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Corruption and China’s Economic Reform
in the Early 21st Century
by
Gregory C. Chow, Princeton University
CEPS Working Paper No. 116
October 2005
Acknowledgement: I would like to thank Steven Kou of Columbia University and Yan Shen of Peking
University for helpful comments and the Center for Economic Policy Studies at Princeton University for
financial support in the preparation of this paper.
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Abstract
Past economic reform of the state sector in China consisted mainly of privatization, of
agriculture and of small and medium-size state enterprises, leaving large state enterprises
in the control of the state. Current reform consists of making state-owned enterprises and
banks more efficient and functioning like private enterprises, and gradual privatization of
some large state enterprises. Bureaucrats managing state assets and the selling of assets
take advantage of such power to benefit themselves, including embezzlement of public
funds and taking bribes from citizens needing their help, as can be found in state
enterprises, state-owned commercial banks and in government projects. Reducing the size
of the government sector is a basic solution to the corruption problem in China while
attention should be paid in the privatization process which can involve corruption.
Outline
1. Introduction
2. Review of Past Reform Measures and Current Problems
3. Enterprise Reform Hindered by Bureaucratic Behavior
4. Reform of Banking and Financial System Hindered by Corruption
5. East-West Income Inequality and Western Development Hindered by Corruption
6. Reform of the Legal System
7. A Theory to Explain Bureaucratic Behavior and Corruption
8. Policy Recommendation
1. Introduction
Reform of China’s economic institutions since 1978 has been a gradual process. A major
theme of this paper is that corruption, while not a major hindrance to economic reform in
the past, has become a major hindrance to further reform at the beginning of the 21st
century. The subject of this paper is the role of corruption in further economic reform in
China, and not the economics of corruption per se. Svensson (2005) is a recent paper
dealing with the subject of corruption and includes a number of references but the current
paper is self-contained in discussing our own topic.
I begin by reviewing China’s economic reform and growth since 1978 and pointing out
the main characteristics of reform, the fundamental factors accounting for rapid growth
and the current shortcomings of China’s economic institutions (section 2). With this
survey as the background I go on to examine the problems facing further reform of
different institutions, including the state-owned enterprises (section 3), the banking and
financial system (section 4), the disparity among regions (section 5), the legal system
(section 6). I then offer a theoretical explanation of one importance hindrance to further
reform, namely bureaucratic behavior and corruption on the part of government officials
and managers and staff of state-owned economic institutions (section 7). A
recommendation to reduce bureaucratic behavior is offered in section 8.
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At the outset I would like to point out that the methodology of this paper is different from
the standard approach to empirical economic research, namely, formulation of a
hypothesis followed by empirical testing. We do advance the hypothesis that corruption
is an important hindrance to further economic reform, but do not formulate it in
econometric terms for statistical testing. Many applied economic theorists also formulate
hypothesis to explain economic phenomena without statistical testing. We differ from the
applied theorists in that we do not have a formal mathematical model in the formulation
of our hypothesis and do not use mathematics to deduce implications from the hypothesis
since it is so simple. Given the fact that law enforcement is ineffective when the benefit
of violation is high or when there is a culture of law violation, in China and elsewhere,
we can immediately deduce the implication that the introduction of corporate governance
to state-owned institutions where the officials involved can benefit greatly from violation
or are accustomed to violation will have limited effect. Hence further reform of state-
owned enterprises will proceed only slowly. How useful this paper is depends on the
relevance of the above proposition that corruption is difficult to stop and is a major
hindrance to further economic reform, the importance of the cases in economic reform
affected by corruption that the paper has assembled and the ability to provide a unified
explanation of these cases. A major reason why corruption is now a serious problem for
reform and not before is that much of previous reform of the state sector consisted of
privatization while the current reform consists of changing the performance of the
remaining large state-owned institutions which are controlled and operated by
bureaucrats who could profit from their economic power through corruption.
2. Review of Past Reform Measures and Current Problems
Since economic reform began in 1978, China has become a more market-oriented
economy and its real GDP has increased at an annual rate of about 9.4 percent per year.
The Chinese government deserves credit in guiding economic reform but the rapid
growth is due to three fundamental economic factors. Given the existence of political
stability, these factors are the abundance of high-quality human capital, including both
the skilled and hard-working labor force and the resourcefulness of the entrepreneurs, the
market institutions established even if they are imperfect and the availability of modern
technology and method of management which China can adopt as a new comer. The
same three economic fundamentals had accounted for the rapid economic growth in
Japan before and after the Second World War, Hong Kong, Singapore, Taiwan and South
Korea about two decades before China. In this sense, the Chinese success in rapid
economic growth is not a miracle but consistent with the experience of economic
development of other countries. When we examine the failure of a politically stable
developing country in achieving rapid economic growth I suggest that we look closely at
the first two factors for that county and see which it may be lacking.
Many observers have pointed out the major difference between China’s reform process
which is gradual and pragmatic (based on experimentation rather than ideology) and
reform in the former Soviet Union and some other Eastern European countries which
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adopted rapid changes in economic institutions (such as rapid privatization of state-
owned enterprises) as a form of “shock therapy.” I will not comment further on this point.
Rather I will characterize China’s strategy for economic reform by the following three
main principles.
First is the use of the principle of “leasing” for the operation of state-owned assets. This
idea is called the “responsibility system” in China since the management is given the
responsibility to operate the enterprise and the right to all the residual claims to the
earnings after delivering a fixed rent to the government. The first application of this
principle is the “household responsibility system” in agriculture introduced in 1978 when
farm households were assigned publicly owned land to produce for their own benefits
after paying a fixed amount of the product as rent. Since all the output produced by extra
efforts belongs to the producer, the incentive for the producer under this leasing
arrangement is high. The same principle was applied to the leasing of state retail stores,
small factories and in 1987 to large state enterprises under the “contract responsibility
system” where the management received all residual profits for use by the enterprise after
paying a fixed tax to the government. Even public schools have been leased out to be
operated by private educators.
For the principle of leasing to yield efficient allocation of resources prices have to be set
by the forces of demand and supply. Before price reform was completed in the 1980s and
early 1990s, a supplementary principle to the first is the use of a dual price system, with
the below-market fixed prices applied to the purchase of fixed amounts of scarce
resources allocated by the state while the remaining quantities of output were sold at
market prices. A fixed subsidy does not affect economic allocation if market prices are
used for marginal decisions on the use of inputs and the production of outputs.
The second principle to promote efficiency for state-owned enterprises is to introduce
competition, from other state-owned enterprises, collectively, privately and foreign
owned enterprises. The third principle is to allow and even encourage the development of
a non-state sector which became dominant and accounted for much of the total output and
its rapid growth in China.
It is easy to answer the question whether China’s economy will continue to grow from
2006 on. The answer is yes, because the three economic fundamentals will continue to
operate except that the third factor will gradually be weakened as China’s technology gap
will gradually be closed. A counter argument is to point to the shortcomings of China’s
market institutions, including in particular the state-owned enterprises, the banking and
financial system and the legal system, which may inhibit growth. Observe first that the
Chinese economy has grown so rapidly in the past despite such shortcomings, suggesting
that these shortcomings do not necessarily prevent rapid growth. Those who disagree
need to provide reasons for the difference in the current circumstances that will make the
shortcomings more damaging for China’s economic growth and development. After all,
most economic institutions in the world’s market economies have their shortcomings
also.
The major factor that will hinder further economic reform in China, in my opinion, is the
bureaucratic behavior and corruption of government officials. In Chow (2002) I have
called China’s economy a “bureaucratic market economy.” It is the main purpose of this
paper to develop that theme further and examine the effect of bureaucratic behavior on
further economic reform and development.
I can easily predict that further reform is gradual and slow, as in the past, mainly because
there is inertia due to vested interests of the bureaucracy and because culture (including
the nature of human capital) is difficult and slow to change. However, slow reform will
not inhibit rapid growth in the future as it did not in the past. While confident about the
future growth I am trying to examine in this paper the slow reform process in the future
as a result of bureaucracy. Reform of economic institutions can be effective only when
the people are ready for it.
Besides slow economic reform which some, though not the present author, will consider
detrimental to further development, there are the following two concerns that further
development may be derailed. Let me first comment briefly on these concerns before
proceeding to the main body of this paper. First, China’s economic development may not
be “sustainable.” The word “sustainable” applies to the limit of energy supply and the
damage to the environment during economic growth that will make further growth
impossible or difficult. Most economists do not share this view. While economists pay
serious attention to the problems of the environmental degradation and resource supply
limitation they believe that the problems are soluble. On the environment, a developing
