
provided that three conditions are met.

The first is an increase in tax revenues in relation to GDP to levels needed to accommodate
increases in spending for development needs. Tax revenues have been rising relative to
GDP in recent years (Table 7) and there is significant scope within the current tax
structure for them to increase further. The potential yield from improved collec-
tion of the value-added tax (VAT), 43 which accounts for more than one-third of total
tax revenue, is especially great. Taxes on services and personal income are likely
to increase relative to GDP as services and urban household incomes continue to
grow rapidly, and could be increased further if collection were improved. There is
also scope for enterprise income taxes to rise relative to GDP provided that
restructuring succeeds in raising their profitability. Rough calculations suggest that 53 I

China in the World Economy: Synthesis Report

Table 7. Annual growth in tax revenue, 1994-99

Growth (%)

Share of total
1999

Total

15.8

100

Value-added taxes

11. 0

36.3

Business taxes

20.0

15.6

Consumption taxes

1 1.0

7.7

Tariff revenue

15.5

5.3

Corporate profits taxes- total

6.3

9.6

SOE

0.9

6.0

Collective enterprises

1 1.7

1 .6

Foreign-funded enterprises

35.3

2.0

Personal income taxes

41.5

3.9

Note: Value-added taxes are levied primarily on industry while business taxes are

levied on revenue of service and some other tertiary activities.

Source : China Statistical Yearbook, 2000.

these factors, together with changes in tax provisions that authorities are now con-
templating, could raise tax revenues by a further several percentage points of
GDP over the next five to ten years. 44

Improvements in the tax structure and administration and better mechanisms
for budget planning, formulation, and monitoring would also help to increase tax
revenues and to maximise their benefits. The potential gains from better collec-
tion and compliance underscore the pay off from devoting resources to improve-
ment of the efficiency of the tax administration. Central government authorities
are consolidating numerous extra-budget fees imposed by local governments into
a more coherent and efficient system of taxes that are more even across jurisdic-
tions. Authorities are also considering other changes in the tax system, including a
phased convergence of the tax treatment of foreign and domestic enterprises, that
have the potential to raise substantial revenues and which are ultimately needed
to establish a more level playing field among enterprises.

Effective mechanisms for planning, formulating, and monitoring the govern-
ment's budget are also essential to ensure that revenues are efficiently used.
The budget is typically the single most important overall government-planning
tool in OECD countries but is much less important in China. Government author-
ities endorse the need for budget reform and are planning to establish a Trea-
sury Single Account to monitor outlays and resources of government organs. This
will provide essential institutions for more advanced reforms. However, capabili-
I 54 ties to formulate comprehensive budgets that, 1) include all government revenues

Synthesis of the Main Findings of the Study

and expenditures, 2) are based on realistic forecasts of revenues and expendi-
tures, and 3) are embedded in a multi-year planning context, are still some
way off.

The second key objective is to establish a sustainable system of pension and other
social benefits. Even with no change in the present limited coverage, benefits will
rise more rapidly than GDP as a result of population ageing. Extension of social
benefits to the nearly 80 per cent of workers that are not now covered will not be
feasible at current pension benefit rates, which are quite generous by interna-
tional standards (Table 8). However, in contrast to the situation that has faced
some OECD countries, the authorities are not yet locked into untenably high
benefit rates.

Significant progress has been made in providing the institutional basis for
sharing the financing of social benefits. A three-tier pension system has been
established along lines recommended by the OECD and the World Bank. The gov-
ernment is directly responsible for the first tier, which is a defined benefit plan
financed by a payroll tax and intended to cover one-third of targeted pension
benefits. 45 The remaining two-thirds will be supplied by second and third (volun-
tary) tier defined contribution plans. The financing of health care benefits has
been established on a similar basis.

Recent reforms have gone part of the way toward reducing future pension
benefits and the new pension system provides the basis for further reductions
over time to levels that are sustainable. 46 The challenge in the medium term is
to manage the transition between the presently high benefits promised under
the first tier to current middle-aged and older workers and the lower benefits
that younger workers will receive. Currently, younger workers in the formal sector
are effectively taxed to pay for the higher benefits to those nearing retirement,
which creates incentives to work in the uncovered informal sector. These disin-
centives could be reduced by allowing lower contribution rates for younger or
lower paid workers, while making up for the loss of payroll contributions out of
other revenues. There is also a need to start preparations for organising social
insurance for rural workers. This might be done by initially extending coverage
with lower benefit and contribution rates to selected agricultural areas border-
ing the cities, with a view to gradually raising the rates over time.

The third objective is to contain future non-performing loans and so avoid the need for
another financial system cleanup after the one that needs to be undertaken now. This is abso-
lutely essential: the possibility that new non-performing loans will not be ade-
quately contained is probably the single greatest risk to fiscal sustainability in
China. Thus financial reforms to ensure that financial institutions have the incentives
and capabilities to maintain rigorous lending standards and manage risk are critical
to maintaining sound public finances. I

Table 8. China's pension system compared with selected regions in the world

(China in 1999 compared with regional averages in the mid-1990s)

Region

Participation
as share of labour
force (%)

Contributions as

ratio to wages (%)

Average income
replacement ratio
(%)

Average pension
as percent
of GDP
per capita

Pension spending
as per cent
of GDP

Pensions

All social
insurance

China ( 1 999)

1 8 1

25 2

30 s

77 2

99 2

OECD

Range

79-98

6-35

14-57

25-49

23-98

5-15

Asia and the Pacific

Range

3-73

3-40

4-46

0-3

Central and Eastern Europe 4

Range

32-97

20-45

24-61

24-69

13-92

2-14

North Africa and Middle East

Range

30-82

3-27

13-48

36-78

22-144

0-6

Sub-Saharan Africa

135

Range

1-18

3-24

6-33

40-207

0-3

Latin America and Caribbean

Range

1 1-82

3-29

8-46

13-64

26-64

0-13

1 . The regular urban pension system and that for civil servants.

2. The regular urban pension system. N.B. employee contribution rates increased every year 1997-2001 .

3. Approximate national average.

4. Including the former Soviet Union.

Source: The Table is adapted from Chapter 1 6, Table 16.8, which gives further details. Figures are based on calculations using World Bank data.

China in the World Economy: Synthesis Report

Synthesis of the Main Findings of the Study

Conditions for fiscal sustainability:

- Raise tax revenues sufficiently to accommodate increased needs for spending on
development.

- Establish sustainable benefit levels for social insurance programmes.

- Contain future non-performing loans by sustaining sound lending standards

Reforming central-local government fiscal relations 47

China's fiscal system is relatively decentralised, with local governments
accounting for 71 per cent of government expenditure. Since the major reform of
central-government fiscal relations in 1994, the VAT, business, personal and other
on-budget taxes have been subject to explicit revenue-sharing formulae. Expendi-
ture responsibilities are also explicitly divided, with the central government
responsible for national defence while local governments have the main responsi-
bility for education, agriculture, and most social welfare payments. Transfers
between the central and local government are also relatively large, accounting for
nearly 42 per cent of central government revenues and nearly 5 per cent of GDP.

Despite this decentralisation, many local governments are starved for reve-
nues to meet local needs. While due partly to the low level of tax revenues for
government as a whole, the scarcity at the local level is aggravated by the current
fiscal federalism system. The system has also resulted in large disparities among
richer and poorer regions. P er-capita government expenditure in Shanghai is six to
eight times greater than in most central and western provinces; budget revenues
relative to local GDP are two to three times higher on the coast than in most west-
ern provinces. The fiscal system therefore accentuates the imbalances and lack of
integration among regions.

One of the underlying causes of these problems is the fact that expenditures
are more decentralised than tax revenues. Sub-national governments - provincial
governments and the local levels subject to their jurisdiction, receive about 55 per
cent of total tax revenues, but these account for less than half of their spending,
with the remainder coming from extra-budget funds and from transfers from the
central government. The expenditures assigned to sub-national government are
among the most rapidly growing components of overall government spending.

They are also the areas where the need for further increases is greatest. Sub-
national governments are mainly responsible for supporting SOE workers dis-
placed by labour shedding and for making up shortfalls in contributions to pay for 57 I

China in the World Economy: Synthesis Report

social welfare benefits. Sub-national governments have little (sanctioned) flexibil-
ity in setting the criteria for spending or in determining the rates even on those
taxes assigned entirely to them. Indeed, under-funded mandates from the central
government have added to the pressures on local finances in recent years. Local
governments’ flexibility, even to smooth out fluctuations in their revenue, is lim-
ited by the requirement that their budget be balanced each fiscal year. The
squeeze on sub-national revenues is further heightened by inefficiencies in
spending, such as the maintenance of an excessive number of government staff.

A second problem lies with the central-local government transfer mechanism.
This mechanism is based in part on the earlier system in which transfers to a prov-
ince were related to its success in raising revenues above a targeted base amount.
Partly as a result, the transfer system does not appreciably offset discrepancies
between the tax bases of rich and poor provinces. A third problem lies with the
inefficient distribution of revenues between provincial governments and their
local governments. This is attributable in part to the influence of political and
other non-commercial considerations, and in part to the lack of formal national cri-
teria governing the allocation.

Establishment of a better balance between local government resources and their spending is
a key objective of broader fiscal reforms. Reform of central-local government fiscal
relations is important to reduce the incentives for regional protectionism and
other distorting resource extraction by local governments, and to improve regional
integration. OECD experiences suggest that the appropriate division of responsi-
bilities among various levels of governments to meet these objectives depends
heavily on country circumstances, in particular the capabilities and incentives of
the various levels of government, and may have to change over time . 48 However
the overall objectives of the reforms should be, first, to bring tax revenues of sub-
national governments in to line with their expenditure needs. This is likely to
require both review of the current assignment of tax revenues and expenditure
responsibilities and reform of the transfer mechanism. The second objective is to
improve revenue and expenditure within provinces by setting clearer standards at
the national level and by giving provinces more flexibility in administering their
finances, including some ability to set rates on local taxes and to borrow to meet
short-term liquidity needs.

Improving the flexibility of macroeconomic policy instruments 49

The diverse forces that will impact China’s economy from trade and invest-
ment liberalisation and the restructuring of the domestic real economy will place
heavy demands on China's macroeconomic policy instruments. As the earlier dis-
cussion suggests, macroeconomic policy will need to be able to support higher
I 58 real GDP growth in order to reduce the current slack in labour markets - once

Synthesis of the Main Findings of the Study

structural problems have been alleviated enough to allow higher growth without
igniting inflation. The exchange rate necessary to maintain China’s external balance
may also change, but the amount and direction cannot be predicted in advance. The
study points to three priority objectives for improving the effectiveness and flexibility
of China’s macroeconomic policy instruments to deal with these prospective
changes.

The first is to improve the effectiveness of monetary policy in managing aggregate demand
so that the burden does not fall disproportionately on fiscal policy, as is now the
case. Important steps have been taken in recent years toward developing instru-
ments for "indirect" monetary policy management of domestic credit. At least for
the medium term, the next challenge is largely one of strengthening monetary pol-
icy transmission mechanisms. One important source of the weakness in the trans-
mission mechanisms - the poor financial conditions of enterprises and of banks
that together are responsible for the present credit crunch - is likely to take some
time to fully remedy.

However, much progress could be made in the near term on two other
important steps. The first is to deregulate interest rates on bank loans and on
large deposits. Interest rates in the inter-bank market have already been freed
and authorities have announced plans to liberalise bank loan (and some
deposit) rates within three years . 50 Acceleration in this schedule would be desir-
able. The current restriction on bank loan rates limits the ability of central bank
operating instruments to control the effective cost of credit to final borrowers.

The second step is to improve the flexibility of the money markets. While devel-
opment of the money markets is also a longer process, broadening access to the
market and liberalising the positions permitted to participants would help to
distribute the effects of monetary policy changes more broadly and evenly.

A second objective is to accelerate the development of the government bond market in
order to accommodate the large increase in government debt that is likely to be
needed over the next several years. The current government bond markets are
limited by their segmentation into two tiers, the stock market and inter-bank
market, low liquidity in both the primary and secondary markets, and by disin-
centives to active trading. Banks are the largest holders of government bonds
but are only able to trade in the interbank market (since they have been banned
from the stock exchanges), and tend to follow a buy and hold strategy encour-
aged by the positive gap between bond interest rates and bank loan rates, inte-
gration of the two tiers would probably be the most effective step in the near-
term to improve the liquidity and breadth of the market. As the stock of debt
grows, it will be increasingly important to broaden access by domestic institu-
tional investors, and, at a suitable point, to allow foreigners to purchase govern-
ment bonds. Development of the money market and liberalisation of bank loan 59 I

China in the World Economy: Synthesis Report

rates is also important to bond market development, for example to help securi-
ties dealers to fund inventories of government bonds . 51

The third objective, and the most difficult challenge, is to progressively
increase the flexibility of the exchange rate and capital control regimes. The Chinese
authorities have been considering technical means in the near-term to make
exchange rate management more flexible, notably by widening the band
within which the rate is allowed to vary. However, greater flexibility is likely to
be needed beyond the near term to allow the nominal exchange rate to vary in
line with the requirements of external balance while avoiding the speculative
disruptions that have often accompanied adjustable parity regimes in the
past. Ultimately, a floating exchange rate regime may well be most suitable to
China’s conditions, in part because of the ability it will allow for more indepen-
dent monetary policy once the capital account is liberalised. Capital account
liberalisation, however, is essential to ensure that the foreign exchange market
is sufficiently broad and efficient to determine a price for the domestic cur-
rency that is in line with its underlying competitiveness. Progressive liberalisa-
tion of the capital account will also be needed to allow domestic businesses
sufficient access to international financial markets as trade and investment lib-
eralisation progresses, and to help spur the development of domestic financial
markets.

Identifying the concrete steps needed to balance these considerations is very
difficult. Recent international experience has graphically illustrated the risk to
macroeconomic stability posed by capital account liberalisation when domestic
financial markets are insufficiently developed or subject to distortiums. The risks
of premature liberalisation are now especially great in China because of the poor
financial conditions of enterprises and financial institutions, weak corporate gover-
nance, and the incomplete development of the financial supervisory and regula-
tory system. However, delay in liberalising the capital account also involves a cost,
since it limits the degree to which the exchange rate regime can be made more
flexible as well as the potential benefits of liberalised capital flows to the domestic
economy.

In the near term, the stability afforded by the present exchange rate
regime is probably beneficial to China's economy but there is also a need to
establish a foundation for greater flexibility in the future. To this end, it would
be useful to partially relax existing capital controls over the next several years
to give enterprises more flexible access to foreign exchange and to create a
broader and more efficient foreign exchange market. Once supervisory mecha-
nisms have been adequately strengthened, further relaxation of controls on
portfolio capital flows, starting with equity and government bond markets,
would be useful.

©OECD 2002

Synthesis of the Main Findings of the Study

Creating the framework for a market-based regulatory system 52

Regulatory reform is a major part of the policy effort to realise the full bene-
fits of trade and investment liberalisation. Establishment of the conditions
needed to integrate the internal economy and the frameworks for market func-
tioning is a process involving new regulation in some areas, deregulation in
many others, and revised regulation nearly everywhere. The overall objective is
to focus regulation on establishing and enforcing the rules and processes for
effective market functioning, rather than on resource extraction or government-
directed resource allocation.

One of the most basic lessons OECD countries have learned from their expe-
riences over the past fifty years is that regulation is not simply a collection of laws
and regulations in individual areas but a process in its own right. To be fully effec-
tive, the regulatory process, and not simply its individual components, needs to
be based on a comprehensive and coherent long-term framework with clearly
defined priorities and strategies. There is a growing body of evidence that a
coherent regulatory process can yield significant economic benefits in terms of
lower costs to business, greater choices for consumers, improved innovative
capacity, and other gains.

The potential benefits of a comprehensive regulatory framework are espe-
cially great for China for at least three reasons:

• First, it would help to level the playing field for domestic firms in competing
with foreign enterprises that benefit from a coherent regulatory framework
in their own countries.

• Second, a comprehensive framework is needed to harmonise regulatory
policies that up to now have largely been developed sector by sector, or
driven by outside commitments such as those under WTO. It would also
help to improve co-ordination, consistency, and accountability in the regu-
latory efforts of the myriad government agencies and levels that too often
operate in isolation, and sometimes at cross-purposes, in China.

• Third, an overall regulatory framework can contribute to China's effort to
establish a market economy by providing a more rigorous basis for balanc-
ing purely economic objectives with other social values, such as equity and
the need to provide support to those displaced by economic transformation.

OECD experience, and the work of OECD experts with non-member countries,
underscore that there is no single blueprint for an effective regulatory framework
that is applicable to all. The appropriate institutions and strategies depend
heavily on the traditions and circumstances of each individual economy. However,
OECD experiences suggest several guiding principles. The first is the need to develop
the institutional structures within government for regulatory planning, co-ordination,

China in the World Economy: Synthesis Report

and accountability across all its components and levels. Most OECD governments
now have central regulatory co-ordination agencies with government- wide scope.
In the United States, for example, the Office of Management and Budget provides
this co-ordinating role. China presently does not have such a function, but several
current organs reporting directly to the State Council have more limited co-ordina-
tion roles that could serve as the basis for development of a broader regulatory
co-ordinating body. Development of such a capability could help greatly to over-
come administrative blockages and delays in mandated reforms and to achieve a
clearer definition of responsibilities for particular regulatory areas across govern-
ment agencies. Over a longer period, a regulatory co-ordinating body could serve
as a catalyst for more fundamental rationalisation of regulatory policies that are
now carried out by numerous bodies.

A second principle is that regulatory authorities need to have tools to objec-
tively evaluate the impact of proposed policies and the trade-offs they involve.
Such tools are particularly important when, as in China, developing markets and
institutions are subject to distortions that increase the risk that poorly designed
regulations will have perverse effects. In China, policy evaluation is most often
carried out through consultations with local government officials, the testing of
certain policies at selected local levels before nationwide implementation , 53 and
by commissioning government and academic think tanks to develop policy
options and assessments of the impact of proposed actions. However, more for-
mal tools that could be applied directly by government agencies are likely to be
needed as regulatory policy develops. In OECD countries, competition policy is
often used to evaluate not only the impact of particular regulations on competi-
tion but also their trade-offs in terms of efficiency, environmental standards, and
other broader goals. The regulatory framework needs to explicitly require the use
of such tools by regulatory agencies and to specify their applicability and priority
in particular areas.

Transparency is the third requirement of an effective regulatory framework and is
the area where China's regulatory system most lags behind that of OECD countries.
Transparency is essential to all phases of the regulatory process, from formulation, to
implementation, and to ongoing administration. Transparency rests first on the princi-
ple that those regulated, as well as the general public, need to be accurately and thor-
oughly informed about regulatory rules and their changes. Public knowledge of the
rules is necessary not only for those regulated, but also to ensure that government
agencies at all levels are fully aware of their obligations, to ensure accountability, and
to prevent capture of regulatory organs by special interests. Disclosure of regulations
also serves as a commitment by regulatory authorities to the public that can help to
buttress their credibility. Efforts to inform the public need to go beyond purely formal
but ad hoc means (such as announcement in the speech of a senior official) to include a
I 62 pro-active effort to inform the public through channels that can be easily accessed.

Synthesis of the Main Findings of the Study

Box 4. Priorities for strengthening the government’s capabilities
to foster economic development

Problem

Priority objectives

Some suggested steps

Public finances are

Bolster the capacity of

a) In the medium term,

insufficient to adequately

the fiscal system by raising

continue to improve tax

meet development needs

revenues relative to GDP,

collection and compliance;

while maintaining fiscal

completing the establishment

reform tax provisions

sustainability

of a financially viable
system of social benefits,
and contain further non-
performing loans

to reduce distortions;
and strengthen public
management of the budget
b ) Over a longer period,
reduce pension benefit
rates to viable levels
as coverage is extended

Local government fiscal

Establish a better balance

a) In the near term, review

resources are insufficient

between local government

current assignment of

to meet their responsibilities

resources and expenditure

revenue and expenditure

and very unevenly
distributed

responsibilities

responsibilities
b } Over a longer period,
reform the transfer
mechanism to better direct
funds on the basis of need;
and establish criteria for
a more efficient allocation
of fiscal resources within
provinces

Macroeconomic policy

Bolster the effectiveness of

a) Liberalise bank loan rates

instruments are insufficiently

monetary policy instruments;

in the near term and

flexible

accelerate the development
of the government bond
market, and move toward
greater flexibility in the
exchange rate and capital
control regimes overtime

remove restrictions that
inhibit the money and
government bond markets
b) Over the longer term,
liberalise the capital
account and exchange
rate regimes in line with
development of domestic
financial markets and
improvements in financial
discipline and supervision

The regulatory framework

Develop a comprehensive

a) In the near term, develop

needs to be better aligned

government-wide

bodies to co-ordinate

with the needs of

regulatory framework

regulatory policy for the

an integrated market

in which the government

government as a whole

economy

is an arms-length formulator
and arbiter of rules for
the market

b) Continue efforts to improve
transparency and develop
explicit tools to evaluate
regulatory impacts

©OECD 2002

China in the World Economy: Synthesis Report

Finally, an effective regulatory system requires strong enforcement media-
nisms that are consistent with the rule of law. Regulatory enforcement in China is
decentralised to lower government levels to a greater extent than in most OECD
countries. Regulatory authorities at these levels are hampered by interference
from local governments are prone to capture by special interests, and often lack
effective sanctions for violators. Operating without clear mandates or guidelines
from the central government, local regulation is often excessive and intrusive.
OECD countries typically have enacted explicit laws to clarify the scope of regula-
tors and sanction abuses. The study suggests that China could build on several
existing administrative laws to develop a more effective legal framework to
achieve the same goals.

Conclusions

Collectively, the chapters of this study highlight the impressive progress
China has made in recent years to prepare for further integration into the world
economy. In nearly all the areas examined, the authorities have been moving in
the direction needed to deal with inherited problems and to foster conditions to
allow the benefits of trade and investment liberalisation to be realised. The
chapters highlight areas where, based on OECD experiences and perspectives,
further changes are likely to be needed to reinforce policies now underway or
planned, and to improve prospects for achieving China's economic development
objectives.

Although China has already opened considerably to international markets,
the potential gains from further trade and investment liberalisation are very great.
However, as the individual chapters illustrate, realisation of these gains is neither
inevitable nor automatic, and depends crucially on progress on domestic eco-
nomic reforms. Trade and investment liberalisation does not radically alter the
priorities for domestic economic reforms, but it does make some steps all the
more urgent.

The overall conclusion that emerges from the study is that China's develop-
ment has now reached a stage that calls for a somewhat different emphasis in
reforms from that prevailing earlier. Past policies to develop individual segments
of the economy were based in part on the limited development of markets and
their supporting mechanisms in the early stages of the reform era. As the scope for
market forces has progressively increased and development has advanced, the
administrative distinctions among these segments have come to have less and
less economic meaning. Thus the problems and challenges of SOE and non-state
enterprises are becoming more and more similar; conditions in the rural economy
now depend more on national economic developments than on developments
specific to the agriculture sector or rural industries themselves. Problems in individual

Synthesis of the Main Findings of the Study

areas and the policies needed to deal with them have become increasingly interde-
pendent. As a result, the benefits to separate development of preferred sectors
have reached sharply diminishing returns, and the risk that they will impose dis-
tortions that will be counter-productive for the overall economy has increased.

Rather than seeking to replicate past policies, future policies need to be based on
their underlying lessons, the most important of which is that allowing greater
scope for market forces is the key to successful development.

Future economic reforms need to continue and broaden the trend in recent
years toward measures with economy wide scope, focused on two essential objec-
tives. The first is to foster the integration of the domestic economy in order to rea-
lise the benefits of trade and investment liberalisation and to sustain China's
development over the longer term. As underscored by the high degree of internal
integration of the United States economy, and the strenuous efforts the European
Community has been making to achieve it to a comparable degree, internal inte-
gration is essential to the development of an advanced continental economy.
Domestic integration in China is essential to achieving better utilisation of labour
and other resources as well as to ensure that resources are efficiently employed in
the future. Integration of the domestic economy involves the elimination of inter-
nal barriers to mobility in factor and product markets, creation of a more level
playing field among enterprises and other economic segments, and greater scope
for market forces in certain areas. Integration among China's regions, and between
rural and urban areas, needs to become a major priority, not simply to improve
equity, but to sustain the development of the economy as a whole. Development
of interior provinces is likely to have to depart somewhat from the model sug-
gested by China's coastal development, with the emphasis on integration with the
rest of the country and improvement in the local business environment, rather
than on special zones or other government preferences, as the keys to success.

Success in integrating the domestic economy also depends on achievement of
a second key objective, which is to strengthen the framework conditions necessary
for efficient market functioning. This is an ongoing process that continues even in
the most advanced economies. However, in developing countries such as China,
limited institutional development and the distortions left by central planning make
framework reforms a critical priority. The study has identified five priorities for these
reforms. These are to clarify property rights and strengthen exit mechanisms so that
state-owned as well as other assets can be allocated to their most efficient uses; to
improve competition and, in the process, break down regional and other protection-
ist barriers; to bolster enterprise governance by making managers and their boards
more independent and accountable while strengthening external discipline; to but-
tress the powers and capabilities of financial supervisory authorities; and to under-
pin reforms generally by improving the independence and enforcement capabilities
of the judiciary. While likely to take some time to complete improvement in 6; I

China in the World Economy: Synthesis Report

framework conditions needs to be given high priority in the near and medium term
since the adjustments entailed by trade and investment liberalisation are likely to
create incentives to interfere with competition and impose other distortions to mar-
ket functioning in order to protect incumbent interests.

More than in the past, success in achieving these objectives will require co-
ordinated policies on a broad range of fronts that takes account of the increasing
interdependence among current problems. At the same time, policies need to be
carefully sequenced in order to establish the pre-conditions for subsequent
reforms. In this regard, measures to break through the vicious circles that are block-
ing progress on broader reforms take on a particularly high near-term priority.
Timely restoration of financial system solvency is important not because it will be
sufficient by itself but because international experience suggests it is necessary to
allow broader financial and real sector reforms to proceed. Government imposed
and other obstacles to enterprise restructuring need to be removed as soon as pos-
sible if the business sector is to keep up with the imperatives that will come with
trade and investment liberalisation. And government financial resources need to be
bolstered in order to provide the support needed to facilitate these and other
reforms that will need to be undertaken in the medium term.

Finally, China's government will need to continue to play a key role in the eco-
nomic reform process. The chapters identify measures to bolster public finances,
reform central-local government finances, improve the effectiveness of macroeco-
nomic policy instruments, and develop a more comprehensive regulatory policy
framework in order to improve the capabilities of the government to support reforms.
These changes point to a broader need to re-orient the role of the government in the
economy that is not unique to China. Public ownership of enterprises, the use of tax,
regulatory, and other policies to influence resource allocation, and reliance on credit
rationing and other direct interventions in macroeconomic policy were much more
common in OECD countries during the 1950s and 1960s than they are now. Public gov-
ernance in OECD countries has since evolved toward a more effective framework
based on the following principles. The task of public finances is to extract sufficient
resources to achieve the government's objectives through means that minimise dis-
tortions to market forces. The task of macroeconomic policy is to sustain internal and
external balance in the economy through market-based policy instruments. And the
task of government regulation, including regulatory reform, is to formulate, enact, and
enforce rules to sustain competition and other framework conditions needed for
market functioning. With this evolution, has come a need to rationalise government
structures and capabilities in order to ensure that policies are adequately co-ordi-
nated, understood by those they affect, and are carried out in a mutually reinforcing
and consistent manner over time. Public governance in China is already moving in this
direction and will need to continue to do so as the domestic economy develops and
integration with the outside world proceeds.

©OECD 2002

Notes

1 . Barry Naughton (1995), Crowing out of the plan-. Chinese economic reform, 1978-93, Cambridge
University Press.

2. This section is based mainly on Chapters 1-3 on agriculture and the rural sector.

3. Grains account for nearly two-thirds of total cultivated land. As throughout the reform
period, the government establishes procurement prices and delivery quotas for major
grains, including wheat, corn, and rice, and controls grain marketing, while allowing
farmers to sell their surplus above the quota in the open market. The Governors’ Grain
Bag Responsibility System (GGBRS) introduced in 1995 sought to increase production
by raising prices to farmers. The result has been led to rising surpluses. Despite pro-
gressive reduction in support prices in recent years, the gap between procurement and
market prices has continued to widen. The grain procurement system is not covered by
China s WTO agreement but is likely to become increasingly expensive to maintain
once the domestic market is opened to lower cost imports from abroad.

4. REs, as the term is used in this synthesis, include all rural non-agricultural enterprises,
including single owner and other private firms. This term is equivalent to TVEs as they
are defined in Chapters 1-3. TVEs are sometimes defined more narrowly as rural collec-
tive enterprises; these account for most rural industrial output.

5. See the simulations discussed in Chapter 4 on industry implications and in Annex 2.

6. This sub-section is based on Chapters 4-6 on industry issues and Chapter 10 on foreign
direct investment.

7. China ranked only eighth among developing country recipients of foreign direct invest-
ment in 1999. Studies cited in Chapter 10 on foreign direct investment suggest that
China does not outperform other developing countries on average once its size and
other characteristics are taken into account.

8. Empirical evidence on the impact of trade and investment liberalisation on China's
industries is reviewed in Annex 2.

9. This section is based on Chapter 7 on banking, Chapter 8 on insurance, Chapter 14 on
priorities for the financial system and financial regulatory policy, and Chapter 15 on
capital market development.

10. China's financial system is relatively large, as measured by the ratio of domestic credit
to GDP, compared to countries of comparable development. (See Chapter 14 on finan-
cial system priorities, Figure 4),

11. As mentioned in Chapter 7 on the banking sector, a recent People's Bank of China sur-
vey indicates that a significantly higher portion of bank lending goes indirectly to non-
state entities than is apparent from official figures on their direct lending. This pattern
is indicative of the importance of informal credit channels in China. However the degree

China in the World Economy: Synthesis Report

to which non-state non-financial businesses are recipients of these indirect funds is
unclear. Much of the indirect financing probably goes through informal financial channels
into the stock market or other investments that banks are not allowed to engage in
directly.

12. Foreign banks' ability to lend foreign currency will be constrained by the underdevel-
oped domestic interbank market and foreign exchange and other regulatory constraints
not covered by WTO accession. See Chapter 7.

1 3. See Chapter 22 on macroeconomic issues.

14. China's trade (merchandise exports plus imports) to GDP was 38 per cent of GDP in 1999,
compared to 26 per cent for the Euro area, 19 per cent for the United States, and 1 7 per
cent for ]apan. China ranks third among the five largest developing countries by this mea-
sure, behind Russia and Indonesia but substantially above Brazil and India.

15. China’s domestically held public debt is about 22 per cent of GDP.

16. See the estimates discussed in Chapter 14.

1 7. Studies reviewed in Annex 2 suggest that real GDP growth could be boosted by an amount
ranging from virtually negligible to as much as 0.5 percent annually through 2010. The esti-
mated effects on employment are small.

18. See Chapter 21 on regional issues.

19. See Chapters 2-3 on the rural sector and Chapter 16 on labour market and social poli-
cies.

20. See Chapter 16, on labour market and social policies.

21. See Chapter 17 on environmental issues and Chapter 1 on the agricultural sector.

22. See Chapter 1, concluding section.

23. See Chapters 4-6 on industry implications.

24. See Chapters 7 and 8 on the banking and insurance sectors, respectively, Chapter 14
on financial system priorities, and Chapter 15 on capital markets,

25. Partial clean-ups that simply reduce the amount of negative capital tend to have little
impact on internal incentives to maintain prudential standards or to monitor loan con-
tracts. See Aghion, Philippe, Olivier lean Blanchard, and Wendy Carlin (1994), "The eco-
nomics of enterprise restructuring in Central and Eastern Europe" , Centre for Economic Policy Research
Discussion Paper No. 1058.

26. Chapter 14 on priorities for financial system development presents rough illustrative
calculations suggesting that the cost to Chinas government of a thorough clean up in
the near-term could range between 30 and 60 per cent of GDP, depending on the true
extent of non-performing loans, the recovery rate, and other circumstances. This range
is comparable to the costs incurred by other developing countries that have undergone
severe banking crises. The cost to China's government could be lower if the clean up
were less comprehensive, or authorities were to rely substantially on the banks to
"grow out" of their problems, but as argued in the text and in the chapters on the finan-
cial system, this is a risky strategy that could easily lead to greater costs in the future.

27. See Chapter 21 on regional economic issues.

28. The issues summarised in this and the following sub-section are discussed in detail in
Chapter 13 on enterprise governance issues.

©OECD 2002

Notes

29. A basic step was taken in 1993 with the enactment of the Company Law providing for
the establishment of legally autonomous limited liability and joint-stock companies, and
specifying the rights of shareholders, and powers of managers and their boards of directors
and supervisors. The company law does not coverall types of enterprises. Collective enter-
prises are subject to an earlier law. Private enterprises were not officially sanctioned
until 1998 and are still subject to ambiguities about their legitimate scope.

30. Chinese authorities, including the Chairman of the China Securities Regulatory Com-
mission, have explicitly stated that they regard the OECD Principles on Corporate Gov-
ernance as the international benchmark in this area.

3 1 . See the Economist article cited in Chapter 13 on enterprise governance.

32. Discipline is further constrained by the limited rights of minority shareholders.

33. As noted in Chapter 4, enterprise governance has improved most in sectors that are
competitive.

34. Cyril Lin, Corporate governance in China (2000).

35. The decentralisation of state administration has effectively increased the number of
"owners". Creation of separate asset management companies has not resolved this
problem because the companies tend to function very similarly to the line government
agencies from which they are typically derived. The separation of SOEs from their con-
trolling line agencies may have had the perverse effect of making it easier for other
government entities to interfere in their operations.

36. This section is based on Chapter 12 on competition law and policy but also draws on
Chapter 1 1 , on regulatory reform.

37. Overt barriers to product market competition are focused on a few products, such as
automobiles and beer, and have been declining as a result of central government
crackdowns.

38. These amount to RMB 300 000, or US$36 000, in retail trade and RMB 500 000 (US$60 000) in
wholesale trade and manufacturing. See Chapter 13 on corporate governance.

39. See Chapter 14, the section on regulatory/supervisory policies, for further discussion of
these issues,

40. This power now lies with the Ministry of Finance.

41. The issues for this sub-section are discussed in detail in Chapters 16 (section on pen-
sions), 17 (public budget management) and 18 (tax policies), as well as Chapter 22 on
macroeconomic implications.

42. See Nicolas Lardy (2000), "Fiscal sustainability: between a rock and hard place”, China
Economic Quarterly.

43. A 1997 study by the World Bank estimated that only 70 per cent of the VAT due to
authorities was actually collected and there seems to have been only limited improve-
ment since that date. See, World Bank, China 2020 (1997).

44. See Chapter 22 on macroeconomic policy issues and Chapter 18 on tax policies.

45. Under current policy the first tier benefit replaces 20 per cent of a worker's average
wage, although changes now being considered could raise this to 30 per cent.

46. Calculations developed in Chapter 16 suggest that a 20 per cent replacement rate in
the first tier could be financed by a payroll tax of 10 per cent, even with the expected
rise in the dependency ratio.

China in the World Economy: Synthesis Report

47. Further discussion of these issues can be found in Chapter 20 on central-local govern-
ment fiscal relations.

48. This conclusion is further supported by recent Secretariat economic surveys of Russia
and Brazil. See the chapters on central-local government relations in the OECD Economic
Surveys for Russia (2001) and Brazil (2001).

49. These issues are discussed in detail in Chapter 22.

50. As with other policies, the exact timetable implicit in official announcements is not
entirely clear, but three years from the time this plan was first stated would be in 2003.

51. As discussed in Chapter 15 on capital markets, China could improve the liquidity and
depth of the government bond market by adopting techniques already used in major mar-
kets, such as standardising terms on bond issues, consolidating issues into a limited num-
ber of categories, and establishing a pre-announced schedule of regular issues.

52. These issues are discussed in Chapter 1 1 on regulatory policy; see also the portion of
Chapter 12 on competition policy.

53. An example is the housing reform now applying nation-wide but which was first tested
for several years in Shanghai.

OECD/CCNM Publications on China

Published in 2001

• China's Agriculture in the International Trading System
Code 142001 11 IP ISBN 92-64-18682-4

• Business Cycles and Cyclical Indicators

lointly published by the OECD Statistics Directorate, the Centre for Co-
operation with Non-Members and the National Bureau of Statistics of The
People's Republic of China (NBS)

• Research of Methodological Issues on National Accounts (Series No. 4)
lointly published by the OECD Statistics Directorate and the National
Bureau of Statistics of The People's Republic of China (NBS)

Published in 2000

• National Accounts for China - Sources and Methods
Code 1 42000281 PI , ISBN 92-64-18550-X

• Reforming China’s Enterprises

Code 1 1 20001 71 Pi , ISBN 92-64-17697-7

• Reussir la reforme des entreprises en Chine
Code 1 1 20001 72P1 , ISBN 92-64-27697-1
(also in Chinese)

• The Agro-food Processing Sector in China - Developments and Policy
Challenges

Code 14200001 I PI, ISBN 92-64-17179-7

Published in 1999

• Agriculture in China and OECD Countries - Past Policies and Future
Challenges

Code 141 999071 PI , ISBN 92-64-17094-4

• Environmental Taxes - Recent Developments in China and OECD countries
Code 971 999071 PI, ISBN 92-64-17092-8

China in the World Economy: Synthesis Report

• Research of Methodological Issues on National Accounts (Series No. 3)
Jointly published by the OECD Statistics Directorate and the National
Bureau of Statistics of The People's Republic of China (NBS) Published
in 1997

• Agricultural Policies in China

Code 51 19971 I 1 PI , ISBN 92-64 15562-7

• Politiques agricoles en Chine

Code 51 19971 1 2P1 , ISBN 92-64-25562-1

• Applying Market-based Instruments to Environmental Policies in China and
OECD Countries

Code 971 9971 71 PI , ISBN 92-64-15618-6

• Les instruments economiques des politiques d'environnement en Chine et
dans les pays de l'OCDE

Code 9719971 72PI , ISBN 92-64-25618-0

• Research of Methodological Issues on National Accounts (Series No. 2)
Jointly published by the OECD Statistics Directorate and the National
Bureau of Statistics of The People's Republic of China (NBS)

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