#2980 - Explain The Growth Of The Nonstate Sector And Later The Private Sector... - Chinese Economic History Since 1850

The non-state sector has featured as a vital organ of growth for the Chinese economy during the reform-era. There was a virtual non-existence of a private before the reforms at the end of 1978 (Naughton, 1995). In 1985, the non-state sector accounted for around 35 percent of China’s total industrial output and by 1999, it accounted for more than 72 percent. During the same period, an increase from 55 percent to 72 percent of total industrial growth was contributed by the non-state sector (Bai et al., 2001). Yet, in recent years, growth in the private sector has declined, and this change in momentum is important to consider.

It is fundamental to first define what is meant by the non-state sector before examining its growth. The non-state sector in its simplest form can be taken to mean enterprise not in the state sector. However this is ambiguous. Therefore, it should be clarified that the non-state sector, when discussed by most economists and academics, refers to all enterprises excluding those in which the state exercises controlling ownership. With this clarification in mind, it is possible to explain more precisely, the growth of the non-state sector.

Naughton (1995) argues that the growth of the non-state sector can only be understood in the context of the transformation of the overall system. This approach provides an excellent starting point for evaluation of the non-state sector growth over the last three decades and later the private sector. Two key explanations for the initial rapid growth path are proposed. Firstly, an evident shift in rural policy from the late 1970’s provided far-reaching benefits for the non-state sector. Secondly, the transitional system paradoxically created the conditions for growth. Furthermore, the same system can be used to explain the decline in growth of the legitimized private sector over more recent years.

Following the Third Plenum in 1978, Chinese policy towards the rural areas was “radically transformed” (Naughton, 1995). Despite the primary objective being to raise rural income by transferring income-generating activities to the countryside and improving prices, there were significant benefits for the non-state sector. Most importantly new sources of investment were created and the monopoly powers of state-owned enterprises (SOEs) were reduced, though nowhere near to market economy standards.

Raising agricultural prices, reducing extraction from rural areas and increasing state investment in agriculture essentially led to a decrease in the effective tax rate on the rural sector. By increasing the flexibility of the agricultural sector and lowering the playing field in which it interacted with the more advantaged urban industries, the new policies introduced incentives for experimentation and increased productivity. This experimentation ultimately led to the percentage of households participating in household farming increasing from just 1% in 1979 to 99% in 1984 (Lin, 1992) and agricultural output subsequently soared. As a result, total household saving climbed from 7% of income in 1978 to 17% in 1982. (Naughton, 1995). Given that rural extraction by the central government was relaxed, a new source of income and thus potential investment now existed within the rural areas. This created a viable capital base from which the non-state sector could grow.

The benefits for the non-state sector of higher household savings were realized because of central government policy on rural enterprise and the implicit step-back from SOEs. In 1979 a policy was laid out which stated “We should raise the share of commune and brigade enterprises in the total gross income… from 29.7% in 1978 to around 50% in 1985” (State Control document on township and village enterprises). This new emphasis on township and village enterprises (TVEs) reduced the major barrier to entry for the non-state sector, by taking some income earning potential away from the monopolistic SOEs whilst increasing the legitimacy of the non-state sector.

The shift in rural policy created the potential for the growth of the non-state sector by leveling the playing field, and it was certainly the catalyst that kick-started its rapid growth. However, the foundations and mechanisms for growth lay in the transitional system and institutions in China.

The traditional institutions which were in transition in China during the beginning of the reform-era, provided much of the momentum for the rapid growth in the non-state sector in the 1980s and early 1990s. Without the distortions that the transitional institutions created, the growth of the non-state sector during its initial stage would have been much more muted. Given the pervasive disadvantages that the non-state sector had in comparison to the SOEs, for financial and legal matters, it is hard to wonder how the non-state sector managed to grow. However, the same system that provided the non-state sector with its inherent shortcomings provided the basis for the rapid initial growth. The most significant of these were intra-governmental decentralization and information decentralization (Bai et al., 2001).

Intra-governmental decentralization was a key policy during the late 1970s to late 1990s. Although primarily used as an economic tool and as a way of keeping the finely-tuned nomenklatura intact, decentralization within government created favourable distortions for the non-state sector. Local governments gained abilities and incentives to develop local businesses. Although local governments could not help the non-state sector overcome the entry restrictions for some industries that central government controlled, the rent-seeking opportunities that private enterprises provided for them were incentivizing. Through supporting local private businesses (helping them avoid regulations and taxes and providing them with access to local financing) local governments helped the non-state sector grow. Although this support was often in return for some control and economic benefits (sometimes in individuals), this proved a mutually beneficial arrangement, and the non-state sector was free to flourish.

A further benefit that the transitional institutions provided for the non-state sector were central government reforms that decentralized the flow of information. During the reform era the Chinese government gradually reduced the monitoring of transactions by the banking sector and allowed cash to be used for many business transactions. This created a form of anonymous banking (Bai et al., 2000) which favoured the non-state sector considerably. Private enterprises would certainly have taken advantage of this and were able to evade taxes by hiding transactions and profits. Bai et al. argue that effective tax rates were therefore much lower than what they officially were and so the non-state sector grew partly because of this.

Therefore, although the shift in rural policy provided the catalyst for growth in the non-state sector, the traditional system that was under transition to being increasingly decentralized provided significant distortions that helped the non-state sector grow more than was otherwise possible. However, only temporary growth...