Lujiazui, a financial center in Shanghai that has been transformed from a rural area to a district with gleaming skyscrapers over the past four decades Photo: TUCHONG

The rise of the economics of transition in China preceded its emergence in the international economic community, a fact well-supported by evidence. Although a few foreign economists at the time were examining certain aspects of China’s economic reforms and publishing research on them, the economics of transition did not develop into a research field within the international economics community until the large-scale economic transitions in the Soviet Union and Eastern Europe around 1990 attracted international attention. In particular, in the initial stages of their transitions, those countries all experienced economic recession without exception, especially in Russia. These transitions, particularly the severe economic downturns that accompanied them—most notably in Russia—challenged the assumptions of mainstream Western economists, who had not anticipated such outcomes based on their understanding of Soviet-style economic planning and economic transitions.

In his paper on the nature of the Soviet-style economic systems and their implications for reform, American economist Richard E. Ericson highlighted that the planned economy has its own inherent logic, and partial reform would not work. Only an overhaul of the planned economy, replacing all its components, could create room for a functioning market-based system. According to Ericson, reforms had to be leapfrog-style and large-scale, and involve the complete abandonment of previous economic, social, and political structures, as a step-by-step reform approach was unlikely to succeed.

At this time, the positive developments in China’s economy and its unique reform strategy began to attract the attention of international economists. A particularly compelling question was why China’s reforms managed to avoid the economic downturns experienced elsewhere. What had China done right, and what important factors had economists overlooked?

Different starting points for reforms

In 1994, the Organization for Economic Co-operation and Development (OECD) in Paris, France, published a collection of papers focusing on China’s economic reform, titled From Reform to Growth: China and Other Countries in Transition in Asia and Central and Eastern Europe. Its editors, Chung H. Lee and Helmut Reisen, pointed out in the introduction that enough time had passed for economists to evaluate the empirical evidence on different transition approaches. Regardless of the reason, the difference in impact between the two approaches was striking: China’s GDP had grown at an average rate of over 8% over the past decade, while Russia and Central and Eastern European countries had experienced production declines ranging from 15% to 50% over the past four years. This disparity makes comparing the transition experiences of these countries and extracting lessons valuable to other transitional economies.

Economists Wing Thye Woo and Jeffrey Sachs argued in 1994 that the difference in performance between Russia and China during the early stages of transition can be simply attributed to different starting points for reforms. In the Soviet economy, the proportion of planned control was far greater than in China before 1978. China, predominantly an agrarian country with a level of agricultural labor similar to that of Russia in 1910, had not yet undergone the urbanization and industrialization that the Soviet Union and Eastern Europe had completed. This made China’s reforms resemble the classic “dual-sector model” discussed in development economics. In other words, China and the Soviet Union and Eastern Europe began their respective reforms at very different stages of economic development. Woo and Sachs believed that the latecomer advantage helps explain that the success of China’s reforms was not because gradualist or experimental reform approaches were suitable, but because China’s initial economic structure became an advantage in the process. This is a conclusion supported by the reform experiences of other East Asian countries and regions. It is precisely the difficulty of this structural adjustment that made market reforms in the Soviet Union and Eastern Europe much more arduous than in China.

A gradualist reform strategy

However, emphasizing the importance of initial conditions does not negate the importance of partial, gradualist reforms in achieving successful transitions. One obvious outcome of implementing a “big-bang” approach is that the original state-owned industries may behave monopolistically, rather than spontaneously forming competitive market structures. In our paper, my co-authors and I have argued that unless a new private sector has already been expanded through local reforms, the rapid “entry” of private enterprises may slow due to immature capital markets in the early stages of transition, meaning radical reforms will not immediately create a decentralized competitive market structure. According to this viewpoint, a reasonable reform strategy should be to gradually reduce the state sector’s dependence on planning while allowing the development and market access of the non-state sector. Therefore, the success of China’s economic reforms is not solely due to favorable initial conditions; it is also largely the result of effectively implementing a practical gradualist reform strategy.

Even from the perspective of macroeconomic stabilization, China’s marginalist incremental reform approach is an important strategy worthy of attention and reference. Ronald I. McKinnon’s “Gradual versus Rapid Liberalization in Socialist Economies: The Problem of Macroeconomic Control” offers valuable insights into this issue. In this paper, McKinnon compared the impact on macroeconomic stability exerted by the macroeconomic stabilization policies under the radical reform approach and China’s gradualist approach, respectively. This paper found that China’s fiscal policies were very similar to those adopted in the Soviet Union and Eastern Europe, and, like the latter, China’s public finance situation (such as the share of government finances in the GNP) deteriorated sharply after the reforms. However, from 1978 to 1992, China underwent a gradual liberalization process with a fairly stable price level, while Russia and Eastern European countries that adopted radical liberalization after 1989 faced very serious inflation.

Dual-track transition model

McKinnon found that the answer to the enigma of China’s economy lies in its dual-track transition model, particularly in the reform strategy of dual-track pricing for traditional state-owned enterprises (SOEs). He wrote that “at the outset of the liberalization in the early 1980s the SOES were not permitted to bid freely with each other for scarce domestic resources or to bid unrestrictedly in an open market for foreign exchange. Producer prices in transactions among SOEs remained under centralized control and were only gradually phased out as the decade progressed. However, the government allowed a two-part pricing system to develop. Once SOEs had satisfied their delivery commitments to each other at centrally controlled prices, they could sell at the margin any excess production to the rapidly growing non-state enterprises at market-determined—and usually somewhat higher—prices.” According to McKinnon’s analysis, it was exactly this transitional strategy of dual-track pricing implemented in the early stage of reform that allowed China to avoid resorting to the “inflation tax.” This approach, McKinnon argued, could also be adopted by other transitional economies.

As early as 1992, three American economists published a paper in The Quarterly Journal of Economics, arguing that the failure of the Soviet Union’s partial marketization reforms (1985–1991) might be attributed to the reformers’ inability to continue fulfilling their core obligations in allocating essential means of production. Consequently, after the reforms, some key providers of means of production were free to decide to whom they sold, while private enterprises were also free to obtain them at market prices. However, price control remained in place for the state sector. Constrained by the original planned system and price controls, SOEs were unable to compete with private enterprises for various means of production, leading to stagnation. At the same time, a significant proportion of essential means of production flowed from SOEs to the weaker private sector. In their paper, they observed that China also took the partial reform approach, but with one exception: the Chinese central government continued to maintain very strict enforcement of the nation’s planned quotas, allowing enterprises to sell only the portion of output exceeding the state quotas to private buyers. As a result, the government effectively controlled input loss. In contrast, the Soviet government nominally retained the allocation quotas for SOEs, but in practice significantly relaxed their enforcement of the plan.

The fulfillment of planning obligations is vital for preventing supply loss and economic decline during a transition. However, this obviously depends on political conditions. China advanced partial reforms within its existing political system, administrative structures, and power structures, thereby maintaining government authority and leveraging existing political and organizational resources.

Thirty years later, the high tide of the economics of transition has receded. The journal Economics of Transition has become Economics of Transition and Institutional Change, which indicates that the economics of transition can and should be included as an important part of theories of institutional change. Theories of institutional change offer a more general and expansive framework concerning institutions and economic development. This shift will also provide more opportunities for Chinese economists. In fact, China’s successful economic transition and development have not only created historical opportunities for Chinese economists to contribute to the field of the economics of transition but also, as China rises to the status of an economic power globally, provided strong incentives for Chinese economists to expand their research perspectives and analytical scope in the study of institutional change and economic development.

Zhang Jun is dean of and a professor from the School of Economics at Fudan University.