1. The Fundamental Institutions of China’s Reforms and Development
Chenggang Xu
University of Hong Kong
July 19-23, 2010
Chicago Workshop on the Industrial Structure of Production
Chicago Law School, Chicago GSB, Coase Foundation

2. Outline of this talk
Compared with the rest of the world, China’s fundamental institution is unique
It is inherited from China’s unique long imperial history
The Chinese Communist Party’s rule since 1949 and the unique political-economic campaigns (the Great Leap Forward Movement and the Cultural Revolution) are directly responsible for shaping up China’s fundamental institutions
China’s fundamental institution is a double-edged sword
Responsible for China’s unprecedented economic growth
Also create grave political-socio-economic problems
Sustainability of China’s growth is determined by the stability of China’s political-economic system, which is determined by China’s fundamental institutions, including their reforms

3. Theoretical vs. empirical studies of institutions
Divorced theoretical and empirical studies of institutions
Theoretical literature (e.g. Coase, North, Hurwicz-Maskin-Myerson, Williamson, etc.)
Studies basic mechanisms which govern the incentives of agents and coordinate activities in political/economic games
The problems are universal but solutions are context specific
Cross country literature (e.g. IMF, Acemoglu, Shleifer, etc.)
Measure the distance of each country’s institution from the “best practice” institution
Often ignore how specific incentive problems are solved
Institutions of most of the countries in the world have an European origin: a standard approach may well apply
Through colonization: N/S America, Australia, Africa, South Asia
Through voluntarily adoption: Japan
The “best practice” in general is path-dependent
The optimal mechanism to solve incentive/coordination problems can be different for countries with different historical paths 3 3

4. The so called “China puzzle”
China is different: has never been a colony of Europe
By “best practice” based measurements Chinese institutions are worse than the average of developing/transition economies
Quality of government, law, finance, corporate governance, etc.
The coexistence of “bad” institutions and great growth performance of China contradicts the cross country literature => “China puzzle”
This “puzzle” is an illusion, since this “standard” approach ignores important Chinese institutions which deals with incentive/coordination problems
Institutions evolved from China’s unique long imperial history explain much of today’s development
The only empire on earth which last for more than 2000 years
These institutions also explain serious social/economic problems in today’s China

5. The fundamental institution of China: Regionally Decentralized Authoritarianism (RDA)
Highly centralized personal controls – in contrast to a federal state
Provincial level officials are controlled by the central government
Nested personnel controls over all level subnational officials
Personal control as incentive instruments for the central government to lead
China is one of the most politically centralized countries in the world
Highly decentralized in economy – in contrast to an unitary state
Subnational governments are enabled: control most resources in China
Most firms are under great influences of sub-national governments
Sub-national governments control most of the land
China is fiscally most decentralized economy in the world
Regions are relatively self-contained and are alike in structure
China is not one, but 22 countries (WSJ, 9/2009)
Provide conditions for regional competition and regional experiments
The RDA determines China’s policies, development, and problems

6. Stylized Governance Structure of China This governance structure is evolved over a long history6 6

7. Stylized Governance Structure of China in 14th Century (Ming-Qing) is similar to today’s RDA regime7 7

8. Centralized Political Governance
The central government controls
The personnel matters of sub-national governments
Commands high economic sectors (e.g. banking, railway etc.)
Party ideology and the mass media
Delegate/rescind power to regions (Chinese Constitution)
Centralized personnel control deals with incentive problems
Appointment, promotion, demotion and cross-region rotation of regional leaders as a control instrument
Rewards, penalties and regular performance assessments as essential control instruments
Personnel control as a key ingredient of regional competition
Personnel control as a key element of maintaining control & containing corruption
Highly decentralized implementation conditional on highly centralized personnel control

9. RDA as the institutional foundation for regional competition & regional experiment
Regional competition and regional experiment are the key reform strategies that make China’s market reform successful
Proper government support is a necessary condition for market development, the question is how
The RDA provides the institutional foundation for regional competition and regional experiment
Effective regional tournament competition requires
Officials’ career paths are linked to the performance ranking
Regions are alike in structure of regional economies
Regional competition => High powered incentives + autonomy => local governments initiate/implement reforms
Almost all early successful reforms were initiated by sub-national governments as regional experiments (e.g. HRS, SEZs, etc.)
Regional experimentation requires regional decentralization
Complementary tasks of an experiment in a region must be controlled by the sub-national government

10. Regional experiment is essential in pushing market reform forward
Without regional experiments market reform would not be started
Market reform is controversial (ideology and nested interests)
Under the “consensus based collective decision rule” every top leader can “veto” a market reform initiative
Experiment approach weakens political resistance to reforms
When a reform is tried only as regional experiments
When a new reform is an option: the dual track approach
Regional experiments lower risk of reforms
A failed experiment would not impact the national economy
Invite thousands of local officials to involve institutional innovations
Need locally invented new institutional arrangements to deal with intrigue political/incentive problems => new institutions
Locally initiated experiments have paved the road of national reforms
Land reform, special zones, TVEs (1980s); privatization, social security and large scale layoffs, industrial clusters (1990s); …

11. Regional competition is essential in pushing market reform forward
How to motivate government officials in reforming the institution in which they have nested interests determines the fate of the reform
Tournament-like regional competition provided powerful incentives to sub-national governments in early reforms
High powered incentives to take risks in experimenting reform policies locally
High powered incentives to implement tested experiment results
Regional competition is a de facto selection mechanism in regional experiments to contain negative impacts of conservative ideology
Some local experiments are not in market reform directions, but what matters in regional competition is performance
Among all experiments being tried, outcomes of market reform experiments often dominated others in regional competitions

12. Characteristics of China’s RDA Regime Compared with Other Regimes
Add the role of markets and how the political regime interactions with markets in the comparison

13. Decentralization and Incentive compatible reform
Why decentralization is crucial?
Incentive issue makes engineering approach (or central planning approach) of reform unfruitful
Reforming an institution affects and is affected by interests of stakeholders of this institution
Reforms ignoring interests of majority stakeholders of the existing institution will fail
Local incentive problems and local institutional arrangements varies greatly over the nation
Local history determines local stakeholders interests
A decentralized evolutionary approach is more likely to be incentive compatible and to fit with local conditions
Decentralized institutional innovations are essential in dealing with local problems
Most successful reform policies were evolved in the process of resolving local incentive and coordination problems

14. Why decentralization functioned in China
“China is the only country [in the world] where the local governments have played a leading role in increasing rates of growth” (Bardhan and Mookherjee, 2006)
What institution of China contributes this?
The national government is sufficiently strong
To keep political and economic stability
To keep macro control
The central government’s objective
Priority on growth and economic efficiency
Preference in supporting market economy
Subnational governments are enabled: they have controls over sufficient amount of resources in wide ranges
A condition for regional competition/experiment
Particularly important when many markets are to be developed
Subnational governments are empowered: they are authorized to take reform initiatives or development-enhancing initiatives 14 14

15. Enablement of subnational governments
Enablement of subnational governments is almost overlooked in the literature
Enablement does not come out automatically with empowerment
Enablement is a necessary condition for commitment and institutionalization of decentralization
Not enabled subnational governments would not be able to take policy actions and decentralization would not work even when they are empowered legally
The high degree of enablement of subnational governments is a powerful double-edged sword: it is also create serious problems in today’s China
Enabled to intervene judicial process: local courts are de facto (historically had been de jury) subordinates of local governments
Enabled to appropriate land: as de facto landlords
What does this powerful double-edged sword do depends on the nature of regional competition/experiment
It can be highly destructive as well

16. Grave problems created from regional competition: Multi-equilibriums under regional competition
Regional competition and experiment function well when there is single well-defined objective, e.g. GDP growth
When subnational governments have multiple tasks regional competition may lead to multi-equilibriums
Tasks in conflict with GDP growth are often ignored: e.g. inequality, citizens’ rights, environment, etc.
Subnational governments may race to the top/bottom for different tasks
Multi-equilibriums in regional experiments: what to be experimented are determined by the nature of the race
May experiment novel ways of corruption
May experiment how to block judicial independence
May refuse to promote tested welfare-enhancing policies
Race to the bottom in regional competition/experiment explains most of today’s serious socio-economic problems

17. An ultimate limitation of an authoritarian regime
A large number of performance indicators are used in assessing subnational governments; some of them are conflicting to each other
GDP, social stability, environment, family planning etc.
There are unsuccessful attempts of designing a comprehensive indicator which summarizes all relevant objectives, e.g. Green GDP
If this approach succeeded the multi-task problem would be resolved
Difficulties with this approach: information/incentive problem
Information related to market activities is summarized by GDP
To find correct information for activities unrelated to markets is challenging
If the information is used for incentives of local officials and if the information is only available locally, then local officials have incentives to distort the information
New incentive problems in solving multi-task problem

18. Marginal improvements as a transition
It may be possible to design some mechanisms to solve these new incentive problems, but these mechanisms may be very costly
A combined approach is to take away some tasks from subnational governments, which will substantially reduce the multi-task problem
Market activities should be separated from subnational governments
This will preserve strong incentives for firms when multi-task problem weakens subnational governments’ incentives
Responsibilities for those activities with strong cross-region externalities should be centralized or be regulated by the central
Tasks to be handled by the central should be divided into groups and handled by specialized ministries, special courts, and special regulatory regimes
Given the information problem, using a decentralized approach to preserve decentralization is likely to be more effective
Improving judicial independence and free press are among the most important fundamental reforms that China should take further

19. Judicial independence & free press
Chinese local courts had been subordinates of local governments
This de jury relationship is abolished officially but de facto local courts are often backyards of local governments
Without judicial independence the petition (上访) system is a chance for citizens to address their cases, but it does not work &getting worse
Judicial independence is a key to solve many “unsolvable” problems
Illegal land expropriation, rent-seeking, corruption
Measures to build judicial independence
Litigations against a local government should be allowed to be launched outside of the jurisdiction of this government
The appeal system should be re-built in order to check and constrain local governments’ abusing power
Monitoring via free press is a key to check and to constrain local governments effectively but there exist serious problems nationwide
Maintaining and improving judicial independence and free press should be major aspects of personal performance assessment; violations should be punished heavily

20. Concluding Remarks
China’s long run growth depends on its political stability
Conflicts between local government and citizens are getting worse in recent years – threatens social stability
Worsened strikes by workers’ being laid off
Worsened violent protests by peasants' losing land
Nervousness lead to tightened censorship
Ultimate solution: transform the RDA regime into a democratic federal state
Officials at all levels should be elected
Local governments should be accountable to their constituencies, not the upper level government
The multi-task problem of government officials will be transformed into one dimension, being elected

21. Increasingly intensified conflicts between local government and peasants
2010年1月11日江苏邳州市运河镇事件
Thank You