China's Development Challenges: Economic Vulnerability and Public Sector Reform (Routledge Studies on the Chinese Economy)

China’s Development Challenges

This book argues that a major potential source of social tension in transition and developing countries is not poverty as such, but vulnerability to poverty, despite high growth rates. It demonstrates how, in China, many of the recent reforms to the public sector (such as decentralization from central to local government; the reduction in public services provided by the state; the increasing practice of local governments charging formal and informal fees for basic services which were previously freely accessible; de-collectivization of the rural commune system and market sector experimentation in Economic Processing Zones) have made many households extremely vulnerable to poverty. Having to find funds to pay for health and education leaves households and migrant families exposed should macroeconomic fluctuations related to factors such as trade, resource imports, and financial volatility have an adverse impact on the Chinese economy overall. This book argues that to become less vulnerable to macroeconomic shocks China will need to shift from an export oriented development strategy to a domestic consumer demand-driven development strategy, and this would need to be supported by public sector reforms, i.e. strengthening of public service provisions in the health and education sectors as well as expanding social security programs. The book discusses these problems, relates them to the economic literature and outlines the likely consequences. Richard Schiere works for the African Development Bank Group. He designed and implemented the China-Africa research programme. He started his career at the United Nations in Cambodia and then in their headquarters in New York. He has a PhD in Development Economics from CERDI-CNRS, University of Auvergne, France.

Routledge Studies on the Chinese Economy Series Editor Peter Nolan, University of Cambridge

Founding Series Editors Peter Nolan, University of Cambridge and Dong Fureng, Beijing University

The aim of this series is to publish original, high-quality, research-level work by both new and established scholars in the West and the East, on all aspects of the Chinese economy, including studies of business and economic history. 1. The Growth of Market Relations in Post-reform Rural China A micro-analysis of peasants, migrants and peasant entrepreneurs Hiroshi Sato 2. The Chinese Coal Industry An economic history Elspeth Thomson 3. Sustaining China’s Economic Growth in the Twenty-First Century Edited by Shujie Yao & Xiaming Liu 4. China’s Poor Regions Rural-urban migration, poverty, economic reform and urbanisation Mei Zhang 5. China’s Large Enterprises and the Challenge of Late Industrialization Dylan Sutherland 6. China’s Economic Growth Yanrui Wu

7. The Employment Impact of China’s World Trade Organisation Accession A.S. Bhalla and S. Qiu 8. Catch-Up and Competitiveness in China The case of large firms in the oil industry Jin Zhang 9. Corporate Governance in China Jian Chen 10. The Theory of the Firm and Chinese Enterprise Reform The case of China International Trust and Investment Corporation Qin Xiao 11. Globalisation, Transition and Development in China The case of the coal industry Huaichuan Rui 12. China Along the Yellow River Reflections on rural society Cao Jinqing, translated by Nicky Harman and Huang Ruhua

13. Economic Growth, Income Distribution and Poverty Reduction in Contemporary China Shujie Yao 14. China’s Economic Relations with the West and Japan, 1949–79 Grain, trade and diplomacy Chad J. Mitcham 15. China’s Industrial Policy and the Global Business Revolution The case of the domestic appliance industry Ling Liu 16. Managers and Mandarins in Contemporary China The building of an international business alliance Jie Tang 17. The Chinese Model of Modern Development Edited by Tian Yu Cao 18. Chinese Citizenship Views from the margins Edited by Vanessa L. Fong and Rachel Murphy 19. Unemployment, Inequality and Poverty in Urban China Edited by Shi Li and Hiroshi Sato

22. Poverty and Inequality among Chinese Minorities A.S. Bhalla and Shufang Qiu 23. Economic and Social Transformation in China Challenges and opportunities Angang Hu 24. Global Big Business and the Chinese Brewing Industry Yuantao Guo 25. Peasants and Revolution in Rural China Rural political change in the North China plain and the Yangzi Delta, 1850–1949 Chang Liu 26. The Chinese Banking Industry Lessons from history for today’s challenges Yuanyuan Peng 27. Informal Institutions and Rural Development in China Biliang Hu 28. The Political Future of Hong Kong Democracy within Communist China Kit Poon

20. Globalisation, Competition and Growth in China Edited by Jian Chen and Shujie Yao

29. China’s Post-Reform Economy – Achieving Harmony, Sustaining Growth Edited by Richard Sanders and Chen Yang

21. The Chinese Communist Party in Reform Edited by Kjeld Erik Brodsgaard and Zheng Yongnian

30. Eliminating Poverty Through Development in China China Development Research Foundation

31. Good Governance in China – A Way Towards Social Harmony Case studies by China’s rising leaders Edited by Wang Mengkui 32. China in the Wake of Asia’s Financial Crisis Edited by Wang Mengkui

35. Financial Sector Reform and the International Integration of China Zhongmin Wu 36. China in the World Economy Zhongmin Wu

33. Multinationals, Globalisation and Indigenous Firms in China Chunhang Liu

37. China’s Three Decades of Economic Reforms Edited by Xiaohui Liu and Wei Zhang

34. Economic Convergence in Greater China: Mainland China, Hong Kong, Macau and Taiwan Chun Kwok Lei and Shujie Yao

38. China’s Development Challenges Economic vulnerability and public sector reform Richard Schiere

China’s Development Challenges Economic vulnerability and public sector reform

Richard Schiere

First published 2010 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon, OX14 4RN Simultaneously published in the USA and Canada by Routledge 270 Madison Avenue, New York, NY 10016 Routledge is an imprint of the Taylor & Francis Group, an informa business This edition published in the Taylor & Francis e-Library, 2009.

To purchase your own copy of this or any of Taylor & Francis or Routledge’s collection of thousands of eBooks please go to www.eBookstore.tandf.co.uk. © 2010 Richard Schiere All rights reserved. No part of this book may be reprinted or reproduced or utilized in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. The views expressed in this book are those of the author only, and the presence of them, or of links to international organizations and regional development banks such as the United Nations and the African Development Bank Group, does not imply that these organizations, their Executive Boards, or their managements endorse or share the views expressed in the book. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data Schiere, Richard. China’s development challenges : public sector reform and vulnerability to poverty / Richard Schiere. p. cm. – (Routledge studies on the Chinese economy; 38) Includes bibliographical references and index. 1. Poverty – China. 2. China – Economic policy. 3. China – Social conditions. 4. China – Economic conditions. I. Title. HC430.P6S35 2010 338.951 – dc22 2009028600

ISBN 0-203-86124-8 Master e-book ISBN

ISBN10: 0–415–47865–0 (hbk) ISBN10: 0–203–86124–8 (ebk) ISBN13: 978–0–415–47865–6 (hbk) ISBN13: 978–0–203–86124–0 (ebk)

Contents

Foreword and acknowledgement Preface Abbreviations

ix xi xiv

PART I

General introduction on the developmental challenges of China 1 2

China’s reforms in transition and development perspective The evolution of poverty and inequality since the opening-up period

1

3 22

PART II

Managing vulnerability and increasing livelihood opportunities 3 4 5

35

Macroeconomic vulnerability and managing the risk of interdependence

37

Reducing household vulnerability and increasing livelihood opportunities

54

Estimating regional vulnerability and inequality

68

PART III

Public sector reforms, fiscal decentralization and social security 6

Fiscal decentralization and public service provision reforms

83

85

viii

Contents

7

Establishment and expansion of social security

101

8

The impact of public sector reforms on vulnerability

117

Conclusion Notes Bibliography Index

129 133 135 151

Foreword and acknowledgement

The recent development of China is truly fascinating. Historically speaking, there has never been such a massive poverty reduction and economic growth in such a short period. Through its accomplishments, China has transformed from a poor state-planned oriented economy to a country that provides additional financial resources to global governance institutions such as the IMF and strengthen its voice in the World Bank. These successes are even more remarkable as this country had to overcome transitional challenges (i.e. domination of state sector, political economy of state-owned enterprises, lack of institution for “pricing”, etc.) as well as developmental challenges (i.e. largely an agricultural based production sector, lack of physical infrastructure, overpopulation, high rate of migration and urbanization, low education level, etc.). China is at a crossroad in its economic development strategy. Previously the country had pursued an aggressive export oriented development strategy, which was at the heart of high economic growth and poverty reduction. This has led to dependence on foreign export markets as well as exposure to assets denominated in US treasury bills, which became evident in the wake of the 2008 financial crisis. To reduce this vulnerability would require a reorientation of the development strategy towards a domestic demand-driven growth based on consumer spending. Internationally this rebalancing would be well received, as one of the reasons that caused the crisis was the fundamental mismatch in the balance of payments between China and the United States. This led to too much liquidity in financial markets and loose monetary policy in the United States which, in combination with far reaching deregulations, encouraged a speculative housing boom. In short, one of the main causes of the 2008 financial crisis was over-consumption (and lack of savings) by America, and over-saving (and lack of consumption) by China. During the past few years China’s development, and its impact on global affairs as well as an other developing countries, has been the subject of my academic and professional life. This acknowledgement would not be

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Foreword and acknowledgement

complete without mentioning my family, mother, father and brother who not only patiently listened to my endless “vulnerability”, “public sector reform” and “China” stories but also never failed to encourage me to continue on the chosen path. I also want to thank my new born daughter for giving me the energy to stay awake at night. Finally, and foremost, I have to thank my wife, Yukiko, who provided comfort in times of uncertainty and was more convinced than anybody, not only that I could complete this book but also that the book needed to be completed.

Preface

China’s developmental successes in the last three decades resulted in an exponential increase in wealth and a decrease in poverty. At the beginning of transition in 1978, China had a poor state-driven economy with an autarchist development model and was still suffering from the aftermaths of the Cultural Revolution. Three decades later China is an emerging global power which is reshaping the global financial architecture by alleviating funding shortages of the IMF and strengthen its voice in the World Bank. Moreover, Chinese sovereign wealth funds are also investing in private financial institutions (such as Morgan Stanley) that have felt the brunt of the 2008 financial crisis. The 2008 financial crisis and the subsequent economic downturn have placed vulnerability and public sector reform at the forefront of the policy debate in China. This is the case for both macroeconomic vulnerability which focuses on aggregated and nationwide risks, and household vulnerability that highlights the difficulties of risk management at family level. Macroeconomic vulnerability stems from the growth of interdependence between China and the rest of the world. On the import side, China became vulnerable as it had insufficient primary commodity resources (petrol, nickel, iron, ore, etc.) to fuel its industrialization efforts. This led to strengthening of bilateral relations with resource-rich countries in Africa, Latin America and Asia. These investment, trade and aid relationships are not accompanied by human rights and good governance criteria as is the case with traditional multilateral development banks. This shift is sometimes referred to as the “Beijing consensus” by recipient countries. On the export side, China became vulnerable to export markets and FDI inflows, which was an inherent part of the export oriented development strategy. Although this export oriented development strategy was at the heart of high economic growth and poverty reduction in the first three decades of transition, it also meant that job opportunities were linked to demand from foreign markets for Chinese goods. As the 2008 financial crisis

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Preface

unfolded, it became evident that migrant workers and graduate students would especially feel the brunt of economic downturn, despite the massive 4 trillion Yuan stimulus package and the accompanying 5 trillion Yuan in soft loans provided by the Chinese banks. Within a fiscal decentralized state with a centralized authority, this stimulus package could lead to unproductive investment, local protectionism and an increase in Non Performing Loans. This combination could threaten social stability and the development of a harmonious society. Another source of macroeconomic vulnerability related to the export oriented development strategy is that this policy led to the build-up of enormous foreign exchange reserves of nearly US$ 2 trillion, which are mainly invested in treasury bills of the United States. This led to another source of national vulnerability as these assets are exposed to the potential threat of inflationary policies in the United States which might be necessary to fund its fiscal stimulus as well as the recapitalization of its banks. For China to become less vulnerable to macroeconomic shocks would require shifting from an export oriented development strategy to a domestic consumer demand-driven development strategy. This would have to be supported by public sector reforms, in particular the strengthening of public service provisions in the health and education sectors, as well as expanding of the social security program. These public services provisions and social security programs have been abolished or restructured in such a way that large parts of the population were excluded from these interventions, in particular the 130 million migrants as well as most of the rural population. The lack of access led to a substantial increase in household vulnerability during the transition period. Reducing household vulnerability would have to focus on expanding basic safety-net provisions which would decrease household vulnerability to ill health and accidents. Besides the positive effects of wealth redistribution on social stability, this will also translate into reduced saving by households and more consumer spending. In turn, this is key to shifting growth opportunities away from an export oriented development strategy to a domestic demand-driven consumer spending. Reducing household vulnerability would also require addressing a range of issues such as the environment management and citizens’ participation in decision making processes so that households can defend their interests in the public domain. These issues will be addressed gradually through policy experimentation at local level, and if successful, this will form the blueprint that would be implemented at national level. To implement these public sector reforms would require more involvement of the central government in providing public service provisions as well as in implementing social security programs. Although this would be

Preface

xiii

somewhat contradictory to the fiscal decentralized nature of the state in China, more central government involvement could address a wide range of issues which are currently difficult to address due to a weak tax base or inadequate capacity at local level. Furthermore, local government has an additional burden of “transitional debt”, which was created by supporting loss-making state-owned enterprises (SOEs) and continuously providing social security to urban workers even if the original company went bankrupt. Finally, a centralized approach would facilitate providing a basic safety-net for the migrants who frequently change jobs and work in different regions of the country. This is critical for the development of a harmonious and stable society in China.

Abbreviations

AIDS BRIC CCP CMS DAC EPZ EU FDI FE FFS FOCAC GDP GHG GNP HDI HIV ICA IMF NCMS NGO NIC OECD OLS PA RFR SARS SDR SEZ SOE TSS TVE

Acquired Immune-Deficiency Syndrome Brazil, Russia, India and China Chinese Communist Party Cooperative Medical System Development Assistance Committee Export Processing Zones European Union Foreign direct investment Fixed effect Fee For Service Forum on China-Africa Cooperation Gross domestic product Greenhouse gas Gross national product Human development indicators Human Immunodeficiency Virus International Commodity Agreements International Monetary Fund New Rural Cooperative Medical Scheme Non-governmental organization Newly industrialized countries Organization for Economic Co-operation and Development Ordinary least square Productive assets Rural fee reforms Severe Acute Respiratory Syndrome Special Drawing Rights Special Economic Zones State-owned enterprises Tax sharing system Township Village Enterprise

Abbreviations UNDP VAT WHO WTO

United Nations Development Programme Value added tax World Health Organization World Trade Organization

xv

Part I

General introduction on the developmental challenges of China Introduction In the last three decades, China has made remarkable progress in overcoming transitional challenges (i.e. domination of state sector, political economy of state-owned enterprises, lack of institution for “pricing”, etc.) as well as developmental challenges (i.e. largely an agricultural based production sector, lack of physical infrastructure, overpopulation, high rate of migration and urbanization, low education level, etc.). As part of the transition process, China’s international trade has grown exponentially and the country acceded to the World Trade Organization (WTO) in December 2000. The rapid economic growth also gave the country more political influence in global affairs, in particular with resource-rich developing countries in Africa, Latin America and Asia. Moreover, the 2008 financial and economic crisis could accelerate the debate on China’s re-alignment of economic weight with political influence, in particular as the economies of the United States of America and Europe shrink, China’s growth is continuing albeit at a lower rate. This trend will also result in a stronger voice for the country in the global financial architecture, most notably the IMF and World Bank. China’s rapid growth and poverty reduction can be attributed to incremental reform process as well as “a learning state”. This refers to a public sector which learns from previous mistakes and implements development policies that are successful, through experimentation of policies at local level. This started with the introduction of the household responsibility system at the beginning of the 1980s that led to massive rural poverty reduction. During this period, vulnerability did increase as social safetynet provisions were abolished or privatized. In essence, previously free social services became “commodities” for which citizens had to pay. In addition, Township Village Enterprises (TVE) were created. These public– private owned companies were highly successful in creating employment and producing consumer products that were often not manufactured by

2

General introduction on the developmental challenges of China

state-owned enterprises (SOEs). In the 1990s the reform process spread to the urban areas with the privatization of SOEs. Unlike rural areas, reform in cities was accompanied with social security programs (as urban industrial workers are more inclined to cause civil unrest) although in practice these safety-nets were often under-funded. Another adverse effect of the rapid economic growth was the rise in multidimensional inequality, which accelerated creating wealth in the eastern regions through the “coastal development” strategy. These inequalities created a large floating population of 130 million migrant workers and led to unequal distribution of human capital and reinforced the “twin-peak” poverty–growth path, in which inequality and economic growth increase simultaneously. The first part of the book is organized as follows. The first chapter, “China’s reforms in transition and development perspective”, emphasizes that the development success was the result of policy experimentation and how this contributed to economic growth and poverty reduction. It further highlights the importance of WTO accession and the impact of China on the international global financial architecture. Finally, this chapter compares China’s development experience with other transition and Asian countries. The second chapter, “The evolution of poverty and inequality since the opening-up period”, focuses on the link between the various reform initiatives and the poverty impact. It further highlights the impact of reforms on public service provisions in the health and education sectors, in particular the effect of user fees on vulnerable segments of the population such as the poor and migrants. Some of these issues are being addressed through the “new socialist countryside” in the Eleventh Five-Year Plan (2006–10).

1

China’s reforms in transition and development perspective

Introduction China is often viewed with admiration for its remarkable developmental successes, not only because of its massive reduction of poverty and high level of economic growth, but also as this country is steadily increasing its global influence. However, successful outcomes of the reforms were by no means clear cut and predictable. At the beginning of the reform in 1978, China was still in the aftermath of the Cultural Revolution which severely distorted social and economic structures. What sets China’s development apart from the reform of many other transition and developing countries, was its cautious and slow pace as well as its decentralized policy experimentation. This meant that policies were first tried out at provincial level. If successful, they were subsequently adopted at national level. Moreover, the slow pace of reform created a political economy in which the vested interest groups such as the communist party elite, the bureaucracy, as well as society at large could support the liberal reform agenda. The final step in transition was the accession into the World Trade Organization (WTO), which required both deepening of the market based allocation system as well as internationalization of the economy. Moreover, this international treaty effectively “locked” China “in” a market based economic system. The emergence of China as an economic and financial power was further enhanced in the wake of the 2009 G-20 summit in London, which highlighted China’s important role in the global financial architecture. The success of China is more striking when considered in the perspective of its overall transitional and developmental challenges. The remainder of this chapter is organized as follows. The first section, “Reasons for reforms”, highlights the difficulties as well as the political economic effects of the disastrous great leap forward and the Cultural Revolution. The second section, “Overview of social-economic developments during transition”, provides an overview of the transition and development challenges of China. The third section, “WTO accession as the

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General introduction on the developmental challenges of China

end of transition”, emphasizes that the transition from a planned economy towards a market-driven allocation system will likely come to an end as this accession “locked-in” the market based allocation system and private ownership. The fourth section, “The emerging role in the global financial governance architecture”, highlights the important role of China in the world, in particular in the wake of the 2008 financial crash, which triggered an unprecedented economic crisis with massive repercussions. The fifth section, “China as a transition country”, highlights the different reform paths in comparison with Eastern Europe and the former Soviet Union. The sixth section, “China as an Eastern Asian developing country”, compares China’s developmental process with that of other countries in the region, notably Japan, South Korea and Chinese Taiwan. Finally, “Main observations of chapter” considers various political economy arguments underpinning the Chinese reform process.

1.1 Reasons for reforms Although China’s reforms are considered a success in terms of poverty reduction and economic growth, its outcome could not have been predicted. The reform and opening-up period was officially launched in December 1978 at the Third Plenum of the 11th Central Committee. At this event, Deng Xiaoping officially launched “Four Modernizations” in the areas of agriculture, industry, national defense, and science and technology. The goal of the “Four Modernizations” was to accelerate development by stepping up the volume of foreign trade and opening up its markets, especially for the purchase of machinery, from advanced developed countries like Japan, the United States and Europe. Later this was complemented with a variety of reforms aimed at decentralizing the economy. The “Four Modernizations” were operationalized by a 10 year plan, which was severely hampered by a shortage of capital, as was the case with many transition and developing countries. International trade and foreign direct investment (FDI) were meant to alleviate the shortage of capital by attracting foreign currency to finance capital imports. These were the first signs that indicated China’s leaders were taking a pragmatic approach to the transition process. At the same time, these initial reforms were a departure from the original dogmatic political approach which shunned both capitalist motivation and foreign economic intervention in the domestic affairs of the country. Moreover, it was a fundamental change from a strict command economy whereby the state controlled almost all output from the service sector: 94.4 percent of agricultural production and 97.5 percent of industrial production was sold at state-fixed prices (UNDP, 1999). There was no notion of an independent financial sector as there was a monobank system, which meant that the bank sector was

China’s reforms in transition and development perspective

5

simply the state’s cashier that channeled financial resources to statedirected development projects. The radical policy shift from a planned autocracy to a system that permitted foreign economic influence was made more politically acceptable by the social and economic disaster caused by the Cultural Revolution and the Great Leap Forward. This was referred to as the “decades of chaos” as there was social turmoil that severely affected the economy as well as society at large. An example of this chaos was that during the Cultural Revolution, all primary schools in urban areas in China were closed for two to three years. Secondary and tertiary level institutions were closed for much of that period as well. Universities were closed from 1966 to 1970– 71, although those students who had entered university before the Cultural Revolution, and had not completed their degrees, were allowed to stay there without formal teaching until 1970–71 (Zhang et al., 2007). With these kinds of social turmoil still fresh in the memory of everybody, from the party leadership to the people in the street, Deng Xiaoping could gain political support for his reform program as it meant a radical departure from the policies that underpinned the chaos of the Cultural Revolution. China also saw the rising economic power of South Korea, Chinese Taiwan and especially of their long term rival, Japan, as a geo-political threat. For China to keep its dominant position in Asia would require additional economic development, which was held back by lack of industrialization as 71 percent of the labor was allocated to agriculture, which has a low marginal productivity. This was not only linked to the fact that China was mainly an agricultural society, but also because in the late 1950s nearly all Chinese agriculture had been organized into people’s communes and people’s production teams of some fifty people. Therefore industrialization of China was low and the limited industrial production of the SOEs, generally speaking, was inefficient. This was one of the reasons why Township Village Enterprises (TVEs) could fill the gap as there was a lack of any consumer goods production, which SOEs were not able to fill (Kai-sing Kung and Lin 2007). The roles of government and public administration were also important to establish domestic-owned policies relevant for China. This was because China had traditionally been a country with a decentralized structure, in which a local government could undertake policy experimentation. If successful, this policy was implemented nationally. This policy formulation and development process is linked to the traditional decentralized system of government in China that had an M-form organization, in which regional governments (be it province, county, township or village) had considerable responsibility for coordination within their jurisdiction (Maskin et al., 2000). An M-form organization (multi-divisional form) is

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General introduction on the developmental challenges of China

defined as an organization that consists of “self-contained units’ where complementary tasks are grouped together (Qian, Roland and Xu, 2003). Therefore regional governments are less reliant on each other and this would facilitate policy experimentation. In particular, a large number of SOEs, including many in heavy industries, were subordinated to the regional governments even before the economic reforms. Hence, each region was relatively self-sufficient, while the scale of enterprises was small and industries were less concentrated. In this environment, regional policy experiments can be carried out in a less costly way because the disruptive effect to the rest of the economy is minimal (Barrell et al., 2000). Although the introduction of a market system was undertaken incrementally, the overall objective of reform and opening up was clear: to improve the economic welfare of the people at large. Against this yardstick, the reform measures that worked have been kept and improved; those that did not were discarded. Overall, policies were not imported from foreign countries without adaptation. Rather, policies were geared toward the development of a system that can best deliver the economic welfare outcomes and is most adaptable to the changing social, political and cultural conditions. As such, transition from a planned economy to a market based system was seen from a pragmatic point of view as a means to improve welfare and not an end in itself, nor ideologically driven.

1.2 Overview of social-economic developments during transition The socio-economic changes in China have been dramatic over the last twenty-five years. While growth rates of GDP have averaged close to 10 percent per year for nearly two decades, average materialistic standards of living have been transformed, pulling about 500 million people out of poverty, more than at any other time in human history. However, the benefits have not been equally divided, with the elites and middle class enjoying an affluent lifestyle, while an estimated 100 million people remained poor (World Bank, 2001). Moreover, 30 million children of school age are not going to school (World Bank, 1999). These poor are predominately located in rural areas of the middle and western regions of China. The reform process first started in rural areas and subsequently spread to urban regions. One of the first rural reforms was abolition of the commune system in the countryside – where 90 percent of the population used to live – and its replacement with small-scale, de facto privatized family farming. This started at the end of the 1970s and is also referred to as the introduction of the household responsibility system. It was combined with a reduction of top-down autocratic planning and direct control of the

China’s reforms in transition and development perspective

7

economy, while market mechanism was slowly introduced along with fixed supply quota. Moreover, local political leaders were encouraged to engage in economic enterprises, which were later referred to as the Township Village Enterprises (TVEs). At the same time, China started abandoning its isolationist position in the world and embarked upon the development of international trading relations with other countries. As such, China created four Special Economic Zones (SEZs) (and subsequently “open cities”) to allow foreign enterprises to collaborate in new joint ventures with their Chinese counterparts. There SEZs enjoyed special privileges, including a relaxed regulatory as well as tax holidays, to encourage foreign direct investment. As these areas were located in eastern parts of the country, these cities became China’s “engine of growth” and had the official policy of becoming rich first. Deng Xiaoping promised that the benefits of this strategy would eventually trickle down to the rest of the country. This policy resulted in an increase of regional inequality as well as inequality between social classes (Kanbur and Zhang, 1999). As such, the objective of attracting hard currency necessary to finance capital imports for economic development was deemed more important than having an egalitarian society. This was a major departure from the traditional central credo of the Chinese Communist Party (CCP) which focused on creating an equitable society for everybody, in particular for the peasants upon which the revolution was originally built. The urban reform process started a decade later than the rural reform, in the beginning of the 1990s, with the privatization of SOEs. The smaller SOEs were first privatized and at a later stage, new forms of enterprises were created, including stockholding as well as foreign (partial) participation in companies. The objective of privatization and changing the ownership structure of companies was to “harden the budget constraints”, by strengthening corporate management. The process of privatization of Chinese SOEs had a major impact on the urban areas, as social provisions and social security disappeared, which were traditionally provided by these companies. Laid-off SOE employers were often not only hit by a sudden loss of income, but more importantly, also by the loss of secondary benefits such as housing, schooling, health care, pensions, etc. To some extent, local and central governments tried to limit the impact of these policies by providing minimal safety-net measures. However, in general it can be stated that the privatization process led to increased vulnerability as primary benefits (such as income), as well as secondary benefits (such as housing, schooling and pensions), were not automatically provided any more by the state, as used to be the case before reforms. The central government acknowledges social-economic challenges, particularly in rural areas. It is in this context that Premier Wen Jiabao

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General introduction on the developmental challenges of China

proclaimed the “new socialist countryside”, which had the objective of enhancing living standards in the rural areas by improving public provisions, expanding health insurance, providing tax relief for peasants and improving rural infrastructure. This was part of the pro-rural policy to address the widening urban–rural multi dimensional inequality.

1.3 WTO accession as the end of transition China became the 144th member of the World Trade Organization (WTO) in December 2000. With this engagement, and obligations of full market liberalization stemming from the treaty, China’s transition from a planned economy to a fully functioning market based system can be considered as coming to an end. Moreover, with WTO engagement, China became committed to deepening its economic integration with the rest of the world as well as accepting a broad set of domestic reforms which would transform the role of the State, in terms of industrial policy (including severely limiting preferential policies and lending practices), to a regulator of the market-driven economy.1 The welfare and distributional effects of China’s WTO accession have been extensively studied on regional level (Wang, 1999; Hertel and Walmsley, 2001; Fan and Zheng, 2000). These studies noted that although the aggregate effect at the national level is positive, all regions in China may not benefit equally. Some regions may be hurt due to the existing differences in economic development and openness. Furthermore, the WTO accession requirements (such as opening-up of domestic markets) may cause farm incomes to fall, exacerbating the rise in inequality since the mid-1980s between farm–nonfarm and inland–coastal aggregate income (Kanbur and Zhang, 1999). Moreover, and judging from past results, gains of additional economic growth are not likely to be distributed equally among regions. Lessdeveloped areas, such as the northwest and southwest, have gained very little from the prosperity of the eastern regions as they lack infrastructure and human capital to participate in economic growth. This is despite the “Western Development Strategy” which was part of the “Overall Plan of Western Regional Development during the Tenth Five-Year Plan Period” (2001–5) that included, among others, financial support, infrastructure development, education, cooperative measures and industrial policies (Golley, 2007). A possible explanation for the continuous drive by the Chinese leadership to accede into WTO and “lock in” China’s development into a market-based system could be found in the political economy. From this perspective, WTO accession could enhance the interest of the Chinese bureaucrats and business elite as deeper global integration and more trade

China’s reforms in transition and development perspective

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might create more wealth for this class (Zweig, 2002). This is rooted in the wealth creation opportunities of rent seeking and doing business. Through granting preferential treatment to foreign investors and lowering transaction costs, the bureaucratic elite and high party members could gain from liberalizing their economic activities and integrating themselves with the world economy. This argument is similar to the role of TVEs, which “bought in” local political leaders through wealth accumulation due to the liberalization of the markets. At the same time, the political economy argument, in combination with the M-structure of the country (Maskin et al., 2000), in which decentralized agents have local power, could reduce the enforcement capacity of the Chinese central government. This could be a major impediment as the WTO requires a standardization of domestic regulatory framework across the country to ensure uniform enforcement of foreign trade and investment policies (WTO, 2001). This commitment should in theory oblige local governments to relinquish parts of their economic autonomy to central government and increase local governments’ accountability to central government. However, out of the desire to protect regional development, their political careers and rent-seeking opportunities, local leaders are likely to compromise the interests of foreign businesses and WTO obligations (Diao et al., 2003). From a transition point of view, WTO accession could be seen as a continuation on the path to transform from a planned towards a marketbased system of economic coordination. In addition, WTO accession will also deepen the links between the domestic economy and international markets, which could exacerbate regional inequality in China.

1.4 The emerging role in the global financial governance architecture Although the 2008 financial crisis triggered a serious recession in many industrialized countries, it has accelerated the emergence of China as an economic superpower. An example of how the financial crisis increased the global position of China in the financial markets is that the top three largest global banks in 2009, as measured in market capitalization, are Chinese. This could be compared to the previous year in which the United States of America had seven of the top 20 banks. Moreover, the 2009 global recession provided the opportunity for Chinese parastatal enterprises to buy companies and technology worldwide with US$ 13 billion in Europe and the United States (International Herald Tribune, 2009a) as well as purchase US$ 5 billion worth of Morgan Stanley shares. These investment activities are a logical consequence of three decades of high economic growth which has led China to become the fourth largest

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General introduction on the developmental challenges of China

economy in the world with 4 percent of the global economy, 6 percent of global trade and 12 percent of global manufacturing output. The relatively strong economic and financial position of China is currently not reflected in the global financial governance architecture which is dominated by Western countries by formal and informal rules. One of the pillars of the current financial governance is the dominant position of Western countries in the IMF and World Bank, which often influences policies in many developing and transition countries. This strong role of Western countries is not only reflected in the voting powers of these international organizations in which the United States of America and Europe have a de facto veto, but also by informal arrangements such as the gentleman’s agreement whereby the head of the World Bank is elected from the United States, while the chief of the IMF is designated from Europe. Due to these vested interests, it is difficult to introduce an inclusive voting system reform that reflects the economic reality of the twenty-first century. This is not only relevant for China, but also for other emerging countries such as Brazil, South Africa and India. Besides the formal and informal agreement that limits the influence of emerging and developing countries, it should be noted that there are sometimes genuine efforts to be more inclusive, such as with the appointment of Justin Yifu Lin as the World Bank’s chief economist and senior vice president in 2008. This is remarkable as he is not only the first Chinese economist to have a senior position, but also the first non-Westerner. Although China is relatively under-represented in the world financial governance architecture, it has a large stake in global stability, particularly as it holds US$ 2 trillion in US treasury bills. Although there is an argument that over-saving in Asia, in combination with under-saving by the United States, is one of the fundamental causes of the financial crisis, it is in China’s own interest to secure growth in Western countries so that exports can resume and the impact of Chinese unemployment will be limited. This is critical as not only 20 million migrant workers (from about 130 million) in labor intensive export industries were laid off, but also 30 percent of the graduate students could not find a job. While migrant workers are largely disbursed over a wide geographical area, graduate students are politically vocal and are integrated in urban social networks, which could create unnecessary civil unrest (Financial Times, 2009). Therefore it is in the self-interest of China to play a constructive role to end the current economic downturn. The first step that China undertook to address the financial crisis was the launching of a stimulus package of 4 trillion Yuan. This was supplemented by the banks providing another 5 trillion Yuan in soft loans to stimulate the economy. In this sense, China has opted to “help the world economy by first helping themselves”. However, Western countries that are

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majority shareholders in the global institutions have also suggested that China could contribute US$ 100 billion to the replenishment of the IMF, as many transition countries in Eastern Europe and Central Asia are seeking the assistance of the fund to address their balance of payments crisis. Asian development countries seem to have sufficient foreign currency resources to address the financial and economic downturn. China is responding in two somewhat contradictory manners. On the one hand, China has indicated that it is reluctant to provide resources to the IMF without having a formal larger voting power in the organization. In addition, China suggested that if the IMF needs additional resources in the short term, it could issue bonds, which China could consider buying. On the other hand, China has supported the expansion of the Chiang Mai initiative in Asia which is a bilateral swap arrangement between countries to address short term liquidity difficulties. In February 2009, this initiative had expanded to US$ 120 billion and 80 percent of the funds were from Japan, China and South Korea. Individual borrowing countries would have different lending ceilings, i.e. Indonesia can borrow $12 billion, Thailand and the Philippines $9 billion each and Malaysia $6.5 billion under the arrangements (Henning, 2009). In the run-up to the G-20 Summit in London in April 2009, China, through the governor of the Chinese Central Bank, Zhou Xiaochuan, suggested that the US dollar could be replaced by a “super-sovereign reserve currency”, based on a basket of currencies and commodities (Xiaochuan, 2009). In essence, this is a revival of an old idea by John Maynard Keynes, a famous economist born in the last century, who proposed in the 1940s to introduce a global currency. This would not only eliminate the inherent risks of credit-based sovereign currency, but also make it possible to manage global liquidity. The Chinese governor suggested that the IMF could play a key role in managing such a “supersovereign reserve currency”. The underlying reason for this proposal is that China has a large amount of US treasury bills worth nearly US$ 2 trillion, and is vulnerable to a depreciation of the US dollar, in particular if the US Government continues to increase expenditures to support the recapitalization of banks and fund the fiscal stimulus package. This would eventually lead to increased inflation and reduce the real value of US treasury bonds. Although China’s economic and financial influences are bound to increase steadily over time, this country still has many internal development challenges, including environmental degradation, rapid urbanization, high levels of inequality and poverty, lack of a comprehensive social security system, rebalancing internal growth toward domestic consumption, etc. With these kinds of internal development challenges, the domestic political understanding and willingness in China is limited for

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General introduction on the developmental challenges of China

providing additional resources for international institutions such as the IMF and World Bank. This willingness will be further eroded if additional financial support is not clearly linked to increased formal influence (i.e. share of voting power) and informal influence (i.e. positions in international organizations). These challenges would make it unlikely that China would provide large sums of funds to the IMF and World Bank, although a small sum might be acceptable and would contribute to stabilizing the world economy.

1.5 China as a transition country The People’s Republic of China, created in 1949, had its foundation in the planned economic allocation system. As a communist country, China had similarities with other transition countries in Eastern Europe and the Soviet Union, such as lack of property rights and lack of transparent markets. Besides similarities in terms of transitional challenges, China had several characteristics that made its transition process different from former communist countries in Eastern Europe and the Soviet Union. For example, in the 1970s, compared to other communist countries, China was considered over-populated, lacked human capital and was dominated by a poor agricultural sector. Also, China’s reform had a specific trajectory compared to other transition countries, which can be characterized as follows. (a) Pace of transition and dual track approach The debate on the pace of transition is linked to the time when the first market oriented reforms were launched as well as the different stages of the reform process. In Eastern Europe, the first elements of reforms started as early as 1968 in Hungary, 1980 in Poland, and 1985 in the Soviet Union. In many of these transition countries, the reform process was divided into two stages. The first stage covered policy measures and reforms that were relatively easy to introduce and could be implemented in a fairly short time span, such as: i

attracting foreign direct investment (FDI) through the creation of Export Processing Zones (EPZs) and (limited) import liberalization; ii rural reforms including de-collectivization of farming, introduction of the household responsibility system, granting of individual landuse licenses and lifting of urban–rural migration restrictions; and iii privatizing small and medium size enterprises and liberalization of prices in non-strategic sectors, which included labor market reform and the abolition of life-time employment (Wei, 2006).

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The second was more difficult as the reforms had a higher degree of uncertainty and required a longer period of implementation. This stage included reforms such as: i

enhancement of the competitiveness of large-scale SOEs (this encompassed the change of ownership structures and improvement of corporate governance); ii shifting the banking system from a monobank in which one-bank dominated lending and borrowing, to private banks of which the activities were overseen by a central bank; and iii recreating social safety-nets, which were organized by the companies, not at the national level. The second stage of reforms was more difficult to implement, had less predictable outcomes and were politically more risky (Wei, 2006). These two stages of reform were similar in many transition countries, in which first micro-level reforms were introduced before the macro market system was reformed. However, the big difference is that in Eastern Europe, piecemeal reform in the first stage failed in the 1960s and 1970s, and the second stage was jump-started during the “shock-therapy”, with immense social costs, at the end of the 1980s and beginning of the 1990s (Qian, 1999). This was also linked to the political upheaval due to the overthrow of communist regimes in Eastern Europe as well as to the dismantling of the Soviet Union. Moreover, privatization was considered a means to create private property and disperse wealth so as to minimize the chance of a non-democratic counter-revolution. In contrast, in China the first stage was more radical, while the second stage was less radical, as there was no need to disperse assets quickly to avoid a communist oriented counter-revolution or coup d’état. The success of the first stage allowed China to build a political momentum for further reform without revolution and political dismantling of the communist system. The transition in China was characterized by a “dual-track” approach which meant that the development of the private sector was created alongside the old state-driven sector. This dual-track transition enabled the private sector to grow slowly but surely and to eventually replace the public sector. The private sector growth was mainly attributed to the development of TVEs, while the larger SOEs were only privatized at the end of the 1990s. The dual-track approach provided the opportunity for economic agents participating in the market economy, to be better off, whereas the maintaining of the planned economy implicitly compensated potential losers from market liberalization by protecting the status quo. This had a considerably positive effect in terms of political economy. Another desirable

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General introduction on the developmental challenges of China

feature of the dual-track approach was its minimal additional informational and institutional requirements. For example, commune households had the possibility of selling directly to the market after they fulfilled their quota and they could purchase grain (or other) outputs from the market for resale to the state to fulfill its responsibility. The result of the dual-track approach was that the state procurement of domestically produced grains remained essentially fixed between 1978 and 1988, while during the same period the grain output increased almost one-third. (b) Policy experimentation and decentralization One of the main characteristics of China’s reform is its approach in terms of policy experimentation, which is closely linked to the M-structure of regional decentralization (Qian and Xu, 1993; Qian et al., 1999). Experimentalization has its advantages, in particular from an “evolutionaryinstitutional perspective”, as reform and change are always risky. The risk stems from lack of knowledge in terms of future outcome as well as from uncertainty in implementation. In this perspective, reforms cannot have a blueprint. To minimize the cost of policy failure, regional experimentation was encouraged. This regional experimentalization was linked to the M-structure of public administration, which made regions relatively “selfcontained”. By contrast, in Eastern Europe and the former Soviet Union there was a U-form organization, which meant that every reform had national implications, which increased the cost of policy failures and limited opportunities for policy experimentation (Roland and Xu, 2000). A unitary form organization is decomposed into “specialized units” where similar tasks are grouped together (Qian, Roland and Xu, 2003). Therefore any policy experimentation would have an impact on the whole economic system, which is much riskier. One example of policy experimentation was de-collectivization in which the household responsibility system was established in rural areas. In 1978, rural areas in China were operating under the collective farming system. In that year, Fengyang county in Anhui Province began to experiment with contracts (with local governments) for delivering a fixed quota of grain in exchange for farming on a household basis. This practice was subsequently imitated by other counties in the province and promoted by the provincial government before it was promoted by the central government. By 1984, almost all farm households across China had adopted this method. Like the agricultural de-collectivization, the development of the Economic Processing Zones (EPZs) was not a policy objective that was implemented top-down, but rather the result of policy experimentation. In the 1980s China first established four zones in Shenzhen, Zhuhai, Shantou, and Xiamen to allow foreign investments, while the rest of China

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was still under central planning. At a later stage, successful employment and accounting practices that were part of the EPZ policies, were adopted elsewhere in China (Qian, 1999). The policy experimentation approach was supported by a decentralized administrative M-structure with a centralized political system (Maskin et al., 2000). In such a system, local governments on a regional level were responsible for coordinating policies within their region. At the same time, the central political structure provided central government the possibility to create policy yardstick competition among local officials by rewarding or punishing them on the basis of economic performance (Zhang, 2006). This was supported institutionally through standardized national statistical data and accounting systems that could compare provinces with each other. (c) The role of Township Village Enterprises (TVEs) A key element of the TVEs is the engagement of communities and local governments (i.e. town or village) in private companies. As with the decollectivization of the agriculture sector, the TVEs were allowed to sell their products at market prices and operated in competitive markets. The TVEs were a major source of growth and employment, in particular in rural areas. This was the opposite in the Soviet Union and Eastern Europe where most labor was in large scale SOEs which collapsed with transition. This had major consequences, as privatization often meant not only a loss of income but also a reduction in housing benefits, schools, and pension. It made the transition process in the Soviet Union and Eastern Europe, politically speaking, much more difficult, as there were many more “losers” than “winners” in the first phase of transition to a market economy. In China, the TVEs are a typical transitional phenomenon as the community government played an important role in protecting TVEs in an environment lacking secure property rights (Chang and Wang, 1994). Without the rule of law and with a still prevailing anti-private property ideology, private enterprises in China were subjected to insecurities. In addition, the community governments were more likely to invest revenue in local public goods than private entrepreneurs, which in turn ensured higher future levels of government revenues. TVE after-tax profits were mostly used for two purposes: reinvestment and provision of local public goods (Che and Qian, 1998). Therefore, the government entities behavior was overall not rent-seeking oriented and the TVE were less worried about revenue confiscation. Moreover, local governments had regulator authority over the local economy through issuing business licenses, coordinating local business development and resolved disputes, which could be used not only to protect, but also to promote TVE in their jurisdiction. Local government could also use political connections with state banks

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General introduction on the developmental challenges of China

to channel loans to TVEs. This is important as in transitional and developing economies, capital is scarce and new entry firms have great difficulty obtaining it. In addition, TVEs, with community government control, provided collateral and therefore could attract capital from State banks. Hence, local government control over firms did not only benefit local officials, but also improved efficiency on the grounds that they provided more secure property rights and more local public investment. Moreover, the TVEs “bought-in” local actors and made them agents for economic development (Oi, 1992), which in a political economy perspective ensured sustainability of market oriented reforms over the long term. (d) Political economy, rent-seeking and building win-win coalitions Many transition economies in Eastern Europe and the former Soviet Union went through a “big bang” or “shock therapy”. This refers to a short period in which many reforms were enacted and this created a “winner takes all” situation. This presented a serious political economy problem and was the result of a rapid reform strategy that created vested and entrenched interest groups. However, this was not the case in China, which demonstrated that the winners of early reforms were not necessarily the losers at a later stage nor did these winners manage to “take all” (Hellman, 1998). The first and foremost reason for this was the slow pace of reform while the economy grew rapidly. This allowed old vested interest groups to adapt without losing out. Therefore, it can be argued that the bigger the gains from growth of the private sector, the bigger the compensation for the loss of rent-seeking opportunities in the state sector. Moreover, the dual-track liberalization provided opportunities for old groups (i.e. CCP members, bureaucrats, etc.) as well as new groups (i.e. the peasantry, TVE employers, etc.) to benefit. As such, China’s reform benefits were relatively evenly distributed and there were relatively few losers, while the winners increased massively. This created the political momentum for continuous reform aiming at further market systems introduction, although inequality did increase massively. From an institutional perspective, it can be added that the decentralized structure of China which diversified rent distribution away from the central government and encouraged inter-regional competition among local governments to attract investment, limited the amount of rent local governments could extract. Moreover, as noted earlier, the local government became an actor of development through their activities in the TVE which resulted in “buying into” the reform process. This can be classified as “the helping hand” which was especially useful in the beginning of the transition phase when networks were important to gain access to key financial resources and markets.

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However, a decentralized structure could also become a “grabbing hand” when local government focused on rent-seeking, which inhibited private sector development and economic growth (Chen, 2004). In China, local government is considered a “helping hand”, while in Russia local government was considered a “grabbing hand”. These differences are often linked to the political economy of reform by which China had a prospect of long term economic growth while Russia was characterized by high uncertainty as well as social political turmoil (Shleifer, 1997).

1.6 China as an Eastern Asian developing country China is well known to have adapted its policies and reform processes to fit its specific country circumstances. Besides the characteristics of a transition economy which were similar to Eastern Europe and to the former Soviet Union countries, China’s policies also had elements similar to the Asian development strategies, in particular in regard to the first generation of Asian Tigers, e.g. Japan, South Korea and Chinese Taiwan. Comparison is useful as it provides an opportunity to examine growth paths of different Asian developing countries. One of the more interesting aspects of such comparison is the extraordinary economic growth and poverty reduction process. Just as in the case of China, nobody predicted the success of the first Asian Tigers at the beginning of their reforms. For example, in the 1950s South Korea was just recovering from the devastating war with North Korea. Nobody predicted that this country would be one of the world’s fastest-growing economies and achieve OECD status in three decades.2 Although discussions and debates on the Eastern Asia model are widespread and numerous, this section only highlights some of the similarities between the development and reform process in China and that of the first generation of East Asian Tigers. These three countries had to overcome economic problems related to relatively large and dense populations as well as a resource shortage.3 The development process of Japan, South Korea and Chinese Taiwan can be characterized by the move from cheap, labor-intensive manufacturing to more heavy industries and subsequently to advanced electronics. This was undertaken through rapid export growth as well as the increased importance of exports in each country’s output structure.4 The advantage of this strategy, in particular in comparison with the import substitution approach followed by other developing countries (i.e. India and Brazil), was that exports fostered competition and encouraged the introduction of new technologies. Neither can be achieved through import substitution as the internal markets of developing countries were often too small for that scale of economy (Bruton, 1998). These characteristics made the export oriented

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General introduction on the developmental challenges of China

development model different from India and Brazil which had sizable internal markets. The elements of the East Asian development model are based on several common characteristics including high investment ratios, small public sectors, competitive labor markets, export expansion, and government intervention in the economy. Furthermore, investments in human capital and capacities to absorb new technology are two other economic features shared by the first generation of Asian Tigers (Kuznets, 1988). Although China was still considered a planned economy at the start of the reform in 1978, the Chinese leadership was open to pragmatic introduction of the market system and several elements could have been inspired by the East Asian development experience. The first element was the emphasis on exports promotion which became a tool for economic development and growth. Although this was first implemented through the four EPZs (and subsequently a tranche of “open cities”), it was later adopted in other coastal regions and is currently an element of the “Western Development Strategy” (Golley, 2007). In China, the policy of creating SEZs was meant to attract foreign investment, by exempting investors from regulations applicable elsewhere in China (particularly relating to hiring and firing of workers and foreign ownership) and also providing excellent infrastructure, was highly successful. In addition, China’s FDI was export oriented and also directed in part to investment in infrastructure to support the EPZs (Srinivasan, 2006). An underlying reason for the success of export oriented industries in China as well as in East Asia development was the low labor cost, due to the abundance of labor. This was the case as well with the first group of Asian Tigers, which also had an abundance of cheap labor, at least during the first phases of development, in combination with weak labor laws and unions. The second element in which China’s development was similar to that of the East Asia model, is the role of the state in facilitating development. For example, in South Korea the state was considered a “learning state” (Bruton, 1998), while in China policy experimentation was a key element for the success of development. Although South Korea, Chinese Taiwan and Japan had different policies, their governments were considered flexible and responsive to new information and implementation processes. Thus when mistakes were made, the governments of South Korea, Chinese Taiwan and Japan learned from them (Bruton, 1998). This was similar to the learning state in China which was linked to the decentralized M-structure of the state. The third element is human capital accumulation. Investment in human capital in Chinese Taiwan, Japan and South Korea has been above average, compared to other developing countries. Their greater effort is

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reflected in enrollment data that indicate, for example, that secondary school and higher education enrollment as a proportion of the people in relevant age groups has been considerably higher in Chinese Taiwan and South Korea than in comparable countries outside Asia, and has been about the same as in Japan. In China the emphasis on education and human capital accumulation is illustrated by the introduction of a compulsory Education Law in March 1986, which required free education for all for the first nine years of schooling, although inequality in equipment and quality of teachers still remain a problem. Furthermore, empirical evidence indicates that education in China helped improve the total factor productivity. For example, Chen and Fleisher (1997) studied the relationship between education and total factor productivity in China during the period 1979–93. Using the number of newly graduated college students as a measure of investment in education, they found that the investment in education contributes significantly to both the level and the growth rate of total factor productivity in China. Finally, the fourth element is the high savings rate which characterizes both China’s and other Asian countries’ development experience. Domestic saving by source for Japan (1978–84) and Chinese Taiwan and South Korea (1974–83) shows that corporate saving is minor in all countries, though somewhat higher in South Korea (10 percent of the total) than in the other two (4–5 percent) (Guariglia and Poncet, 2007). In China the private saving rate was around 47.7 percent during the period 1990–2005, which is higher than South Korea (40.1 percent) and Japan (33.8 percent) for the same period (Zhang, 2007). More importantly, in these Asian countries the saving rate was substantially higher than in the US (19.4 percent) and France (26.9 percent). However, given that the Chinese state banks’ primary function was to channel up to 80 percent of savings to SOEs, it is by no means sure that these investments actually translated into productive growth.

Main observations of chapter After thirty years of experience, several lessons can be drawn from China’s transition period. From a transitional perspective, China has moved from a state planned economic coordination system to a decentralized marketdriven economic system. This latter was “locked-in” by WTO accession. From a development perspective, China has achieved high levels of growth and poverty reduction, which have spread to large segments of society. The downside of the rapid enrichment process in China is that wealth has been highly unequally distributed, which in itself can cause political instability and threatens social cohesion. The most important lesson is that growth is possible with non-perfect

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General introduction on the developmental challenges of China

institutions, both in a development and transition context. For example, TVEs can be considered an institutional arrangement in transitional environment. At the beginning of the 1980s this public–private structure of ownership grew because: i

private businesses were discriminated in resource mobilization and regulatory treatment; ii fiscal decentralization provided local government the possibility to engage in private sector activities, both in terms of revenue generation as well as career tracts of local officials; and iii access to credits from the banking system that were still controlled by the state banks. However, as the transition process advanced, the TVEs were often privatized or changed ownership structures (Kai-sing Kung and Lin 2007). The success of China, both as a transition and development country, can therefore indicate that some “transitional institutions” are more effective than the “best practice institutions” for a period of time because of the secondbest principle. In other words, it is better to work within a less distorted economic system and adapt to it than to create a whole new economic system, which is not adapted to the local context of a specific country. This has been the mistake of many poor developing countries which followed the policy advice of Bretton Woods Institutions. Secondly, China had a large agriculture sector at the beginning of reform, and therefore lacked the extensive social services and safety-nets that were provided normally by SOEs. The consequence of this was that the “losers” of transition were relatively small compared to other transitional countries in the Soviet Union and Eastern Europe. Moreover, industrial urban workers were left out in the first stages of transition in the beginning of the 1980s, as reforms focused on the rural areas through the de-collectivization of agriculture and the introduction of TVEs. The positive aspect was that the “winners” of transition were created in the rural areas, before “losers” emerged in the urban sector through the restructuring of the SOEs. This created bottom-up momentum for additional reforms which gradually spread to the entire economy and, from the start, involved opening the economy to foreign investment and trade. Thirdly, in the context of transition, the emphasis was placed on changing enterprise behavior and improving managerial skills that are more suitable to new business environments, instead of changing ownership structure alone. The incremental process in the introduction of a market system is underpinned in “the evolutionary-institutional perspective”, in which gradual change is preferred over abrupt reform. In the case of China, the role of the government has been redefined, and the governing

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mechanism redesigned, but not minimized, while many transition countries in Eastern Europe and the former Soviet Union had the role of government reduced through the “big-bang” and “shock therapy” approach, which had the objective of kick-starting the private sector. In this context, the transition in China may best be characterized as a progress of controlled decentralization, which has been accompanied by the induced behavioral changes in both private and public institutions. Fourthly, China has advantages and disadvantages related to size of country compared to other countries that went through the Eastern Asia developmental experience such as Chinese Taiwan and South Korea. The advantage is that China’s domestic market would be able to attract foreign direct investment, in particular as it is located close to the Japanese market. Furthermore, and due to its internal market size, China could also engage with other countries. However, the disadvantage is that the amount of production it could export would influence the terms of trade and depress its own prices on the world market. Another disadvantage, in terms of development policies and WTO accession, is that China has limited “policy space” for government to engage in industrial policy. For example, “picking winning industries” is severely limited by WTO requirements. This is because WTO regulations and practices prevent the kind of development and industrialization strategies that was practiced by the first Asian Tigers from the 1960s onwards. Although it is clear that international pressure will force the Chinese government to undertake a more market-based strategy, China’s influence in the global area is likely to increase, in particular as discussions are continuing on the global financial architecture and reform of the Bretton Woods Institutions. Finally, it could be noted that the overall developmental success and poverty reduction were not anticipated, both in China as well as in the first wave of Asian Tigers. However, it is evident that the next twenty-five years would be more difficult in terms of achieving sustainable economic growth as current economic problems are linked to multifaceted challenges like poverty, inequality, urbanization, migration, environmental regulation, water-management, inequality, etc.

2

The evolution of poverty and inequality since the openingup period

Introduction The evolution of poverty is closely linked to the overall reform process in China. This process started in the rural areas in the beginning of the 1980s, with the de-collectivization of the commune system, and then spread to the urban areas in the beginning of the 1990s with privatization of state owned enterprises (SOEs). The effects of these reforms have been a reduction in absolute poverty in the countryside, while inequality increased massively (Kanbur and Zhang, 1999; Ravallion and Chen, 2007). Also regional inequality increased substantially due to the official policy of creating wealth in the Eastern regions through the “coastal development” strategy. These inequality trends were reinforced by the introduction of market-system and public sector reform which resulted in user fees, both formally and informally. This led to reduced access to essential public services for the poor in China. These inequalities could reinforce the “twin-peak” poverty–growth path, in which inequality and economic growth rise simultaneously. This chapter presents an overview of poverty and inequality in China. The first section, “Poverty and regional equality before the reforms”, highlights the policy of poverty reduction as well as regional disparities before the opening-up period. The second section, “Reduction of rural poverty”, focuses on the drastic reduction of rural poverty through decollectivization of agriculture as well as through employment generated through Township Village Enterprises (TVEs). The third section, “Urban poverty and privatization”, emphasizes the growing urban poverty in China through privatization of SOEs as well as through rural–urban migration. The fourth section, “Health sector and poverty”, stresses the transitional effects of China’s health care system and its consequences for vulnerability while the fifth section, “Education sector and poverty”, underlines the role of human capital in the reduction of vulnerability. The sixth section, “Multidimensional inequalities and twin-peak growth

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scenarios” underlines the threat of not addressing inequality in China. Finally, the “Main observations of chapter” summarizes the most important issues of this chapter.

2.1 Poverty and regional equality before the reforms Before the communist regime took power in 1949, poverty in China was extensive and the population suffered from common diseases like cholera, typhoid, hookworm, malaria and tuberculosis. High death rates were also caused by disasters such as floods and droughts (Worth, 1973). This was aggravated by many years of war, both with imperial Japan as well as with the militias of Chiang Kai-Shek. Despite initial difficulties, the Chinese communist government managed to improve health and educational indicators across the country. This was important as such social improvements strengthened the legitimacy of the regime and provided “visible” improvement to the peasantry, which formed the backbone of the revolution. An example of such social improvements was the Cooperative Medical System (CMS), which provided basic health care to a large part of the rural population. It was an integral part of the overall system of collective agriculture production and social services. CMS organized rural health care into a three-tier structure. The first tier comprised of “barefoot doctors” that provided both preventive and primary-care services, including prescription drugs. For more serious illnesses, barefoot doctors referred patients to the second tier, consisting of township health centers. Finally, the most seriously sick patients were referred to county hospitals, which formed the third tier. Under CMS, the financing of health care relied on a pre-payment plan, which included farmers’ premium contributions (0.5–2 percent of a peasant family’s annual income), village Collective Welfare Fund, and subsidies from higher level governments. By the late 1970s, 90 percent of the rural population was covered by CMS schemes (Liu et al., 1995) and China’s population health had improved to such a level that life expectancy had doubled to 70 years while infant mortality, a key variable of development, declined from 300 per 1,000 births in 1950 to 31 per 1,000 births in 1999 (Murray and Cook, 2002; Liu et al., 1999). Another social achievement of the Maoist decades in China was the expansion of access to basic primary education for children, and the provision of adult literacy classes to overcome illiteracy. As schools were built and teachers trained, China shifted from an illiterate, uneducated country to one that provided basic education to a large majority of the population (Banister and Zhang, 2005). However, this education was often limited to primary school and not necessary focused on increasing enrollment in secondary and higher education. For this reason China had low

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General introduction on the developmental challenges of China

human capital compared to other communist countries that encouraged higher education to support industrialization, but which were considered to have low human capital of the health care system. Due to socio-economic improvements under communism, China had become a more equitable country (Jian et al., 1996). However, Chinese policymakers shifted radically in 1978. Instead of pursuing equitable development policies across China, they instituted an uneven regional development policy by adopting a “coastal development” strategy. This led to the creation of various “coastal open regions”, including the five special economic zones of Shenzhen, Zhuhai, Shantou, Xiamen, and Hainan province; 14 coastal open cities; seven free-trade zones in coastal cities; and three open economic zones of the Pearl River, Yangtze River and Minnan Delta. As a result, the coastal provinces group known as the “five dragons” – Guangdong, Fujian, Jiangsu, Shandong and Zhejiang – has grown at a rate of more than 10 percent each year since 1978, while Heilongjiang – with a soviet-style heavy industrial base – lagged behind. The objective of the open cities which had these special economic zones, was to attract foreign investment so as to create regional economic “growth points” in eastern China. To support these initiatives, the state introduced preferential treatment for special coastal zones (Fan, 1995). These regions received more investments and projects from the state and had more authority to approve investment proposals. They also enjoyed greater financial autonomy such as for obtaining credits and loans (Naughton, 1987). Favorable policies attracted qualified personnel, technology and physical capital, especially foreign investment (Yang, 1990). From a policy perspective, regional inequalities resulting from promoting coastal regions were considered inevitable for the advancement of the country, and consequently were not considered as a problem but rather an inconvenience (Tu, 1995). This is especially true as it was assumed that a fast pace of development in the coastal areas would spur development of the lagging regions through a “spread effect”, which was essentially a trickle-down on a spatial basis. The central government believed at the beginning of the reform that some people and regions may get rich first but eventually the whole country would become wealthier. Therefore regional disparities and inequality were not considered a problem by the CCP leadership and the bureaucratic establishment of the central government. However, this changed and a “Western Development Strategy” was included in the “Overall Plan of Western Regional Development during the Tenth Five-Year Plan Period (2001–5)”. This strategy included financial support, infrastructure development, education, cooperative measures and industrial policies for regions that lag behind (Golley, 2007).

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2.2 Reduction of rural poverty Poverty was, and to most extend still is, a mainly rural phenomenon in China, where 90 percent of the people lived in 1978. This is because Chinese peasants have traditionally been disadvantaged by urban-biased policies through severely restricted urban–rural migration and subsidies for the urban population at the expense of their rural counterparts. This despite the critical role the peasantry played in the revolution and the establishment of the communist state. Nevertheless, China has massively reduced absolute poverty over the last twenty-five years due to three policy induced reasons. The first reason was the dismantling of the commune system, so that peasant households were once again able to farm on their own plot of land. The de-collectivization and privatization of land-use rights were also referred to as the “household responsibility system”. In this system, households were still responsible for delivering a fixed quota of crops to the government but were also able to sell any surplus above that quota on the free market. The household plot was leased for up to fifteen years from the government. Agricultural procurement prices were also raised to promote agricultural production. Peasants were allowed to choose crops and to pursue activities other than traditional agriculture. The de-collectivizing of agriculture and the shifting of responsibility for farming to households brought gains to the country’s rural community that happened to be the poorest. As Ravallion and Chen (2007) pointed out, this seems to have attributed to halving the national poverty rate during the first few years of the 1980s and can be considered “low-lying fruits” of agricultural reform. It contributed to an increase in the annual growth rate of agriculture from an average of 2.5 percent in 1952–77 to 7.4 percent in 1978–84. The second reason was the growth of TVEs, which created employment in small and medium size towns. Under this institutional structure, rural villages and townships were given the right to establish small-scale industrial, construction, and commercial enterprises outside the central plan. These TVEs absorbed excess labor from agriculture that otherwise would move to urban areas in search of work. The growth of TVEs is all the more striking as it became the number-one producer of China’s industrial production in 1995, thus overtaking the position of SOEs. A large body of research analyzes why and how the local governmentowned TVEs, instead of the more conventional private firms, have contributed most to China’s impressive economic growth during the first two decades of the reform (Che, 2002). The suggestion is that local government ownership can be considered a second-best arrangement in transition countries, in particular when few constraints restrict government’s

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General introduction on the developmental challenges of China

predatory behavior. This is because local government ownership can act as a commitment mechanism that limits rent-seeking activities, thereby constraining the predatory behavior of the local government during the beginning of reforms. The third reason for reduction of poverty in the countryside has been the increased rural–urban migration. The push factor of this migration was the poverty in the countryside, while the pull factor was rapid economic development in the coastal urban areas. This had a strong poverty reduction effect on the countryside (e.g. Knight and Song, 1999; Rozelle et al., 1999; Zhao, 1999). Remittances from migrants also rose with the outflow of labor from villages, reaching 9 percent of rural income in 2001 (Deininger et al., 2003). The flow of remittance created by migration catalyzed development in rural areas (Zhao, 2002). However, a more recent phenomenon is the return of migration. This stems not only from the denial of permanent urban residency status, but also from underrewarding of migrants’ human capital in cities (probably due to their lack of access to skilled jobs), as well as from family separation and the expected likelihood of obtaining decent non-farm jobs by the more educated in their home villages. Because of the effects of growing agricultural production, the employment generated by TVEs and migration, the total number of rural poor declined from 250 million in 1978 to 32 million by 2000 (Liang, 2006).

2.3 Urban poverty and privatization Although poverty was traditionally mostly a rural phenomenon in China, urban poverty has emerged in recent years due to significant reforms in the labor market in urban areas. During privatization in the beginning of the 1990s, urban poverty was exacerbated by the close integration between industrial and social service provisions (Wu, 2005). This was part of the wider industrialization policies that started in the 1950s in which the integration of social services (health, education, housing, pension benefits, etc.) were closely tied to SOEs. In combination with the urban hukou (household registration) system, urban poverty was virtually non-existent in China (World Bank, 1997). The exception was the “three Nos” poor group, with no ability to work, no savings or other income source, and no relatives to depend on. Once the privatization process was launched in the beginning of the 1990s, growth of urban poverty and inequality started increasing. This was because industrial restructuring ensured that SOEs had their “budget constraints” hardened while at the same time market rules were introduced. These SOEs were characterized by a strong dependency on party networks and subsidies of central government. The privatization led to redundant

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workforces and poor performance in terms of share of total industrial output between 1978 and the late 1990s. This share dropped from 77.6 percent in 1978 to 28.4 percent in 1996. In addition, there were also geographical inequalities as FDI and imported technologies were mainly located in major cities in the eastern region. Therefore, in the eastern part of China, SOEs could take advantage in upgrading toward capital and technological intensive industries. Traditional industries in sectors like textiles and metal processing became redundant. This created the new urban poor which composed of laid-off or unemployed workers from SOEs, low-paid workers in informal or low-rank service sectors, and pensioners. This development was highlighted in a study by Meng (2001) which demonstrated that 17.5 million SOE workers were made redundant by the end of 1998 as restructuring and mass lay-offs hit workers in the heavy industries, textiles and machinery. By that year, it is estimated that the total number of employees in the SOEs had been reduced by 25 million (Brooks and Tao, 2003). The State Council reported 26 million people registered as laid-offs and 9 million unemployed in the urban areas. Many of these unemployed workers were trapped in poverty due to lack of income as well as the collapse of the social services provided by SOEs. The restructuring of SOEs and the introduction of market reforms resulted in urban poverty as socialistic welfare systems were unable to provide adequate social services for the urban poor. The most important change in the welfare system during the economic reform is the retreat from providing workplace-based social services to individual (or if possible, local government) based social care (Wong, 1998). Before 1978, employment was the only direct source of security and insurance for urban residents, since the insurance and security system was exclusively financed by work-units, mostly state or collectively owned enterprises (Chow and Xu, 2001). The obligations to provide welfare services such as medical care and housing were transferred from SOEs to public social insurance agencies and individuals. Since 1998, Chinese cities have established a three-tier safety network based upon three programs, which were respectively, the Labor Security Program to ensure basic living expenses for laid-off workers, the Unemployment Insurance Program and the Minimum Standard of Living Program for urban residents. The Unemployment Insurance Program covers 101 million people and the Minimum Standard of Living Program supports 19.6 million people. The social safety-net did not cover all disadvantaged groups and it mainly focused on supporting workers that were laid-off because of restructuring. Some estimates indicate that only about five percent of the current urban poor residents qualified for government assistance (Yan, 2003). These safety-nets had the objective of

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General introduction on the developmental challenges of China

compensating the urban “losers” of the transition, thereby reducing the risk of civil strife. Another source of urban poverty is rural migration to cities, which as stated in the previous section, had a strong impact on rural livelihoods due to the flow of remittance it created. This group of urban poor comprised of rural migrants who have low-paid or unstable jobs. Millions of rural residents working in the cities live in poverty as they either engaged in low-pay jobs or faced unemployment. In addition, enormous numbers of rural laborers migrated to urban areas with the relaxation of controls on population movement. Most lived in poor conditions under the restriction of the household registration system and related policies of inequality. Without residentship, the vast majority of migrants were not eligible for any entitlement to social welfare benefits in urban areas. Even some migrants with de facto urban residentship, such as those who migrate to the city through marriage with urban residents, lack urban hukou (household registration) status. Overall the contemporary urban poor can be categorized as mainly employed in manufacturing industries or low-rank service sectors and thus have received most of the negative side effects of economic restructuring. Low-paid jobs, unemployment, migrants that pushed wages down and lay-offs of household members lead to low household income. As such, new urban poverty groups as well as the traditional urban poverty groups were situated at the lowest stratum of income distribution. This could be the reason why the emergence of new urban poverty in China is strongly associated with increasing intra-urban income inequality (Bian and Logan, 1996; Gu et al., 1999; Gu and Liu, 2002). Poverty significantly affects both educational investments and learning. Children from households that are both poor and credit constrained are three times as likely to drop out of school. Thus, for some of the poor, the lack of available funds is a major obstacle to financing educational investments. Therefore, even with high enrollments and prioritization of education by government, poverty still may be an important issue in educational attainment (Connelly and Zheng, 2003). In addition, there is also a clear gender bias in educational investments which may be due to lower returns on education for girls, the perception that girls will marry into other families and from parental preferences that favor sons (Song et al., 2006).

2.4 Health sector and poverty Before decollectivization, China had a model for community financing and health care organization covering the provision of preventive and primary care services to the majority of the Chinese population. This model

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contributed significantly to China’s “first health care revolution” and reduced the infant mortality rate from about 200 per 1,000 live births (in 1949) to 47 per 1,000 live births (in 1974). During the same period the life expectancy increased from 35 years to approximately 65 years (Gu et al., 1993). After decollectivization and introduction of market reform in rural areas at the end of the 1970s, the Cooperation Medical System (CMS) was phased-out. With the individual household responsibility system, the communal administrative structure, which employed barefoot doctors as health “workers”, and the collective welfare fund (the main source of financing for drugs and other services) disappeared. This had two fundamental reasons. First, the ideology of private responsibility was over-valued compared to equal access. Hence, economic efficiency was emphasized while equality in health service was ignored. This resulted in a drop of CMS coverage to just 40–45 percent of China’s villages in 1983 (Zhou, 1991). Secondly, the CMS suffered from patronage and corruption as well as poor management. Although the CMS was based on local communities, it was controlled and managed by local officials who were not held accountable. As a result, people lost confidence in the governmentrun CMS program and refused to make financial contributions once the system became voluntary in the early 1980s. In response many communities voluntarily designed their own funding mechanisms, and many villages fell back to a Fee-For-Service (FFS) payments system. The phasing out of the CMS led to medical expenses becoming a significant burden on rural households as 90 percent of this group paid out-ofpocket for their health services (Liu et al., 1996). Many of the households that recently fell below the poverty line were actually health-stricken rather than poverty-stricken (Gustafsson and Li, 2004; and Banister and Zhang, 2005). The results of the abolishment of the CMS, as well as the privatization of the SOE, led to an increase in out-of-pocket health expenditures by which most of China’s people pay for basic level care at clinics or outpatient departments of hospitals (Henderson et al., 1994). For catastrophic or chronic medical needs whose costs are high, poorer people often cannot afford the pharmaceuticals or the hospital fees. In practical terms, this means that if an individual gets very sick, his or her family may not be able to pay for needed medications or hospital costs. High user fees are charged even for emergency services in public hospitals and clinics. The introduction of formal and informal user fees and lack of health coverage led to the start of the insurance industry in China, which has developed rapidly, especially since the 1990s. However, the large gap between urban and rural incomes remains a problem as rural residents lack the means to pay for insurance. Low coverage exposes rural Chinese residents to health and related financial risks which may have negative

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General introduction on the developmental challenges of China

effects on economic development when uninsured individuals cannot receive medical care because of the cost. This leads to a growing gap in terms of quality and accessibility of services between rural and urban areas (World Bank, 2005). The result is a rural health service deficit with among others, wide disparities in mortality rate, growth threats of HIV/AIDS, Asian Flu, Swine Flu, resurgence of tuberculosis (Dummer and Cook, 2007). As part the Premier Wen Jiabao proclaimed the “new socialist countryside” in 2005, a new rural Cooperation Medical Scheme (NCMS) was launched in 2003. This a voluntary insurance system in which a farmer needs to pay 10 Yuan (about 1 US dollar) for medical insurance, while the government contributes a similar amount (Brant et al., 2006). Although this health initiative provides some coverage to smoothen consumption expenditures in times of stress, it does not cover preventative health care as well as migrant population (WHO, 2004). From a vulnerability perspective, health care is important as medical services can help patients recover from ill health as well as mitigate the burden of medical expenditure. It is for this reason that households keep large savings as there is a lack of health care insurance (International Herald Tribune, 2009b). This latter has a strong crowd-out effect on other goods and services, such as human capital investment, physical capital investment and investment in development of human well-being (Wang et al., 2006).

2.5 Education sector and poverty Although high literacy was one of the main achievements of Mao, education for the masses was mainly limited to primary education. Secondary and higher education were not as vigorously promoted. In addition, and as schools were funded at local level, inequality in education attainment and enrolment remained a serious issue. To promote enrollment, the government introduced the “Law of Compulsory Education” in 1986 which officially made nine years of schooling compulsory throughout China (six years of primary school, three years of middle school). By 1990, all provinces were expected to have primary education available for all students. However, according to official Chinese government statistics, only 76% of the counties had realized universal primary education though the population of those counties was 91% of the national total (He, 1996). The inequality in education is related to the local funding of schools and, therefore, rich provinces tend to produce more human capital per capita than poor provinces. Resource constraints also differentially affect access to schooling of individuals in different parts of China, especially in

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rural areas and in the west (Heckman, 2005). This inequality also led to poorly equipped schools with lower quality teachers in rural areas, and therefore faced additional educational hurdles (Brown, 2006). This resulted in opportunity costs for the poor as dropped-out children could be more productively employed on the farm (Connelly and Zheng, 2003). Economic reform also increased opportunity cost. A rural family’s income is closely linked to its own work effort. When there is a real gain to the family from their children’s labor, rural families may be more likely to pull their children out of school before graduation. In the short term, this could provide a gain in income of the household, but in the long term, this could encourage the Inter-Generational Transmission of poverty. Besides the issue of opportunity costs of education of children in rural areas, poverty significantly affects both educational investments and learning. Children from households that are both poor and credit-constrained are three times as likely to drop out of school. Thus, for some of the poor, the lack of available funds is a major obstacle to financing educational investments. Therefore, even with high enrollments, poverty still may be an important issue in educational attainment (Connelly and Zheng, 2003). In addition, there is also a clear gender bias in educational investments which may be due to lower returns to education for girls, the perception that girls will marry into other families and from parental preferences that favor sons (Song et al., 2006). Education and human capital formation is especially difficult for children of migrated families because the hukou system requires students to reside within the local school district in the city and be registered in the school district as well. The reasoning behind these regulations is that since the education budget (elementary school and high school) is allocated through local government, temporary migrant children are not allowed to attend local schools, as it increases the financial burden (Liu, 2003). However, instead of entirely denying access to education for temporary migrant children, many schools in cities allow migrant children to attend, but then their parents must pay “education endorsement fees” (jiaoyu zanzhu fei) which is a significant, and sometimes prohibitively heavy, burden for parents. Given the large concentration of migrants in lowpaying occupations, and difficulties of enrolling in local schools, there is an emerging phenomenon in many large cities for schools that cater particularly to migrant children (Liang and Chen, 2007).

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2.6 Multidimensional inequalities and twin-peak growth scenarios In China, multidimensional inequality (i.e. not only inequality in income, but also in education, health and other indicators), forms a serious risk to stability and the future growth path. This is also reflected in recent theories on inequality and growth that emphasize the importance of understanding why the same rate of economic growth might be less effective in reducing poverty in one country compared to another. Research suggests that in an economy where inequality is persistently low, the poor obtain a higher share of the gains from growth than in an economy in which inequality is high (Timmer, 1997). Therefore, higher initial income inequality entails a lower (absolute) elasticity of poverty to average incomes. Research has indicated that this is also the case in some of the poor states in India (Ravallion and Datt, 2002) where growth reflects the differences of initial economic structure, namely the access of different groups to productive assets (Birdsall and Londono, 1997). There are three channels through which inequality makes the poor less sensitive to growth in China. The first channel is assets needed for collateral. From a capital market perspective, physical assets are likely to affect the extent to which poor people participate in economic growth. This credit-market-failure argument demonstrates why initial distribution matters to the rate of growth by suggesting that asset-poor people are mostly locked out of growth prospects. This leads to underutilization of their productive and growth potential compared to a more equitable society. In this manner, greater initial asset poverty will mean that occurring growth is less (income) poverty reducing (World Bank, 2006). The second channel through which inequality makes poor people less sensitive to economic growth is accessibility of public services such as education and health care. In this perspective, inequality in education is important as this affects the degree to which the poor are equipped to participate in revenue-generating opportunities. Resource constraints also differentially affect access to schooling of individuals in different parts of China, especially in rural areas and in the West (Fan et al., 2002; Kanbur and Zhang, 2005; Heckman, 2005). In addition, inequality in health care leads to less accessible health institutions which make the poor more dependable on “out of pocket expenditures” (O’Donnell et al., 2007). With the abolishment of the CMS and the introduction of the Fee-forServices, there was an increase in “out-of-pocket” expenditures for their health services (Liu et al., 1996). As a result, high inequality leads to lower accessibility of essential public services. Finally, the third channel is that high inequality leads to less effective

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social programs because of increased risk of corruption. This is because in highly unequal societies, the elite tend to capture the state at different levels through political participation and lobbying. The intertwined relationship between local officials and the business elite in China can be traced back to the TVE, in which local economic development was promoted over environmental or social objectives. More recently, the policy priority of economic growth has also been promoted through the targeted responsibility levels, in which local officials were promoted or demoted on the basis of economic growth in their jurisdiction (Zhang, 2006) and not on provision or access of social services. An initial unequal asset base could result in a “twin peak” in which two peaks exist in the distribution of wealth and imply that a country is highly polarized between rich and poor (Quah, 1993). This is the case in Brazil where inequality did not change between 1976 and 1996, whereas the mean income per capita overall increased (Ferreira and Paes de Barros, 1998). To avoid such a “twin peak” growth path, inequality needs to be addressed through better distribution of public services, infrastructure development and human capital. This discussion is also referred to as the poverty-growth-inequality triangle by Bourguignon (2004) in which redistribution of wealth, not income, is underlined. The important point is that the former may favorably affect economic efficiency and growth, while the latter does the opposite.

Main observations of chapter This chapter has focused on the poverty situation and reforms of the public sector in China and its evolvement during the transition. In rural areas the de-collectivization in the 1980s had a positive impact on the livelihood opportunities of poor farmers. However, in terms of public health care and education services, there was a remarkable downside with the introduction of user fees. In urban areas, it was the privatization of SOEs in the 1990s which led to growth of poverty as well as a reduction of health and education services. In both urban and rural areas, the reduction in public services deliveries led to higher inequality because health care and educational services were not provided for all. This increased vulnerability as education is essential in building human capital, while health care is critical to avoid households falling into poverty. The introduction of fees further raised the barrier to access and excluded a large part of the poorer segments of society. This not only reinforced the “twin-peak” growth path, in which inequality remains high despite high economic growth, but also added two additional barriers to income convergence: the household registration system, which makes the movement of the rural poor to prosperous areas illegal; and

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General introduction on the developmental challenges of China

the monopoly state bank system that, because of its bureaucratic nature, disburses most of its funds to its large traditional customers such as SOEs (Demurger et al., 2002).

Part II

Managing vulnerability and increasing livelihood opportunities Introduction The vulnerability as well as the capacity to manage risks has changed dramatically during the period of transition. This is the case for both macroeconomic vulnerability and household vulnerability. Macroeconomic vulnerability increased due to interdependence between China and the rest of the world. In the 1980s, this was linked to the increased exports of China, which were part of its export promotion strategy. This vulnerability grew with the rise in capital flow and FDI. Although this export promotion strategy led to enormous economic growth and poverty reduction, it also led to creation of nearly US$ 2 trillion of foreign currency reserves, which were mainly invested in US treasury bills. In the wake of the financial and economic crisis in 2008, these investments became another source of vulnerability as Chinese assets were exposed to the potential threat of inflationary policies in the United States which might be necessary to fund the US fiscal stimulus as well as its bank recapitalization. It is in this context that China is shifting from an export oriented development strategy to a domestic consumer demand driven development strategy. The high rate of economic growth was accompanied by increased household vulnerability, in particular as multi-dimensional inequality increased dramatically, which led to the exclusion of a large segment of the population. In particular, rural communities had fewer economic livelihood opportunities as well as less access to adequate education and health facilities. As such, they were forced to migrate to urban areas where they lived clandestinely, as they often lacked hukou status. In practice, this meant that they were second-class citizens, which is a potential source of civil strife. Rapid economic growth also created problems such as environmental degradation, ranging from desertification and drought in rural areas to respiratory problems and air pollution in urban areas. Another part of reducing household vulnerability is by ensuring that

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people can defend their rights through political participation and transparent decision making processes. This would provide citizens the opportunity to defend their interests in public debates. In this regard, China has a long track record of policy experimentation at local level before implementation at national level. This also applies to political reforms and the integration of Hong Kong, which has limited democracy, as well as incidental elections of village committees in Hebei, and demonstrated that China is experimenting with various forms of public participation and transparency. The second part of the book is organized as follows. The third chapter, “Macroeconomic vulnerability and managing the risk of interdependence” highlights macroeconomic vulnerability created by the promotion of an export oriented development strategy. This also led to massive foreign exchange reserves, which were subsequently mainly invested in US treasury bills. However, the financial and economic crisis of 2008 exposed China’s vulnerability both in terms of export dependency as well as exposure to US inflation policy which could reduce the real value of US assets, in particular treasury bills. In addition, interdependency with other countries also created additional vulnerability as China is not endowed with sufficient natural resources, which is essential for the continuous industrialization process in this country. The fourth chapter, “Reducing household vulnerability and increasing livelihood opportunities”, describes the negative impact of high multidimensional inequality and the effects on productive assets at a household level, in particular in rural areas. This led to a massive migration flow to urban areas, where rural citizens often lack official hukou status and are treated as second class citizens. In addition, a policy of high growth rates had a detrimental impact on the environment in both rural and urban areas. To improve livelihood opportunities in China would also require effective political participation by citizens. This could take place through transparency in decision making and civil society engagement. The final chapter of the part, “Estimating regional vulnerability and inequality”, provides a basic methodology to estimate regional vulnerability and inequality in China. This is important as China has lifted millions of people out of absolute poverty, although large proportions of the population remain highly vulnerable. This research analyzes the composition of the various assets (liquid assets, social service provisions in the health and education sectors, urbanization, industrial activities and political integration) and its impact on vulnerability. The methodology allows the presentation of the evolution of vulnerability in the last two decades as well as the identification of areas in China which are more vulnerable than others.

3

Macroeconomic vulnerability and managing the risk of interdependence

Introduction Although China’s integration with the world economy has brought increased wealth, it also made the country more susceptible to global economic shocks, ranging from high commodity prices that are imported (such as oil, coal and food products) to macroeconomic downturns caused by a drop in export demand (such as the Asian financial crisis of 1997 and the global financial crisis of 2008). This is particularly important as China is reliant on labor-intensive export industries which could severely affect social stability if demand from export markets drops. This is the reason why it is critical to manage the risk of macroeconomic vulnerability. Historically, macroeconomic vulnerability is often closely linked to commodity price volatility, which in turn is an inherent part of a capitalist market-based system. Developing countries had to manage large swings in prices of their export commodities, which often caused internal macroeconomic instability. For China, which until the middle of the 1970s pursued an autarchist economic policy, international commodity booms and bust had little impact. Volatility on the domestic market in China was almost non-existent as prices were set at the central level, and did not reflect supply and demand. As China opened-up through the transition process, it became more vulnerable to external shocks. The first major macroeconomic shock that hit China was the Asian financial crisis in 1997. Although this did not have a direct impact, as the Chinese currency is not freely convertible and the banking sector was not internationally active, the crisis did have an indirect impact as demand for its labor-intensive exports dropped. In 2008, the volatility of the international prices had impact on the import side, through high food and commodity prices. These commodities are necessary to fuel the expansion of the growing manufacturing sector. In the same year demand from export markets dropped, highlighting the importance of managing the risk related to external volatility.

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The structure of the chapter is as follows. The first section, “Macroeconomic vulnerability in historic perspective”, provides an overview of how the issue of macroeconomic vulnerability evolved over time. The second section, “Risks of trade dependency and WTO accession”, highlights the risk and opportunities of WTO accession. The third section, “Energy security”, emphasizes the risk associated with energy dependency. The fourth section, “Managing financial volatilities”, focuses on the challenges of the banking sector in China. The fifth section, “International implications of Chinese rising interdependence”, highlights the role China has played in the international community with the objective of reducing vulnerability, in particular in Latin America, Africa and Asia. Finally, the “Main observations of chapter” summarizes the most important issues of this chapter.

3.1 Macroeconomic vulnerability in historic perspective Macroeconomic vulnerability is important to address as high fluctuations in GDP and in export earnings can adversely affect economic growth. Overall, negative shocks have a stronger effect than positive shocks in developing countries (Cordina, 2004a, 2004b). This is because many developing countries have difficulty managing extreme volatility in business cycles as they lack the capacity to manage negative macroeconomic shocks and adequate social safety-net provisions. Vulnerability can be disaggregated by identifying the following three elements (Guillaumont, 2007):1 a b c

size and frequency of the exogenous shocks, either observed (ex post vulnerability) or anticipated (ex ante vulnerability); exposure to shocks; and the capacity to react to shocks, or resilience.

If macroeconomic vulnerability is not managed properly, a downturn could lead to households falling into poverty, which could cause civil strife and social unrest. The challenges related to macroeconomic vulnerability in developing countries had first been highlighted in the 1950s and 1960s during the swings in commodity prices of the ’60s and ’70s of the last century. At that time, mainstream economic thinking was heavily influenced by Keynes. The fluctuations in prices were viewed from a structural doctrine that advocates state intervention policies as a means to overcome the structural difficulty of developing countries.2 Sometimes these interventionist polices were combined with the goal of self-sufficiency which could be considered a non-economic objective (Bhagwati and Srinivasan, 1969). An

Macroeconomic vulnerability and managing the risk of interdependence 39 autarchist economic policy was also chosen by China, not only on a national level, but also on a decentralized level, i.e. not only the nation should be self-sufficient, but also sub-national regions should be selfsufficient. This was part of the M-structure production system (Maskin et al., 2000). One of the main reasons for China to pursue this policy was indeed non-economical, as it was preparing for an imminent attack from the Soviet Union, and with a decentralized system it would be easier to organize a people’s guerrilla war against the foreign occupier. For other developing countries, which still had an open trade relationship with the industrialized countries, price fluctuation were linked to the volatility in commodity markets and led to strong boom–bust cycles. Price volatility could be reduced by moving up the value chain and into the manufacturing sector, which is less volatile. However, developing countries could only export raw materials, because semi-industrial goods faced tariffs and quota restrictions. And even if developed countries were willing to lower their barriers, the monopolistic market structure would make it difficult for the periphery to penetrate the center (Streeten, 1990). To move up the value chain would require developing countries to pursue a policy of import substitution. However, this is a long term solution for developing countries, and in the short term fluctuations on the international markets were reduced through commodity market boards. Besides internal economic policies, developing countries as a group also tried to reduce export vulnerability. One of the best examples of this was the initiative of Non-Aligned Countries to set up an International Commodity Agreements (ICA) in 1973. The objective was to stabilize the international commodity prices around a medium-term market clearing price.3 The ICA agreement was ambitious and had the objective of not only to stabilize exports revenues, but also to redesign the international trade and aid architecture. The reason for the failure of the agreement was purely economical. Countries outside the ICA agreement had an incentive to produce as they were not limited by any agreement and could produce as much as they wanted, without being bound by production limitation of producers that were in the ICA agreement. In essence, this was a free-rider problem where developing countries outside the cartel could produce an unlimited amount, while the consequences would be felt by all the producers, which were mainly inside the ICA. The breakdown of the ICA, which was a failed cartel-building initiative, coincided with an overall deterioration of the macroeconomic situation in many developing countries with high inflation and economic stagnation, in particular Latin America. The latter two phenomena were referred to as stagflation. The process of stagflation has been amplified by the energy crises in the 1970s and the debt crisis of the 1980s. In general, stagflation was seen as the failure of developing economics as a whole (Bruton, 1985).

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It was within this context, that the “market failure” of Kenyan doctrine was replaced by the “state failure doctrine” of the liberals. The liberals argued that government intervention should be limited and implied policies of “getting market prices right”, privatization and free trade under the laissez faire concept (Schiere, 2002). This would later be referred to as the Washington Consensus. In this framework, the role of the state in the economy transformed from direct intervention to regulation of a market oriented economy. The reason for this reversal was a new sense of optimism in the solutions of the market allocation system and a new found pessimism in state allocation mechanism. The implication was that the limited amount of safety-net provisions that were available in developing countries, like market boards for commodities and farm production, were abolished. In turn, this led to additional vulnerability of small producers and farmers. These reforms were often supported by the IMF and World Bank structural adjustment programs of the 1980s and at the beginning of the 1990s. The Bretton Woods institutions also encouraged capital account liberalization and deregulation of the financial sector which resulted in free movement of capital. Together with the exponential growth of many financial Asian markets, this led to a massive inflow of “hot money” with short term maturing time, and often led to an overvaluation in stock markets and real estate. The relatively sudden liberalization of the capital market brought many benefits to Asian developing countries, but also contributed to the Asian financial crisis of 1997–98. To illustrate this point: just before the crisis, massive amounts of funds flowed into the Asian countries and then the pattern drastically reversed in the summer, as “hot money” flowed out at a staggering pace. As such, capital movements to Asia swung from annual inflows of almost $100 billion to outflows of the same size (Bank for International Settlements, 1998). This event highlighted the importance of managing macroeconomic vulnerability, as it can cause massive economic and social instability. Although a fundamental discussion of the Asian currency crisis falls outside the scope of this book including if it was “first generation”4 or “second generation”5 crisis, it is evident there was a strong contagious effect as the financial crises started in Asia, then spread to Latin America and Russia. These new macroeconomic vulnerabilities, that were transmitted through the financial system, were often attributed to the lack of sound corporate governance and “crony capitalism”. This was also the case in the financial crisis of 2008 which was triggered by the sub-prime mortgage lending in the United States of America. Again, through the contagion effect, many developing and transition countries were affected. On the positive side, it could be noted that many developing countries in Asia had learned from the 1997 financial crisis by adopting a flexible

Macroeconomic vulnerability and managing the risk of interdependence 41 exchange rate policy as well as building-up large foreign currency reserves in their central banks, thereby creating policy space to bail-out domestic banks or pursue macroeconomic anti-cyclical policies. The vulnerability framework can also be applied to the process of liberalization in the last four decades, starting from protectionism and selfsufficiency to fully liberalized trade and capital markets. Although it created a lot of wealth, in particular in Asia, this liberalization also led to an increase in exogenous shocks and exposure, while the resilience capacity is relatively limited especially in developing countries. This is particularly important for emerging economies like China, which need strong and stable economic growth to absorb the rural migrants that move to urban centers, as well as urban unemployed that have been laid-off when SOEs were privatized. A negative economic shock in this context could have severe ramifications on political stability in the country.

3.2 Risks of trade dependency and WTO accession At the beginning of transition, China’s trade policies focused on encouraging exports, while imports were strictly controlled. The objective of this was to generate foreign exchanges, which were scarce, just like in other former planned economies of the Soviet Union and Eastern Europe. The generation of foreign currency would help finance capital expenditures and was one of the pillars of the opening-up period at the launch of the reform programs. As highlighted in the previous section, research in developing countries indicates that export and trade instability could have a negative effect on growth (Combes and Guillaumont, 2002; Dawe, 1996). Although the period of trade openness is relatively short in China, this country did suffer from export instability, as the Asian financial crisis of 1997 demonstrated. China was not directly affected by this crisis as it did not have a freely convertible currency. However, its economy is intertwined with that of Asia, both through the import side – as almost 60 percent of China’s imports from the Dragons (Hong Kong, South Korea, Chinese Taiwan and Singapore) are used for assembly and re-export – and through the export side, in particular Japan. The intensity of Asian exports to China can thus be explained by the international splitting-up of the valueadded chain within the region (Gaulier et al., 2009). The reduction of Chinese exports was aggravated by the fact that the export basket of China (which focuses on labor-intense manufacturing) was similar to other Asian countries which devalued their currency, and therefore became more competitive. An important factor in the “cushioning” of the Asian financial crises in China was the “dual-track system”, in which the public sector functioned as a “buffer” to the crisis. This, in combination with additional spending in infrastructure, led to a strong

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counter-cyclical effect. The underlying reason for such a strong policy response was that high growth rate is necessary to absorb rural migrant workers in urban areas. The impact of the 2008 financial crisis affects China differently as the “dual track” economic system has mostly been dismantled as part of the accession requirements of the World Trade Organization (WTO) to which the country acceded in December 2000. Therefore, on the one hand, the resilience of the state was limited while the exposure to the negative shock was higher, although it can apply limited WTO sectoral level safeguards for a short period of time. For example, safeguards could be applied to agricultural production and fitted into the goal the Chinese government has set for food self-sufficiency (Anderson and Peng, 1998). On the other hand, the resilience of the state is limited due to abolishment of the dual track system. On the positive side, WTO accession does provide stable access to export markets in the long run, as China has demonstrated that it could use the Dispute Settlement System at the WTO and that it is willing to defend its trading interests by participating in 55 dispute cases as a third party (Gu, Himphrey and Messner, 2008). In the long term, export vulnerability can be decreased through two ways. The first is to move up the value chain. As mentioned in the previous section, price fluctuations in the highly valued manufacturing sector tend to be less volatile. This development path would follow the first generation of Asian Tigers (i.e. Japan, South Korea and Chinese Taiwan). To a limited extent, China has already become an exporter of some high-tech and highskill products, although by and large it is still a large importer of high-tech manufacturing components, mostly from Asia, which are subsequently assembled by low skilled labor and exported (Schott, 2008). Paradoxically, the process of moving up the value chain has been speeded-up because of the economic downturn in 2009 which caused the economic growth projections to drop from 12 percent to 6.5 percent. This was also emphasized by Prime Minister of China Wen Jiabao at the World Economic Forum in January 2009, in which he said that an industrial restructuring and rejuvenation program would be implemented. This included phasing out backward production practices and upgrading industries such as car manufacturing, iron and steel, which would be supported through science and technology initiatives (World Economic Forum, 2009). The second way to reduce export vulnerability is to diversify its export markets away from Europe and the United States of America – as markets in developed countries have been saturated – and focus on other developing countries, in particular Africa. It is with this in mind that China has announced development of several Special Economic Zones on the African continent. By the end of 2008 China had established a mining hub in Zambia and a trading hub for the Indian Ocean Rim in Mauritius. Another

Macroeconomic vulnerability and managing the risk of interdependence 43 three zones are in the process of being established in Nigeria, Egypt, and possibly Tanzania. The development of these zones was fully initiated by China and African governments are recipients once they are finished. These zones will also require investment in infrastructure, both within the zones and linking them to ports and the regional markets (Davies et al., 2008). Once these zones are completed, they will form an infrastructure corridor that will provide the essential links between the fragmented African markets, thereby diversifying exports in the long run. As such, these zones would become central to penetrating the African market with Chinese-made manufacturing sectors.

3.3 Energy security During the first decade of growth, China was not only self-sufficient in energy supplies, but also exported oil. This was reversed in the first decade of economic growth in the 1980s with strong industrial and income growth in the last two decades. This has caused China to gradually become a net importer of energy, and by 2005 its dependence on oil imports had soared to about 45 percent of consumption. Moreover, net oil imports grew at 14.2 percent on an average annual basis in those five years (Berrah et al., 2007). As Figure 3.1 demonstrates, there is a growing gap between petroleum consumption and production in China.

Figure 3.1 Petroleum consumption and production in China. Source: National Bureau of Statistics (CEIC).

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The growth in energy consumption in China is mainly driven by rising per capita income, urbanization, and the expansion of an energy-intense manufacturing sector. To place the energy consumption per unit of GDP in an international context: the Chinese consumption is 2.4 times higher than the global average, 4.9 times higher than in EU countries, and 8.7 times higher than in Japan (China Daily, 2006). This is mainly caused by expansion of energy-intensive heavy industries – for example, cement, steel, and aluminum. With the continuous growth of energy-intense industries, it is estimated that between half and two-thirds of the demand will have to be met through imports in 2020 (Berrah et al., 2007). This has caused some security concerns for Chinese policy makers. Although the energy imports for China, being an emerging country, are high, they are not unprecedented for industrialized countries. For example, it is well known that the United States of America imports about 75 percent of its oil. Energy vulnerability can be reduced through enhanced efficiency and this approach is highlighted in the 11th Five-Year Plan for National Social and Economic Development. This plan proposes to abolish export tax rebates on coal and, natural gas, as well as to increase energy efficiency which until now was discouraged due to disproportionately subsidized low energy prices (Pan et al., 2006). However, in the oil price shock of 2008 the Government of China preferred to subsidize oil imports as this has a strong multiplier effect on production costs for the rest of the economy and inflation. It is clear that energy insecurity will be a permanent vulnerability for China, which is difficult to reduce in the short term as the country is rapidly industrializing. There is, however, the possibility of leapfrogging over the next stages of technical and structural development, thereby skipping the high energy-intense industrialization process. This will not only be achieved through applying new, less energy-intense industrialization, but also by adopting best practices from other countries. For example, in 2006 the Renewable Energy Law was adopted which emphasized renewable energy as a priority for China. It is based on the “feed-in laws” which had some success in promoting renewable energy in European countries, such as hydro, wind, biomass, and solar (Austin, 2005). As Figure 3.2 shows, renewable energy is necessary as a large share of power is generated by thermal power stations that burn coal, which emits high levels of GHG. The long term drop in energy intensity will happen gradually as the economy of China shifts from a manufacturing sector to a less energyconsuming service sector. Although there will be more renewable energy, such as solar electricity and water heating, wind power, geothermal energy and bioenergy, the reduction of energy intensity will mainly be a byproduct of measures embedded in energy and transport policies aimed at cutting energy costs and increasing energy security (Richerzhagen and

Macroeconomic vulnerability and managing the risk of interdependence 45

Figure 3.2 Growth of China’s electricity production. Source: National Bureau of Statistics (CEIC).

Scholz, 2008). In addition, China is expanding its nuclear energy capacity by building 12 new reactors (International Herald Tribune, 2009c). In the short and medium term, China will likely pursue a policy in developing oil resources in countries that have not yet been tied up by Western countries. For example, the most important trading partners for China in Africa are exporters of oil and minerals, with the five largest exporters to China being Angola, the Democratic Republic of Congo, Equatorial Guinea, South Africa, and the Sudan (Tull, 2006). The strategy to reduce vulnerability in regard to energy imports is not only to secure resources for the present, but also to obtain future exploration rights. Regionally, China has also promoted cooperation with other resource-rich countries through the Shanghai Cooperation Organization made up of China, Russia, Uzbekistan, Kyrgyzstan, Kazakhstan, and Tajikistan and is a vehicle to influence a very energy rich region (Gu et al., 2008). These issues will be further discussed in the last section of this chapter. The 2008 financial and economic crisis also provided an opportunity for China’s parastatal companies and sovereign wealth funds to diversify their investments away from US treasury bills. This is often undertaken by providing loans to resource rich countries in Latin America, Africa and Asia.

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In Latin America, China has doubled its investment fund for Venezuela to US$ 12 billion and provided a US$ 1 billion loan for a hydroelectric power plant to Ecuador (International Herald Tribune, 2009d). In Africa, and in the context of the Forum on China–Africa Cooperation (FOCAC), China has increased the value of the China Africa Development Fund to US$ 5 billion, which operates as a sovereign wealth fund. China is also investing several billion US dollars in the mining sector in Australia. These investments around the globe have the objective of strengthening energy independence as well as diversifying investments.

3.4 Managing financial volatilities Before the opening-up period in China, a monobank system was in place and there was no notion of an independent financial sector. In this system the banking sector was simply the state’s cashier that channeled financial resources to state-directed development projects. As mentioned previously, China was not directly hit by the Asian financial crisis of 1997 nor by the sub-prime mortgage financial crisis of 2008. However, the country does have a serious structural problem in the domestic banking as it has a large share of non-performing loans. Until recently, the banking sector was able to cope with these bad debts because the economy was growing at a high rate, by which the Debt-to-GDP ratio dropped rapidly, and because of the high savings rates in China (Zhang, 2007). Overall, the discrepancy between China’s external financial strength (i.e. strong balance of payments, high international reserves and stable currency) and internal financial weakness (i.e. large share of bad debt of domestic and financial systems) is large. The advantage of the external financial strength of more than US$ 2 trillion in currency reserves is that China is financially strong enough to recapitalize domestic banks that have foreign denominated debt (see Figure 3.3). An additional implication for the large currency reserves is the important role of sovereign wealth funds such as China Investment Corporation, which manages US$ 200 billion and has invested in Blackstone Group LP and Morgan Stanley (Bloomberg, 2008). These reserves, denominated in US dollars, are exposed to currency depreciation and inflationary risks. To reduce the exposure to US dollars, the Governor of the People’s Bank of China, Zhou Xiaochuan, has proposed replacing the US dollar as the international reserve currency with a new global system controlled by the International Monetary Fund (Zhou, 2009). The proposal would expand the basket of currencies forming the basis of Special Drawing Rights (SDR) valuation, which are currently only the US dollar, Japanese yen, European euro and British sterling, to all large economies and set up a settlement system between SDRs and

Macroeconomic vulnerability and managing the risk of interdependence 47

Figure 3.3 Growth of China’s Annual Foreign Reserves (USD bn). Source: The People’s Bank of China (CEIC).

other currencies so they could be used in international trade and financial transactions (Financial Times, 2009d). Naturally such a proposal would have serious implications on global monetary governance, as the US dollar would lose its role as a global currency reserve, and the voting share within the IMF would have to reflect an increase for emerging BRIC countries like China. However, China is also promoting in a more subtle manner the role of the Yuan as a global currency. This is done through bilateral arrangements whereby Argentina can draw on US$ 10 billion worth of Yuan to pay for imports from China (International Herald Tribune, 2009d). This is not a stand alone event and Beijing has signed similar agreements worth 650 billion Yuan ($95 billion,
72 billion) with Malaysia, South Korea, Hong Kong, Belarus and Indonesia (Xinhua, 2009). However, before the Yuan becomes a truly global reserve currency, it would have to become fully convertible. The weakness in the domestic financial sector in China could be exacerbated by the WTO accession, which requires the banking sector to gradually open-up to foreign competitors. Competition from foreign banks in domestic markets will increase pressure on Chinese banks, which have more non-performing loans and low capital adequacy. In this situation, a bailout might be required to ensure a viable domestic banking system (Ma, 2006). WTO accession can therefore be seen as a “push factor” to improve the banking system, in particular as entry of foreign banks will put further

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pressure on non-performing loans (Xu and Chien-Ting 2007). In addition, there is also a pull factor which consists of incentives for the financial sector and its firms to improve their governance, transparency, auditing, and accounting standards. This latter is key if Chinese financial companies wish to attract capital to expand their business on the stock market or through international banks. This pull factor will likely have a stronger effect in addressing the dire financial situation than the push factors as there is a clear incentive structure to clean-up the banking system. Although under present conditions China’s central government has enough resources to meet the external obligations of its domestic banks, local governments and (loss-making) state-owned enterprises (SOEs) are also a financial liability. These latter debts include unfunded pension and social liabilities, and re-capitalization of local firms. Another potential liability constitutes the bonds issued by the state-owned Asset Management Company. However, the liabilities of local government and semipublic sector utilities should not necessarily be covered by the central government, for two reasons. First, bailing-out decentralized entities could cause a moral problem (i.e. if the central government helps a decentralized entity that has become insolvent, it might encourage local spending by other entities as they know that they will be bailed-out). Secondly, financially assisting local governments could cause macroeconomic problems as total spending could increase, which could cause a rise in inflation. In turn, this could lead to serious social instability and would be contrary to the objective of achieving a harmonious society. In retrospect, the bad debt of the domestic banks in China is closely linked to their previous role to channel resources to SOEs. The fiscal burden of supporting loss-making SOEs was placed on the banks, which were at the time still the cashier of the state. From an evolutionary-institutional reform perspective, which emphasizes the risk of reforms and the need to gradually adapt to a new institutional setting, this was necessary to ensure a smooth transition. The funding of loss-making SOEs would avoid social unrest as was the case in other transition countries. In addition, this gradual transition process ensured that the political economy underlying reforms could also adapt gradually. In essence, this meant that financial costs of reforms were postponed so as to ensure political support and a smooth transition. From this perspective, it is then only natural for the state to bail-out national banks, although local government should not be financially assisted.

Macroeconomic vulnerability and managing the risk of interdependence 49

3.5 International implications of Chinese rising interdependence Historically, China has been suspicious of multilateral structures, which were viewed as Western dominated and inspired by capitalist motivations. These international organizations would therefore restrain the sovereignty of China. It is for these reasons that, in combination with an autarchist economic policy, China had chosen to isolate itself from the international community until the 1970s. However, with the increase in interdependence through trade and FDI inflows, China became more assertive in multilateral organizations and bilateral relations with other countries. Multilaterally, China has increased its influence over the world and is a member of most international organizations, while bilaterally China has expanded diplomatic relations with energy rich countries in Africa, Asia and Latin America. This engagement is also evident in Figure 3.4 which indicates a growth of outward investments. Its engagement with low-income developing countries ignited an intense debate in Western countries on its effects on traditional development policies of industrialized countries (Sidiropoulos, 2006), which are elaborated by the OECD Development Assistance Committee (DAC). These development policies cover a wide range of issues such as trade liberalization, financial reform, market reforms and conditions. Besides these economic issues, there is a recent trend to expand these policies by political conditions such as human rights, democratic principles and good governance. This is the reason why China’s aid policy is sometimes considered the Beijing Consensus

Figure 3.4 China’s outward FDI Stock by region (US$ mn). Source: Ministry of Commerce of the Peoples Republic of China (2007 Statistical Bulletin of China’s Outward Foreign Direct Investment (CEIC).

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(Stähle, 2008). From the Chinese point of view “development would come first, standards, rights and rules would fall into line. Standards need to be worked out by Africans not imposed by outsiders.” This is contrary to the policy of multilateral and regional development banks which have strict social and environmental safeguards. China is therefore challenging the traditional development perspective by offering an alternative view of what development is and how to achieve it. China has not followed the standard Washington Consensus prescriptions, which are sometimes viewed as “imposed” by traditional Western donors. Aid from China can therefore be relatively limited (i.e. approximately $4.5 billion per year) but it also lacks human rights and governance criteria. In addition, China’s annual foreign aid to Africa is estimated between US$ 1.4 billion and US$ 2.7 billion, while loans are around US$ 8.5 billion.6 Therefore, aid to Africa is mainly channeled through concessional finance by China’s Export-Import Bank. However, the Chinese Government stresses that this is not really development assistance and these policies are guided by the principles of lisuonengji and liangli erxing. This means that, unlike OECD-DAC countries, official donor aid should be within China’s capacity and fiscal capabilities as this country is a development country itself. Just as other newly emerged economies, China’s foreign policy objectives are narrowly focused and are clearly linked to ensuring a steady supply of commodity resources, in particular oil to feed its ever growing economy. In South America, a study by the Inter-American Development Bank (2005) concluded that China’s growth is creating increased demand for agricultural, mining, and energy exports from resource rich countries on this continent (Lora, 2005), although their labor intense manufacturing sectors are in direct competition with China (Sargent and Matthews, 2008). In resource-rich African countries, China seeks to secure future oil and mineral resources, which are often avoided by Western companies due to high levels of insecurity. These relationships are also supported through historic ties with many of the African liberation movements and political elites. In addition, the Chinese government supports domestic companies in their drive to expand overseas through its “Go Out” Strategy, which aimed at creating “national champions” on a global level (Davies et al., 2008). The growth of China’s influence has manifested itself both as a donor and as a trading partner. For example, China became the largest foreign donor in Cambodia with a pledge of US$ 257 million in 2009 (China Economic Net, 2008) and is expanding its influence and affecting traditional donor–recipient relationships. This was also evident in the case of Angola, to which China provided a US$ 2 billion loan that enabled the country the opportunity to avoid IMF conditions, which include strong provisions to reduce corruption and to increase transparency. A more

Macroeconomic vulnerability and managing the risk of interdependence 51 recent case of how China is influencing the traditional donor–recipient relationship is in the Democratic Republic of Congo, where China has offered to provide US$ 9 billion loan to this war torn country, which would fund roads, railways, schools and clinics. However, this loan would have a direct impact on the debt sustainability framework and would threaten the debt relief of US$ 11 billion provided by traditional donors (Financial Times, 2009b). These traditional donors provided debt relief so as to ensure that the Democratic Republic of Congo has additional financing resources to spend on health and education. From this perspective Chinese loans are merely “replacing” debts and would not lead to additional social spending in the Democratic Republic of Congo, which is the original objective of the debt relief initiative. In addition, the commercial relations with other developing countries are not necessarily a win-win situation, in particular with low income countries in Africa. The key issue is not only the management by African governments of resources generated from the revenue boom caused by the demand from China, but also the impact of the competition of Chinese manufacturing on Africa’s weak industrial sector. The consequence might be that resource rich countries reduce their share of added global manufacturing value and manufacturing exports, and increase their reliance on resource-based products. In essence, this argument is similar to the structural doctrine of the 1960s and 1970s. This trend underlines the strong bias of commodity dependent economies toward primary commodities and increasingly away from manufacturing activities, suggesting a downgrading of comparative advantage that may prove damaging to their long term development prospects. However, China’s outward FDI is mainly focused on Asia, as indicated in Figure 3.5. China’s focus in Asia is more on trade and seems to move towards a more integrated production system characterized by complementary rather than confrontational trade relationships (Lall and Albaladejo, 2004). This is in line with the international trend of splitting-up of the value-added chain within the region. China is therefore clearly moving toward deeper integration with the region’s trade and investment networks. For Japan, for example, China was in 2003 the second export market, behind the US, and its first supplier, while South Korea became China’s first export market and its second supplier. As such, China has become an integral part of the engine of growth in East Asia (Gaulier et al., 2009). In the long term, China’s economic power will be translated into global political influence. This process accelerated in the wake of the sub-prime financial crisis of 2008 in which there is serious discussion on reforming the financial architecture, including increasing the voting power in the International Monetary Fund (IMF) and the World Bank for emerging economies, in particular for China. If these global international

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Figure 3.5 China’s outward FDI Stock by regions for 2007 (US$ mn). Source: Ministry of Commerce of the People’s Republic of China (2007 Statistical Bulletin of China’s Outward Foreign Direct Investment).

organizations cannot reform due to vested interest, legitimate and parallel institutions will be created, such as an Asian or African Monetary Fund. The Chiang Mai initiative in Asia demonstrates that this is a realistic option as this regional agreement aims at creating a network of bilateral swap arrangements between countries to address short term liquidity difficulties and to replace in the long term the existing international financial arrangements. This is the reason why the Chiang Mai initiative is considered the first step in the creation of an Asian Monetary Fund.

Main observations of chapter This chapter highlights the macro-economic vulnerability that China faces and the importance of managing the risk of interdependence. As China left the autarchist economic policy of the 1960s and 1970s behind, it gradually opened-up by commercial exchanges as well as by attracting FDI. Although overall the transition has brought great prosperity to China, its options to mitigate have been reduced with the abolishment of the “dualtrack” system as well as the accession to the WTO in 2000. This was evident not only by the financial shock in 2008 caused by the sub-prime mortgage crisis in the United States, but also by the fluctuation of oil and food prices. However, as emphasized by Prime Minister Wen Jiabao at the world trade forum “A fall in the pit, is a gain in the wit” and China seems to take the right policy measures including moving-up the value chain

Macroeconomic vulnerability and managing the risk of interdependence 53 industrial production and stimulating domestic consumption (World Economic Forum, 2009). In addition, the vulnerability of the financial sector and its overexposure of financial assets denominated in US dollars pose a significant risk, although this does function as a buffer for its weak domestic banking institutions. To reduce macroeconomic vulnerability requires a foreign policy that not only focuses on securing energy resources from other developed economies, but also emphasizes responsible corporate governance in developing countries with a weak regulatory framework. On a global level, China is gradually translating its economic power into political influence. This is evident by the recent reform proposals for the financial architecture in the wake of the financial crisis in 2008 triggered by the sub-prime mortgage crisis. These proposals include increasing the voting share of China in the IMF and the World Bank. As such, China has the means to reduce macroeconomic vulnerability and the risks of international interdependence by participating in international forums.

4

Reducing household vulnerability and increasing livelihood opportunities

Introduction Reducing vulnerability and increasing livelihood opportunities encompasses not just income opportunities, but also productive assets. This is especially important as the 2008 financial crisis revealed structural vulnerabilities as the labor intensive exports manufacturing sector reduced output. This resulted in a decline in employment opportunities and remittance to rural areas in China. To ensure the development of a harmonious society would require improvement in livelihood opportunities, in particular for the poorer segments of society. This could only be resolved by addressing issues such as inequality, environmental degradation, natural disasters, migration and political participation. The advantages of addressing these issues would be that households increase their resilience as they would have the capacity to adapt to challenges by changing employment or addressing their grievances to the government. The chapter is presented as follows. The first section, “Origins of the vulnerability approach and Sen capacity”, provides a framework to analyze vulnerability. The second section, “Livelihood approach and multidimensional rural–urban inequalities”, underscores the importance of addressing inequality as well as access to assets (human capital, health care, income opportunities, insurance, etc.) in rural areas. The third section, “Environmental degradation”, emphasizes the role of environmental issues and its effects on vulnerability and livelihoods, in particular for the rural poor. The fourth section, “Natural disasters and crises prevention”, focuses on natural catastrophes, such as earthquakes and floods, which inflict heavy losses on the most vulnerable people in urban and rural areas of China. The fifth section, “Migration and urbanization”, highlights the role of migration and remittances and their impact on rural and urban areas. The sixth section, “Public participation and political reform”, emphasizes the evolution of participatory governance within a decentralized state which is key to improving livelihood opportunities. Finally, the chapter

Reducing household vulnerability, increasing livelihood opportunities

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ends with “Main observations of chapter” underscoring the most important issues of this chapter.

4.1 Origins of the vulnerability approach and Sen capacity Standard poverty analysis in economic literature focuses usually on aggregated income and expenditure variables and often does not consider vulnerability, which features commonly in food security and disaster management literature. This literature defines vulnerability as “an aggregated measure, for a given population or region, of the risk of exposure to food insecurity” (Downing, 1991). Vulnerability is a function of exposure to shock and resilience of households: it correlates positively with the probability and impact of a shock and negatively with the resilience and its determining factors. As the poor’s ability to manage a shock is weak, vulnerable people are extremely sensitive to shocks because seasonal events or unforeseen circumstances may cause them to fall below the poverty threshold (Misselhorn, 2005). Indicators used to measure vulnerability in literature are child malnutrition, child mortality, food consumption, as well as standard measures of poverty. Vulnerability is closely linked to resilience, which in turn is strongly associated with entitlements and capacity of individuals or households. In this framework, “resilience,” or the capacity to recover from negative effects, is also influenced by the assets and entitlements that individuals, households, or communities can mobilize in the face of hardship. The capability of households to cope with, and recover from, shocks and trends of varied nature (e.g. environmental, economic, political, etc.) as well as seasonality is related to liquid assets, including disposable items (classically, jewelry and livestock), social networks and public interventions (Brugere and Lingard, 2003; Hulme and Shepherd, 2003). In addition, safety-nets can reduce vulnerability through protective effects, which are government measures to prevent the non-poor from slipping into poverty (Ravallion et al., 1995). Vulnerability is closely related to the lack of asset ownership and introduces a dynamic concept to poverty analysis. Vulnerability focuses on the transitional poor (i.e. people floating around the poverty line and therefore sometimes poor, but not always) and not on the chronic poor (i.e. people that are always under the poverty line). Key elements in vulnerability are therefore exposure to shock as well as the resilience, which can be measured through multi-dimensional capacity (i.e. human capital, health care, liquid assets, etc.), to absorb a shock. This brings the vulnerability analysis close to the livelihood approach and the notion of Sen “capacity”. Vulnerability also provides useful insights into reasons why individuals

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or households are predominantly poor or not poor at a particular point in time. This fluctuation between being poor and not poor could be caused by structural environmental degradations, seasonal floods, or the sudden flow of remittances from household members that have migrated to urban centers. The insight that vulnerability brings is important as it figures as an element in the mentality of the poor who focus upon reproduction rather than production as the central motivation for managing the domestic cycle, whether annual or intergenerational (Wood, 2003). Therefore, vulnerability does not just result from poverty; it can also reinforce processes leading to poverty. Finally, the vulnerability concept has also been integrated into natural hazards and environment and climate change literature, for which different definitions were developed, including social vulnerability. This is the exposure of groups or individuals to stress resulting from social and environmental change caused by climate change or natural disasters. In this context stress refers to unexpected changes and disruption to livelihoods. This definition emphasizes the social dimensions of vulnerability and follows the tradition of analyzing vulnerability in terms of hazards, food insecurity and lack of entitlements (Adger, 1999). In addition, vulnerability analysis has also been integrated into various academic disciplines, such as environmentalism which refers to vulnerability as the resilience of ecological systems to cope with environmental change, or public health that uses the term to describe humans’ sensitivity to diseases (WHO, 2003).

4.2 Livelihood approach and multidimensional rural–urban inequalities The livelihood approach seeks to broaden the scope of poverty beyond income and expenditure variables. In the livelihood framework, well-being depends on the assets people have access to (classically financial, human, natural, physical and social capital); the factors that influence their access (for instance, gender relations or how markets operate) and contextual factors such as macro policies to mitigate shocks (Ellis and Bahiigwa, 2003). At the center of the livelihood approach is the economic relationship between livelihood assets and the outcomes that result from productive use of these assets in terms of improving or worsening the welfare and well-being of the individual or family (Freeman et al., 2004). The livelihood approach can be applied at family (Linderberg, 2002), community (Sen, 2003) and country level (UNCTAD, 2002). The livelihood approach can be expanded to political and social spheres, which comes close to Sen’s deprivation of basic capacity (Sen, 1999). Rather than merely focusing on low income, which is a standard criterion

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for poverty, it emphasizes the “capacity” of individuals to climb out of poverty. The perspective of capacity-poverty does not reject the notion that low income is one of the major causes of poverty, since lack of income can be a principal reason for a person’s capacity deprivation. Therefore, their vulnerability might be denoted as “livelihood vulnerability”. Sustainable livelihoods literature focuses on the concepts of risks and responses. The outcome is loss of livelihood as well as continued “vulnerability” to future shocks (Alwang et al., 2001). Therefore “livelihood vulnerability” is forward looking and dynamic. The livelihood approach emphasizes not only the importance of income opportunities, but also that of human capital and health care. The latter two are critical as human capital is a structural asset which is key to moving out of poverty, while illness and medical expenditures are often the reason for falling into poverty. Inequality between rural and urban areas in China is multi-dimensional and encompasses income opportunities as well as accessibility of affordable health and educational service. Income opportunities in rural areas are also limited due to lack of infrastructure (such as irrigation and rural roads) and degradation of arable land due to environmental mismanagement. Moreover, the income opportunity of rural farmers might have increased overall in the last two decades, but they also had to pay more through local taxation as well as informal and formal fees for public services, such as basic preventative health care, that were previously provided free of charge (Schiere, 2008). The introduction of fees for services provisions could be considered the result of privatization of services as well as a general monetarization of economic activities during the transition process. Fiscal decentralization limited the capacity of local governments to provide basic services to their constituencies, especially in poor and mainly rural districts as these jurisdictions had less funds to support social safetynets provisions. This increased inequality in social service provisions. Although fiscal decentralization was somewhat reversed by the reforms in 1994 (Jin and Zou, 2005), many local entities are still highly decentralized. The reason for this is threefold. First, it is assumed that fiscal decentralization would improve public service delivery as well as its efficiency. This is based on Oates’ decentralization Theorem which states that a decentralized system is always more efficient than a centralized system for supplying local public goods as local governments know the “preference” of their constituencies (Oates, 1972). Secondly, the official policy was to “let the rich get richer” and these rich provinces were located in the urban eastern part of the country. Therefore poor districts had to fend for themselves and introduced local taxation and service fees to finance their budget. Thirdly, from a political economy point of view, discontent by urban residents is more imperative to address than

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that of poor peasants who are often disbursed over a wider area and not included in civic organizations. Due to high levels of multi-dimensional inequality in income opportunities, health care, education services and political participation, rural areas often have less livelihood opportunities than urban areas. As such, the rural regions in China usually have less capacity at household level to cope with negative environmental or macroeconomic shocks. In addition, the capacity of local government to provide basic social safety-net provisions is limited due to the lack of financial resources, and this also increases the vulnerability of local households.

4.3 Environmental degradation Strong economic growth has brought greater prosperity, but also significantly contributed to environmental degradation that has manifested itself on a global level (i.e. change in weather patterns, expansion of deserts, retreat of glaciers in the Himalayas, etc.) and on a national level (i.e. air and water pollution, acid rain, drop in water-table, salinization, etc.). China’s impact on climate change and pollution is mainly caused by the expansion of the energy intensive manufacturing sector, over-use of water resources, rapid urbanization as well as higher living standards which lead to the use of air conditioners and refrigerators. This was aggravated by a policy of deliberately promoting economic growth over other priorities such as sustainable environmental management. At a global level the structural economic and social changes in China made this country one of the largest emitters of greenhouse gas (GHG) in the world. This will likely continue in the near future as employment generation will remain the top priority, in particular in the wake of the economic downturn following the 2008 financial crisis triggered by the sub-prime mortgages in America. The emphasis on employment generation would ensure absorption of a large flow of migrants from the rural areas that move to urban centers. In the long term this policy of prioritizing employment will lead to per-capita emissions to match those of OECD countries by 2030 (EIA, 2008). As such, China follows in the footsteps of many Western countries that opted to “pollute first and clean up later”. The contradiction between economic growth and environmental degradation is based on a narrow assumption that addressing environmental issues would have a negative impact on economic development and the livelihoods of people. However, this contradiction is a misconception as addressing environment challenges would actually improve economic development. For example, the World Bank estimates that air pollution is costing China 3.8 percent of its gross domestic product (World Bank and State Environmental Protection Administration, 2007; World Bank, 2007).

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Moreover, air pollution from coal, cars, and dust storms is responsible for 3–400,000 premature deaths (Turner and Kim, 2007). If water and air pollution were included, the total cost to the economy, through health costs, crops and other economic losses, is estimated at 5.8 percent of GDP (Dollar, 2007). A vivid illustration of the cost of pollution is the accident at the Petro-Chemical plant in Jilin in November 2005, which resulted in the release of hundreds of tons of toxic benzene into the Songhua River. As the Songhua flows into the Heilong River in Heilongjiang Province that provides drinking water to Harbin and to the Russian city of Khabarovsk, local officials had to close off the water supplies for several days and had to inform Russia of the water pollution. Another dimension of environmental degradation which severely impacts livelihoods is desertification, which leads to soil salinization and loss of arable land. Desertification is caused by a combination of “natural factors” such as climate change, and “human factors” such as over-grazing of land, deforestation, and over-use of natural water resources for irrigation causing, among other things, the lowering of the water-table (Tao and Wei, 1998). While “natural factors” are difficult to address without international consensus and action, the “human factors” are within the scope of the Government of China to address, for instance through limiting of grazing and planting of trees. The expansion of deserts exacerbates food insecurity in rural areas in the interior of China and leads to loss of livelihoods as agricultural opportunities decrease. In turn, these rural poor will most likely migrate to urban centers and become part of the urban underclass. This environmental induced migration could be a serious concern as the Asian Development Bank (AsDB, 2006) estimated in 2006 that the livelihoods of 400 million people are threatened by the expansion of the three largest deserts, the Gobi, Taklimakan and Kumtag. Another study predicts 50 million environmental refugees in China by 2010 will migrate because of water shortages and sand dunes (Turner, 2007). In essence, the rural peasants, which already have limited livelihood possibilities, are negatively affected by climate change caused by the more prosperous, but highly polluting, eastern provinces of China. Although it is evident that China stands to suffer from climate change through desertification as well as air and water pollution, it did not sign-up to the international commitments to reduce its GHG emissions. These commitments would be difficult to attain as China will require an additional 562 new coal-fired power stations by 2012 to satisfy its energy needs. The pollution created by the power stations could eliminate the combined cuts required under the Kyoto Protocol by able industrialized countries (Turner and Kim, 2007). However, from China’s perspective, just like for many other emerging and developing countries, climate change

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is not their problem, as this phenomenon was caused by pollution over more than a hundred years by a small group of Western developed countries (Baumert et al., 2005). Therefore, these industrial countries should take the lead in developing clean energy as well as sharing technology that would enable industrialization and wealth creation while limiting pollution. Nationally, China has started to address environmental problems within its own priorities and at its own speed. For this reason, environmental concerns were included in the 11th Five-Year Plan for National Social and Economic Development, which was adopted in 2005. In this plan China seeks to move towards a more environmentally sustainable growth path. In a practical manner, some large cities have taken the lead to control air pollution by converting taxis and buses to national gas and investing in public transport. This is logical as China has 16 of the world’s 20 most polluted cities, which is also linked to the exponential increase in air emissions which are mainly located in urban areas (see Figure 4.1). In the long term, China is moving ahead in the development of electric cars. It is currently the largest producer of electric cars as well as the second largest producer of electric batteries. The introduction of electric cars could have enormous effect as it is estimated that this would reduce China’s output of GHG by 19 percent (International Herald Tribune, 2009e). However, the most visible area in which China has demonstrated global leadership in environmental management was the increase in forest

Figure 4.1 Air emissions (billion cubic meters). Source: Ministry of Environmental Protection (CEIC).

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coverage by 70 percent in the past 20 years, which reduced desertification (World Bank, 2008). From a livelihood perspective, this would limit destruction of agricultural productive assets and ensure that rural households could participate in economic growth. China has also taken the first institutional steps to address climate change issues by elevating the State Environmental Protection Administration to the Ministry of Environmental Protection in March 2008. This is important as China is traditionally highly decentralized and divides environmental mandates between various regional and local entities. In combination with a high degree of political autonomy of local administrations, this made it difficult to address country-wide environmental degradation within one local province or city. This created a free-rider problem because local governments will always prioritize industrial development as most of the negative environmental impacts will be felt by other jurisdictions. However, with the elevated status of a Ministry, environmental issues are easier to address in all jurisdictions, irrespective of where the polluter is located. It is also important to note that as part of the 4 trillion Yuan anticyclical spending plans, 210 billion Yuan is earmarked for investment in environmental protection and energy conservation, including upgrading coal-burning power-plant, green lighting and developing clean energy (i.e. clean wind and solar power). This would also aim to address pollution in China’s seven major water systems, including the Yangtze and Yellow rivers, which are “mildly” polluted. According to the annual report on the environment for 2007 by the Environmental Monitoring of China, under the protection of the Ministry of the Environment, more than half the 500 cities and counties monitored reported cases of acid rain (China Daily, 2009a). However, this “green” determination might be at risk if environmental programs are inefficiently implemented through a top-down mode with high pressure to spend funding in a short-timeframe. Despite the best efforts of the Government, it is evident that environmental degradation will still affect the livelihoods of the rural and urban poor in different ways. The rural poor peasants, which already have limited livelihood opportunities, are negatively affected by loss of crop yields due to a combination of water pollution, acid rain and desertification. The urban poor are mainly affected through air pollution, which causes 75 million asthma cases per year (Turner and Kim, 2007), which negatively impacts child development, increases health care expenditure and reduces worker productivity. Therefore, environmental degradation will have a negative impact on economic growth. In addition, it is highly likely that the rural poor would be more affected by environmental degradation, resulting in an increase in an already large migration flow from the country sides to cities.

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4.4 Natural disasters and crises prevention In China, natural disasters consist mainly of earthquakes and floods, which not only cause major destruction but also loss of livelihood opportunities. In disaster management literature, vulnerability refers to a lack of response capability to external risk or even disaster (Chambers, 1989; Bogardi and Birkmann, 2004). It indicates the sensitivity of individuals, groups or systems to sudden changes or risks. Disasters are considered the integrated result of interaction between the natural environment and the vulnerability of socio-economic systems. The effects of natural disasters can be mitigated or exacerbated by the lack of preparation and emergency management. In essence, mitigation measures can limit financial, environmental or human losses. However, this requires specific capacities of local government entities. In terms of earthquakes, China is unfortunately located on several fault lines of the tectonic plates. The destructive effect of earthquakes in China was vividly demonstrated on 12 May 2008 in eastern Sichuan. This event killed more than 69,000 people and injured another 374,000. The earthquake affected more than 45.5 million people in 10 provinces. At least 15 million people were evacuated from their homes and more than 5 million were left homeless. An estimated 5.36 million buildings collapsed and more than 21 million buildings were damaged in Sichuan and in parts of Chongqing, Gansu, Hubei, Shaanxi and Yunnan (Cowasjee Earthquake Study Centre, 2008). The total economic loss has been estimated at 86 billion US dollars. The districts or counties of Beichuan, Dujiangyan, Wuolong and Yingxiu were almost completely destroyed (U.S. Geological Survey, 2008). The poor are often more vulnerable as large scale rural–urban migration and lack of urban planning lead to low income urban dwellers to concentrate in substandard housing (UNEP, 2008). This leads to migrants being exposed not only to natural disasters, but also to man-made disasters such as slum fires and health hazards. Although earthquakes are one of the most visible forms of natural disasters, other forms are less severe but may occur on a regular basis, such as drought and flooding affecting rural poor farmers (Ma et al., 2007; Wang et al., 2008). In some areas flooding is a serious issue, with the average annual direct economic loss being estimated to be more than 3.0 billion Yuan. The frequency and intensity of natural disasters also seem to increase and it is estimated that the average annual loss from all forms is over 10 billion Yuan (Qianwen and Junbiao 2007). These natural disasters can severely affect farmers as they are often already poor and lack capacity to recover. This is often reinforced by the lack of insurance schemes, which results in farmers incurring the cost of damaged property

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as well as recovery. This is why natural disasters often bring serious damages to local economy and society. At the central level, China has set-up an International Disaster Abatement Commission that drafted “China’s 21st Century Agenda and Disaster Abatement Program (1998–2010)” (Fuchun, 2002), which has the objective of targeting research and policies towards mitigating the floodinduced losses and construction of a harmonious relationship between floods and socio-economic livelihoods. This is important as the lack of insurance schemes in rural areas increases the negative correlation between, on the one hand, regions that are impacted by natural disasters, and on the other hand by the total sowing areas and the incidence of rural poverty. The negative impacts of natural disasters are further exacerbated if a region is underdeveloped or if the same area is affected in successive years (Wang Guomin, 2005). However, actual improvements need to be made at a decentralized level as local knowledge is key to disaster management and prevention. Moreover, China should develop the physical infrastructure, such as buildings and bridges, that can withstand earthquakes. It is worth emphasizing that earthquakes do not necessarily have to create massive loss of life and destruction as is demonstrated by Japan which experiences these natural disasters regularly without long-term economic damage or loss of human life. In addition, market-based insurance schemes should be set-up to assist poor farmers in drought and flood stricken areas to cover for losses in a particular year. In these circumstances, vulnerability would be reduced by increasing resilience at the individual and society level. This would also reduce migration to the cities as households have better livelihood opportunities in the countryside.

4.5 Migration and urbanization In the nineteenth century, warfare and famine were the main drivers of migration and many Chinese moved from the hinterland to “treaty ports”1 such as Shanghai, Hong Kong and Macau. During the first two decades after the Communists took power, movements of people were considered production “allocation decisions” and were linked to an overarching political and economic reform agenda. For example, during the Great Leap Forward urban populations increased, while during the Cultural Revolution urban educated dwellers were “sent down” to rural areas. In the 1970s, following increased tensions between China and the Soviet Union, the Chinese government decided to disperse industrial activities across central and western parts of China. The movement of these industries also included moving factory workers and their families. At about the

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same time, the hukou system was introduced, and this limited the possibility of moving to urban centers, in particular in the 1980s and 1990s. This avoided creating urban slums that would lead to social unrest, which is the case in many other developing countries. Instead, China adopted a strategy of “Development of Small Towns” under the slogan of “li tu bu li xiang”, which meant “leaving the land but not the village”. In 2007, China had 594 million urban residents, or 44.9 percent of its entire population, up from 21.1 percent in 1982 (Xinhua News Agency, 2008). There are an estimated 130 million migrants in China, which are referred to as the “floating population” (Li, 2007). Migration had “push” and “pull” factors. The “push” factors were the high poverty rates in rural areas, where 90 percent of the people were living in 1978. For example, living conditions are rudimentary in the countryside with only 45 percent of its population having tap water, 49 percent could be reached by bus and slightly more than 25 percent had set places to collect trash (Xinhua News Agency, 2008). More recently, the “push” factors included the transition in agriculture from a labor intensive to a capital intensive sector. This is the only manner to structurally augment productivity and increase a farmer’s income. However, the consequence of the productivity increase in the agricultural sector is the annual loss of between 12 and 15 million jobs and this labor surplus has to be absorbed by the manufacturing sector in urban areas (Johnson, 2000). The “pull” factors for migration were not only high wages, but also entrepreneurial activities in cities. Furthermore, migrants appear relatively indifferent to the quality of life in urban areas, suggesting that this is the main economic reason for leaving rural areas (Chen and Coulson, 2002). Manufacturing and construction employed over 50 percent of all migrant workers. In 2006, the average period a migrant stayed outside his village was 9.4 months (Li, 2008). This relatively short period stems not only from the denial of permanent urban residency status, but also from underrewarding of migrants’ human capital in cities. Migrants in the urban areas also face additional financial burdens as they have to pay “education endorsement fees” (jiaoyu zanzhu fei) for their children (Liang and Chen, 2007). The remittance flows from urban to rural areas have strong poverty reduction effects in the countryside (e.g. Knight and Song, 1999; Rozelle et al., 1999; Zhao, 1999) and are estimated to contribute to 9 percent of rural income in 2001 (Deininger et al., 2003). As such, remittances are a catalyst for rural development (Zhao, 2002). The impact of migration and remittance on vulnerability is complicated. Overall, it can be stated that the average income of migrant households in 1999 was 18 percent lower than that of urban households and 33 percent higher than average rural household incomes. Therefore, vulnerability in rural areas at the household level has probably been reduced by remittance

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flows, while in urban areas individual migrants are likely to join the ranks of the urban poor and are excluded from social services as they often lack residential status. In addition, individual urban migrants lack the extended family and community support structures which are strong in rural areas and can be considered “social capital”. In sum, it can be concluded that due to remittance rural households become less vulnerable, while individual migrants in urban areas become more vulnerable.

4.6 Public participation and political reform Effective public participation is key to reducing vulnerability as this is critical for citizens to defend their rights as well as to seek compensation for decisions which negatively affect their livelihood, such as demolition of homes or seizure of land for large infrastructure projects. Another advantage of public participation is that it strengthens the legitimate government supported by its citizens. This is irrespective of the political system in a country. It is for this reason that Mao Zedong created “mass organizations” such as the Chinese Communist Youth League, women’s league and trade unions, which were the main channels of communication between the “rulers” and the “masses”. These “mass organizations” were not directly part of the public administration, but were important tools to mobilize the people, and they received funding from the state. China also has a traditional culture of “petitioning” or xinfang, as a form of expressing grievances. During the emperors’ time, Chinese wishing to redress their grievances beat drums outside government offices or petitioned visiting imperial envoys, or appealed directly to the emperor. The underlying belief was that although local officials were corrupt and incompetent, the emperor was always divine, wise and good hearted. The communists adopted the petition culture and spread the belief that the Central Leadership in Beijing was always well intended, although local officials could deviate from the “right” path. This system was, and to some extend still is, ideal for China as local courts and legal system are not always effective in resolving disputes due to judicial corruption and to delays in litigation procedures. The Chinese Central Government is also using the xinfang system to maintain a closer and direct link with the masses (Zou, 2006). That this is indeed an effective means to redress grievances is indicated by the extraordinary measures that local officials are sometimes willing to take to dissuade complainants, including sending petitioners to psychiatric health clinics (BBC, 2008a). Despite these challenges in the last four decades China has moved gradually from the disastrous effects of the Cultural Revolution, in which suspicion of being a capitalist was sufficient to be sent to prison, to a country where individuals can decide where to eat, what to wear and which

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career to pursue (BBC, 2008b). The policy behind liberalizing the political system in China is similar to that pursued in the economic domain and can be defined as “crossing the river by feeling the stone”. This is translated into a practical policy of undertaking an incremental reforms process through a trial-and-error process. The incremental reform in the areas of participatory governance was supported by the decentralized M-structure which permitted policy experimentation (Maskin et al., 2000). This M-structure encouraged grassroots democratic developments in particular in the wake of the economic liberalization which started at the end of the 1970s. In the context of political liberalization, this led to an explosion of civil organizations across China ranging from homeowners’ associations and environmental NGOs to animal-raising associations. Official statistics from the Ministry of Civil Affairs show that the total number of registered civic associations increased from 116 thousand in 1991 to 150 thousand in 2004. Unofficial estimates are much higher. In contrast with the Communist Party and the “mass organizations,” the emerging civic associations have more voluntary and active members, and are more effective in mobilizing and channeling public opinion through the media to official decision makers. In this sense, party-state seemed tolerant towards demonstrations of ordinary citizens to air their grievances (Guo, 2007), under the condition that these civil organizations do not threaten the central power of the Party. The M-structure also facilitated experimentation and generated numerous experiments in participatory governance. These experiments included direct elections for the people’s congress deputies at the township and county level and for village committees in Hebei, as well as publishing government proposals and soliciting comments with government response on the website in Guangzhou. Moreover, in more than 70 percent of the county-level governments, a rudimentary public opinion system has been established that includes holding public hearings, advisory meetings and panel discussions to solicit public opinions concerning proposed law drafts. In addition, Shenzhen officials published reform proposals which advocated some local elections and more independence from local legislators and courts (International Herald Tribune, 2008). These initiatives introduced new channels for citizens’ participation in government decision making. One of the main challenges is to link political participation with meaningful resources so that decisions can actually be implemented. However, as will be discussed in Chapter 6, fiscal reforms have led to limited capacity to provide public service provisions to its constituencies, which is the most effective tier of government for delivery of public services (Oates, 1972). This is in contrast with the official policy of strengthening the village

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institutions which require political participation as well as the authorizing of financial resources (Fock and Wong, 2008). The pragmatic approach on participation is also evident from China’s official policy of “one country two systems”, whereby the territories of Hong Kong and Macau were reunified with the mainland. Under this policy, two entities could have separate economic and political systems within the country’s constitution. Although Hong Kong has only limited democracy, whereby 30 of the 60 seat legislative council are chosen through direct election, it provides an opportunity for the mainland to experiment with various participatory decision making processes. Over time, China will identify which form of participatory governance will be the best and seek to explore socialistic democracy with Chinese characteristics. However, in all these policy reforms, the central government does exert a minimal amount of influence on local politics through the career track of Chinese officials who are controlled by the government through appointment and promotion (referred to as the cadre management system), as well as through the membership of the Chinese Communist Party (Huang, 2001). The cadre management system in combination with the target responsibility system is used by the central government to steer local cadres towards the national agenda, with explicit targets ranging from economic growth to fertility control. In general, it is clear that political participation is key for citizens to improve their livelihood opportunities as well as for China’s long term political stability, which would inevitably have an effect on the economic conditions in the country. The legitimacy from the government would ensure that the amount of “sporadic” demonstrations and signs of discontent would be limited, which should contribute to the development of a harmonized society.

Main observations of chapter After two decades of transition in which overall economic living standards have improved for the majority of the population, the contemporary challenges are more difficult to address as high economic growth rate is insufficient to automatically increase the well-being of citizens. Instead, these challenges would require a balancing of economic growth with other development problems such as high levels of inequality, environmental degradation, disaster management, migration, rapid urbanization and political participation. These contemporary challenges are structural in nature and are difficult to address in the wake of the 2008 financial crisis, but must be dealt with in a holistic manner. It is evident that the issues mentioned in this chapter would improve the resilience at household level, which is key for developing a harmonious society.

5

Estimating regional vulnerability and inequality

Introduction Estimating vulnerability is important in a high-growth emerging economy in which a million people have been lifted out of absolute poverty, although large proportions of the population remain highly vulnerable. The objective of this chapter is to present a basic methodology to estimate the evolution of vulnerability in China as well as to decompose vulnerability, using provincial level data from 1982 to 1999. Regional vulnerability is defined in this chapter as the risk to events in which a bad outcome could move the household into poverty on a regional level.1 This research analyzes the composition of the various assets (liquid assets, social service provisions in the health and education sectors, urbanization, industrial activities and political integration) and its impact on vulnerability. The methodology to estimates vulnerability builds on a previous research carried out by Chen and Schiere (2008). The remainder of this chapter is organized as follows. The first section, “Vulnerability, public service provisions and assets”, emphasizes the importance of monetary and non-monetary assets, such as liquid assets, public service provisions, urbanization, economic activities and political participation. The second section, “Data description and methodology”, describes the data and presents the Theil inequality index, which is subsequently introduced in an OLS regression with Fixed Effect. In addition, the coefficients are calculated so as to estimate the evolution of vulnerability. The third section, “Results”, presents the evolution of vulnerability by region in China as well as indicates how it is distinguished between regions and within regions. Finally, the section “Main observations of chapter and policy implications” highlights the limitations of the methodology in this chapter as well as suggests practical policy recommendations that might reduce vulnerability in China.

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5.1 Vulnerability, public service provisions and assets Estimating vulnerability in China is essential as it can determine the impact of negative shocks at the household or macroeconomic level. More specifically, analyzing vulnerability is important for four reasons. First, addressing vulnerability is key to developing a harmonious society which is critical for long term social and economic development of a country. Secondly, emerging economies like China have high inequality despite having enormous economic growth rates over several decades. Multidimensional asset-based analysis would highlight the vulnerability of deprived households. Such an analysis would be necessary so as to avoid a “twin-peak” growth scenario whereby economic growth and inequality increased simultaneously. Thirdly, the average consumption of many households in China is just above the poverty line, which would make them non-poor in absolute terms, but still highly vulnerable (McCulloch and Calandrino, 2003). Finally, vulnerability is an important factor in the decision making of the poor as they lack the capacity to absorb negative shocks (Wood, 2003). As indicated in previous chapters, China’s opening-up and transition led to enormous economic growth and overall poverty reduction of historic proportions. However, the downside was that inequality between regions and rural–urban inequality increased (Yang, 1999; Yao, 1999; Kanbur and Zhang, 2005; Wan, 2007). Unlike inequality and poverty, the issue of vulnerability has not been extensively studied in China and in general does not focus on assets composition (Ravallion and Chen, 1998; Jalan and Ravallion, 1999, 2001; McCulloch and Calandrino, 2003). Productive asset composition is important as it could estimate the dynamics of poverty. This could be done by identifying the capacity to cope, or resilience, of households during a period of stress. Productive assets are therefore important as it functions as a “buffer” in times of stress or economic downturn. Multidimensional asset deprivation would lead to additional vulnerability (Misselhorn, 2005) as households lack not only income, but also human capital, health care and social network to absorb a negative shock. Therefore public service provisions in the health and education sectors are key to address as ill health and “out of pocket” medical expenditures (Jalan and Ravallion, 1999; Sen, 2003) are often associated with a falling into poverty, while human capital is a structural asset that would raise living standards. Urbanization is also an important determinant as public service provisions in cities are more adequate than in rural areas (Kanbur and Zhang, 2005). To ensure that public services provisions are responding adequately to their constituencies would require public participation in local government.

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In China the channel of communication between local government and its citizens is through the Communist Political Party, in particular local governors and party secretaries. This is strengthened by the traditional decentralized M-structure (Maskin et al., 2000) which facilitated policy experimentation in participatory governance. Examples of these include direct elections for people’s congress deputies at the township and county level and for village committees in Hebei, as well as publishing government proposals and soliciting comments with government response on the website in Guangzhou. In addition, in more than 70 percent of the countylevel governments a rudimentary consultative public opinion system is established such as holding public hearings, advisory meetings and panel discussions to solicit public opinions concerning proposed law drafts (International Herald Tribune, 2008). Participatory governance is also facilitated by the exponential growth of civic organizations across China, ranging from homeowners’ associations and environmental NGOs to animal-raising associations. Official statistics from the Ministry of Civil Affairs show that the total number of registered civic associations increased from 116,000 in 1991 to 150,000 in 2004 (Guo, 2007). This growth indicates that citizens are seizing the opportunity to participate in decision making processes. Some industrial activity could also be more sensitive in terms of vulnerability than others. For example, both income opportunities and risk in the primary, secondary and tertiary sectors are different. Although research in this domain is scarce, it could be plausible that the primary sector (which represents agriculture) is highly vulnerable as both income opportunities and risks are relatively high, such as through drought and flooding. The secondary sector (which represents the manufacturing sector) would be less vulnerable as the income opportunities are higher, but risks of unemployment are high, in particular in the wake of the 2008 financial crisis. The tertiary sector, which represents the service sector such as retail, would have higher wages and low risk of unemployment as demand for services are less sensitive to global economic downturn. The analytical framework to estimate vulnerability presented in this chapter is applied on a provincial level and would identify which regions are the most vulnerable through inequality of various explanatory variables that cover liquid assets, public service provisions in the education and health sectors, urbanization, industrial activities and political participation. Overall, high inequality of these variables is related to vulnerability as higher inequality leads to: i ii

lower access to public services for the poor, as they are more dependent on the state than richer people; an increasing gap that will reduce the trickle-down effect of economic

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growth on poverty reduction and increase the risk of staying in poverty (World Bank, 2006); for example, it is hard for an illiterate person to benefit from rapid economic development; iii lower participation in public decision making as the rich “hijack” political participation; and iv lack of collateral, which from a capital market perspective, lowers the possibilities of participating in economic growth opportunities. Therefore, greater initial inequality in asset distribution will mean that the growth that does occur is less (income) poverty reducing (World Bank, 2006). In China, the initial distribution is also important in determining the change in rural poverty during transition (Wan, 2006). This was reinforced by reforms in urban areas whereby state-owned apartments were sold to households at low prices, thereby transferring wealth, and possibly collateral for loans, to urban residents. Although this could be justified from a privatization perspective (i.e. households are more likely to manage their own estate more efficiently than the state), the outcome of this policy was that assets were transferred to urban residents, thereby increasing inequality between urban and rural households (Li and Zhao, 2007). The poor would therefore have less possibility to participate in economic growth and have fewer assets to absorb a negative shock.

5.2 Data description and methodology To estimate the evolution of the asset base of households in China the dataset covers 1982–1999. The following dependent variable is used in the OLS regression with Fixed Effect. Weighed food expenditure Weighed food expenditure is the average of urban and rural food consumption expenditures (see equation 5.1). The assumption is that food consumption expenditure is closely related to poverty as this is the item households would reduce when becoming poor. Practical examples of poverty being measured through food consumption expenditures are also evident in the literature (Barrett, 1999).

WFEpt =

冱冱 t

p

Urb*UFE +

冱冱 t

p

(1 − Urb)RFE

(5.1)

Where WFE is the deflated weighted food expenditure, Urb is the percentage of urbanized population, UFE is the deflated urban food expenditure, RFE is rural food expenditure, p is one of the respective

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Managing vulnerability and increasing livelihood opportunities 28 provinces, t is the respective individual year starting from 1982 until 1999. The explanatory variables of asset composition are estimated by a one stage Theil decomposition index.

The following variables are used to measure Productive Assets (PAi) on a provincial level: 1. Liquid assets (L) Liquid assets are essential to reducing vulnerability as they could be used to absorb negative shocks. Liquid assets are defined as per capita savings deposited by individuals into banks that pay interest. The savings deposit is calculated by adding together all deposits made, but this is deflated by the Consumer Price Index (CPI). 2. Public provision in the education sector (Edu1 and Edu2) Education is key to building up human capital which would result in higher productive activities, essential to reduce vulnerability. The role of human capital in the reduction of poverty is well documented in the literature (Adam and Jane, 1995; Campa and Webb, 1999).2 The public provisions in the education sector are the number of teachers divided by the number of students at this level of education in, respectively, the primary (Edu1) and secondary (Edu2) sectors. The data is from various issues of China Statistical Yearbook, provided by China Statistical Data Compilation of Michigan University. 3. Public provision in the health care sector (HC1 and HC2) Health care is important as illness, especially chronic illness and “out-of-pocket” medical expenditure, is a major factor in making people poor (Jalan and Ravallion, 1999; Sen, 2003). The public service provisions in health care are the number of beds (per 10,000) divided by per health care institution (HC1) and the number of medical personnel per province divided by number of doctors per province (HC2). The data is from various issues of China Statistical Yearbook. 4. Urbanization (U) Urbanization is an important determinant as public service provisions in cities are better than in rural areas (Kanbur and Zhang, 2005). The urbanization is calculated based on the percentage of non-agricultural population over total population. The data is from various issues of China Statistical Yearbook. 5. Industrial sectors activities (IND1, IND2 and IND3) Industrial activity is important as some sectors are more vulnerable than others. For example, income opportunities in the primary industries (IND1), which are based on agriculture, tend to be less than secondary industries (IND2) that are focused on manufacturing. In turn this has fewer income opportunities than tertiary industries (IND3), which are service oriented and less affected by macroeconomic shocks. The data is from various issues of China Statistical Yearbook.

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6. Political integration (POL1 and POL2) Political integration of constituencies is key as this is essential to address grievances of local communities. Unlike Western oriented democracies, China’s channel of communication is through the Chinese Political Party (CPP), in particular through their party secretaries and governors. The longer the tenure of party secretaries (POL1) and governors (POL2), the more likely the party is integrated with the respective jurisdiction. Consequently, this would lead the party to be more responsive to the constituency needs, which in turn would lead to better health and educational services. This data was provided by Yiu Por Chen from DePaul University in Chicago. The methodology to estimate vulnerability is based on a three step approach. First, the one-step Theil decomposition index is introduced in an OLS regression with Fixed Effect. The index provides the opportunity to distinguish the contribution of inequality between regional component (i.e. between regions) and within a region (i.e. between region and provinces). For this research, the provinces of China are divided as follows: Eastern and North-Eastern (Beijing, Tianjin, Hebei, Shanghai, Jiangsu, Zhejiang, Fujian, Shandong, and Guangdong-Hainan, Liaoning, Jilin and Heilongjiang); Interior (Shanxi, Inner-Mongolia, Anhui, Jiangxi, Hubei, Hunan, Henan, Guangxi, Sichuan-Chongqing, Guizhou, Yunnan, and Shaanxi); and Western (Gansu, Qinghai, Ningxia, and Xinjiang). Tibet is excluded due to lack of data. The provinces of Guangdong-Hainan and Sichuan-Chongqing have been merged to ensure compatible datasets. The measurement of inequality in the hierarchical structure of a country can be done by using the province as the basic unit. The standard Theil equation that measures inequality is: Theil inequality index = Σi Σj (Yij/Y) log (Yij/Y/Nij/N)

(5.2)

An inequality measurement can be decomposable if total inequality is the sum of within-group and between-group inequalities. Furthermore, the index depends only on the relative population of each region, not on the absolute population. To obtain a decomposition of the Theil index into a Between Regional component (TBR) and a Within Regional (TWR) component would require the following (see Akita, 2000): Decomposed Theil (Th)= TBR + TWR TBR

= Σr (PAir/Aic) log (PAir/PAic/Nr/Nc)

(5.3)

TWR

= Σr (PAir/PAic)TPI

(5.4)

TPI

= Σp (PAipr/PAir) log (PAipr/PAir /Npr/Nr)

(5.5)

74

Managing vulnerability and increasing livelihood opportunities Where TBR is the between regional component of the Theil index of vulnerability variable, TWR is the within regional component of the Theil index of vulnerability variable and TPI is the between province income inequality. PAipr is the Productive Asset i, in province p and region r; PAir is the sum of the Productive Asset i, in region r; Aic is the sum of the Productive Asset variable i, in the country; N is the population; Npr is the population in province p and region r; Nr is the sum of the population in region r, and Nc is the sum of the total population in the country of China.

Secondly, the Theil inequality is introduced in a fixed effect regression as this method essentially offers control for all stable characteristics of the observations and therefore isolates the various public service provisions on vulnerability. The F-test will measure if the fixed effect is significant, thereby taking the advantage that panel data offers. This regression is adapted to include the following variables: WFE = β0 + βL TL,Y + βEDU1 TEDU1,Y + βEDU 2 TEDU 2,Y + βHC 1 THC1,Y + βHC 2 THC 2,Y + βU TU,Y + βIND1 TIND1,Y + βIND2 TIND2,Y + βIND3 TIND3,Y + βPOL1 TPOL1,Y + βPOL2 TPOL2,Y + χP + δP,Y (5.6) Where WFE is weighed food expenditure and T is the respective Theil inequality of: liquid assets (L), Education provision in primary education (EDU1), Education provision in secondary education (EDU2), Health care provisions 1 defined as amount of beds per health care institution (HC1), Health care provision 2 defined as technical medical personnel per doctor (HC2), Urbanization (U), Primary industry (IND1), Secondary industry (IND2), Tertiary industry (IND3), Political integration defined as the tenure in years for party secretaries (POL1), Political integration defined as the tenure in years for government (POL2), p is one of the respective 28 provinces, y is the respective individual year starting from 1982 until 1999, β0 is the constant, βX are the respective coefficients of the independent variables, χ is the fixed effect and δ is random error. The coefficient is calculated so as to estimate to weighed of various coefficient. The results of assets coefficient are presented in Table 5.1. These averages can be weighed by summing up all coefficients as demonstrated in equations 5.7 and 5.8: βTOT = |βL| + |βEDU1| + |βEDU2| + |βHC1| + |βHC2 | + |βU| + |βPOL1| + |βPOL2| + |βIND1| + |βIND2| + |βIND3|

(5.7)

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Where βTOT is total sum of coefficient, βL is the coefficient of liquid assets, βEDU1 is the coefficient of public service provisions in education 1, βEDU2 is the coefficient of public service provisions in education sector 2, βHC1 is coefficient of public service provision in Health care 1, βHC2 is coefficient of public service provision in Health care 2, βU is the coefficient of urbanization, βPOL1 is the coefficient of Political Integration 1, βPOL2 is the coefficient of Political Integration 2, βIND1 is the coefficient of industrial activities of the primary sector, βIND2 is the coefficient of industrial activities of the secondary sector, βIND3 is the coefficient of industrial activities of the tertiary sector. The weighed coefficient can be introduced into a function to estimate the evolution of vulnerability (V). V= ( βL / βTOT)TL + ( βEDU1 / βTOT)TEDU1 + ( βEDU2 / βTOT)TEDU2 + ( βHC1 / βTOT)THC1 + ( βHC2 / βTOT)THC2 + ( βU / βTOT)TU + ( βIND1 / βTOT )TIND1 +( βIND2 / βTOT)TIND2 + ( βIND3 / βTOT)TIND3 + ( βPOL1 / βTOT )TPOL1 + ( βPOL2 / βTOT)TPOL2

(5.8)

V= (−0.037)TL + (−0.03)TEDU1 + (−0.029)TEDU2 + (−0.11)T HC1 + (0.24)THC2 + (−0.12)TU + (−0.055)TIND1 + (−0.013)TIND2 + (0.22)TIND3 + (0.026)TPOL1 + (0.011)TPOL2

(5.9)

Finally, the Theil index can be decomposed into a between-regional component and a within-regional component (Decomposed Theil (Th) = TBR + TWR). The weighed coefficient can also be used to estimate vulnerability between and within regional components: Theil (T)= TBR + TWR = VBR + VWR

(5.10)

VBR = (−0.037)BRTL + (−0.03)BRTEDU1 + (−0.029)BRTEDU2 + (−0.11)BRTHC1 + (0.24)BRTHC2 + (−0.12)BRTU + (−0.055)BRTIND1 + (−0.013)BRTIND2 + (−0.22)BRTIND3 + (0.026)BRTPOL1 + (0.011)BRTPOL2

(5.11)

VWR = (−0.037)WRTL + (−0.03)WRTEDU1 + (−0.029)WRTEDU2 + (−0.11)WRTHC1 + (0.24)WRTHC2 + (0.12)WRTU + (−0.055)WRTIND1 + (−0.013)WRTIND2 + (0.22)WRTIND3 + (0.026)WRTPOL1 + (0.011)WRTPOL2

(5.12)

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Managing vulnerability and increasing livelihood opportunities Where VBR, is the between-regional component of vulnerability and VWR is the within-regional component of vulnerability. In addition TBR and TWR are respectively the Theil inequality between regions and Theil inequality within regions, of the various variables (L, EDU1, EDU2 HC1, HC2, U, IND1, IND2, IND3, POL1 and POL2).

5.3 Results This section presents results of inequality measurements from the regression in which the weighed food expenditure is the dependent variable, with the eleven Productive Assets variables that measure inequality (L, EDU1, EDU2 HC1, HC2, U, IND1, IND2, IND3, POL1 and POL2). The results of the regressions with OLS and Fixed Effect, as well as the contribution of the coefficient to vulnerability (equation 5.8) are shown in Table 5.1.

Table 5.1 Results of OLS and FE regressions Theil inequality variables

Liquid assets (L) Public service provisions in education 1 (Edu1) Public service provisions in education 2 (Edu2) Public service provisions in Health care 1 (HC1) Public service provisions in Health care 2 (HC2) Urbanization (U) Industrial sector activity in the primary sector (IND1) Industrial sector activity in the secondary sector (IND2) Industrial sector activity in the tertiary sector (IND3) Political integration (POL1) Political integration (POL2) Constant R-square F-test Significant

OLS

FE

Coefficient’s contribution to vulnerability (equation 5.9)

839.98** −521.80**

−832.97** −690.03***

−0.037 −0.03

−375.25***

−662.59**

−0.029

−2857.70***

−2629.37***

−0.11

3293.09***

5461.34***

0.24

−125.34 −1519.06***

−2817.32*** −1274.37***

0.12 −0.055

−1926.21***

−2889.41***

−0.013

3552.81***

4942.85***

0.22

699.78*** 222.47 76.19*** 0.57

598.14* 0.026 245.40* 0.011 370.932*** 0.05 12.62 * is significant at 10%, ** is significant at 5%, *** significant at 1%

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Overall the results are strongly significant with most of the variables in the OLS regression significant and all the variables in the fixed effect regressions. In addition, the F-test demonstrates that the Fixed Effect is significant. The OLS and Fixed Effect regressions indicate that inequality in public service provisions in EDU1 and EDU2 both reduce food expenditure. Public provisions in the health sector are less clear-cut with higher inequality in HC1 reducing food expenditure, while an increase in inequality in HC2 increases food expenditure. The ambiguous results of public service provisions in the health sector could be linked to the introduction of service fees, which limit access to the poor. Higher inequality in urbanization also leads to lower food expenditure, as this could be linked to the quality of public service provision which is higher in cities. From a livelihood perspective, this could mean that households can build up more human capital as well as receive better health care in urban areas, while rural areas are left behind. Higher inequality in the agricultural sector (IND1) and manufacturing sector (IND2) lead to lower food expenditures, while in the service sector (IND3) this is the reverse (i.e. the more inequality in the service sector, the higher the food expenditure). These different results could be explained by the fact that the poor are mainly in the agricultural sector (such as the rural poor) and manufacturing sector (which are the urban poor and migrant workers). This is not the case for the service sector, which in general has a higher value-added component. Higher inequality in political integration between the Communist Party and citizens leads to higher food expenditure. This result could be explained by the livelihood perspective which emphasizes that effective public participation is key to reducing vulnerability as it is critical for citizens to defend their rights as well as to seek compensation for decisions which negatively affect their livelihood, such as demolition of homes or seizure of land for large infrastructure projects. Moreover, public participation is critical to improving the quality of public services provisions in the health and educations sectors (Joshi, 2006). Finally, there is discrepancy in liquid assets between OLS (with a positive impact) and Fixed Effect (with a negative impact). The result of this single variable is therefore not robust. The fixed regression is used to estimate the contribution to vulnerability of the various variables as shown in equation 5.9. The results are presented in Figure 5.1. Figure 5.1 illustrates that the overall trend is that vulnerability first declines until about 1992 and then increases. In 1982, the Western region is more vulnerable compared to the Interior region and the Eastern and North-Eastern region. From about 1992 all regions increase in vulnerability, and the Eastern and North-Eastern region is slightly more vulnerable than the Western and Interior regions.

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Figure 5.1 Result of the weighed vulnerability variables (equation 5.10).

The trend in vulnerability could be partially explained in the following manner. i

Western regions were initially more vulnerable, but became gradually less vulnerable due to agricultural reforms, which generated additional income and were considered “low-lying fruits” of agricultural reform (Ravallion and Chen, 2007). ii The Eastern and North-Eastern region became gradually more vulnerable as social service provisions and job security declined when state-owned enterprises were privatized, which increased vulnerability. This was particularly the case in the 1990s. iii Fiscal decentralization and the introduction of services fees that led to social services became less accessible especially for the poor, and therefore could increase vulnerability.

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Figure 5.2, the decomposition of vulnerability, indicates that the betweenregion component contributes roughly 60–70 percent to the inequality in vulnerability variables, while the within-region component contributes roughly 30–40 percent to the inequality in the vulnerability variables. In addition, the between-region components seem larger in the 1990s than in the 1980s. This could indicate that the growth path between the various regions diverged and consequently inequality increased, in particular as the Eastern and North-Eastern region became wealthy.

Main observations of chapter and policy implications The objective is to present a basic methodology to estimate the evolution of vulnerability in China as well as to decompose vulnerability, using provincial level data on productive assets from 1982 to 1999. The conclusion is threefold. First, public service provision in health care does not reduce vulnerability and this is probably caused by the introduction of service fees, which exclude the poor from essential services. Secondly, vulnerability in the Interior and Western regions first declined until about 1992 and then increased until 1999. The decline until 1992 could be linked to agricultural reforms as well as to the flow of remittances from urban to rural areas, while the increase from 1992 might be linked to fiscal decentralization that encouraged the introduction of fees for basic services. Thirdly, the Eastern and North-Eastern region first had a lower degree of vulnerability but this

Figure 5.2 Decomposition of asset vulnerability index with a between-region component and a within-region component (equations 5.11 and 5.12). Source: Data provided by Belton M. Fleisher and Min Qiang, Ohio University and China Data Center of the University of Michigan.

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gradually increased, in particular in the 1990s. This could be explained by the privatization of state-owned-enterprises, which reduced both job opportunities and social security. Fourthly, the inequalities between regional component (i.e. between the three regions) contribute 60–70 percent to vulnerability variables, while the within-region component (i.e. between individual regions and its provinces) contributes roughly 30–40 percent. Therefore any policy that focuses on reduction of vulnerability in China should be addressing inequalities at regional level. However, the results in this chapter have to be interpreted with caution in regard to their impact on vulnerability. First, not all elements of vulnerability have been taken into account. For example, some geographical areas might be more prone to natural disasters (i.e. floods and earthquakes) or macroeconomic downturn caused by a contraction of labor intensive manufacturing exports. These threats have not been taken into account. Secondly, the issue of vulnerability should ideally be divided between urban and rural areas. Unfortunately, the dataset does not allow it to be disaggregated in this manner. Thirdly, the variables that measure assets of households may not reflect the reality as the variables do not necessary measure effectiveness and accessibility. However, data on informal services fees are difficult to obtain. Despite these limitations, this chapter does present the evolution of vulnerability in China from 1982 to 1999 as well as its decomposition. The policy implication of this research is that to reduce vulnerability would ensure that the population of a province or region in China would have resilience to poverty if there is a negative economic shock. This is particularly relevant in the wake of the 2008 financial and economic crisis. This would decrease social tension and contribute to the development of a harmonious society in China. To further reduce vulnerability, the Government of China could take the following policy measures into consideration. 1

2

Develop regional strategy to ensure that the Interior and Western regions could catch-up. This would reduce inter-regional disparities which contribute 60–70 percent to vulnerability. Such development strategies could include massive infrastructure projects so as to link the less developed regions to the more prosperous Eastern regions. This could be funded as part of the 2008 anti-cyclical stimulus package of 4 trillion Yuan (i.e. US$ 586 billion) and corresponds to about 2 percent of the GDP in China. The package focuses on infrastructure development ranging from rural roads to railway construction (International Herald Tribune, 2009f ). Encourage human capital accumulation in an equitable manner as this reduces the probability of becoming poor. This should especially

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3

81

include migrant families, which are estimated at around 130 million people, who face additional financial burdens as they have to pay “education endorsement fees” for their children. This sum is relatively high for migrants in low-paying occupations (Liang and Chen, 2007). This policy could be introduced as an amendment into the compulsory education law which requires free education for all children up to nine years of age. Increase accessibility of health care as the current system does not reduce vulnerability. This could be done by introducing a law which would compel health care institutions to provide free basic medical care for everybody. The advantage is that it would increase preventive health care, which would reduce the overall medical expenditure. In addition, it would encourage human capital accumulation as well as reduce savings required for these expenditures. This could be part of US$ 123 billion plan to provide universal health care to all Chinese by 2011 (International Herald Tribune, 2009b).

With these measures, vulnerability in China would be reduced, which in turn would contribute to a harmonious society and the well-being of households in China. In addition the methodology used in this paper might be further elaborated so as to estimate vulnerability accurately.

Part III

Public sector reforms, fiscal decentralization and social security Introduction Prior to the reforms introduced in 1978, the public sector managed nearly all economic activities as well as provided basic public service provisions and social security. Although there was poverty, inequality between various social economic groups and regions was limited. Simultaneous to the transition process, fiscal decentralization encouraged local government to engage in economic activities such as developing Township Village Enterprises (TVEs) and establishing Export Processing Zones (EPZs). From a political economic perspective this “bought in” local officials and Chinese Communist Party (CCP) members, which helped build the momentum for further economic liberalization. This fiscal decentralization was combined with political centralization as the central government retained control through promotions and CCP membership. This assisted the central government in steering the broad policy agenda, while leaving the implementation of programs to local government. The public administration structure facilitated policy experimentation at local level, which, if successful, led to implementation of a similar program on a national scale. Another element of the public sector reform was the restructuring of the social security system. This was originally set-up to soften the impact of State-Owned Enterprises (SOEs) privatization on urban industrial workers. As time passed, it became more evident that the social security system is critical to address vulnerability issues in rural areas as well as for the floating population of migrants. Moreover, a basic social security system is key for shifting from the export oriented development strategy that China pursued for the last three decades, to an internal demanddriven economic growth strategy based on domestic consumer spending. Without addressing vulnerability, households will save a relatively large share of their income so as to be able to incur costs associated with ill health or accidents. As such, establishing a social security program would be in line with the development process of other countries, most notably

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the Newly Industrialized Countries (NIC) in Asia. However, in the case of China this would require stronger involvement of the central government as many local governments have “transitional debts” which were created by supporting loss making SOEs and continuously providing social security to urban workers of privatized SOEs. In addition, a centralized approach would facilitate providing a basic safety-net for the migrants, who frequently change jobs and work in different regions of the country. The third part of the book is organized as follows. Chapter 6, “Fiscal decentralization and public service provision reforms”, highlights the impact of fiscal decentralization and privatization. This includes the effects of the “helping hand” of local government as well as of implementing the 2008 fiscal stimulus plan within a federal decentralized state. Chapter 7, “Establishment and expansion of social security”, emphasizes the importance of establishing an adequate safety-net that covers rural regions as well as migrants. The setting-up of such a comprehensive social security program would have to take into account the demographic evolution caused by the “one child policy”. Another key advantage of a basic social security system is that it would assist in shifting from an export oriented development strategy to a domestic demand-driven economic growth strategy. Chapter 8, “The impact of public sector reform on vulnerability”, describes the impact of fiscal decentralization and public service delivery on food expenditure, which is a proxy for vulnerability. The main conclusion is that revenues from fiscal decentralization lead to lower food consumption due to additional taxation, while public service provisions in the primary and secondary education sector result in lower food consumption. The latter could indicate that there are substitution effects in income if children attend school instead of contribute to the family income by working on the farm in rural areas, or for informal migrants who have to pay a relatively large sum to educate their children.

6

Fiscal decentralization and public service provision reforms

Introduction China has gone through several phases of decentralization and centralization during the last fifty years. This included vertical decentralization (i.e. between the central and local government) and horizontal decentralization (i.e. between government and state-owned enterprises). A key element that characterized horizontal decentralization was that local government bureaucracy was “bought into” the transition process as it had a stake in the successful development of Township Village Enterprises (TVEs). Another manner in which fiscal decentralization supported China’s development was by providing “policy space” for policy experimentation which leads to the introduction of Economic Processing Zones (EPZs). However, the downside of fiscal decentralization has been that in combination with privatization, it led to “marketization” of public goods. In practice this meant that previous free and accessible health and education services became commodities for which citizens had to pay for through user fees. This reduced accessibility, in particular for poorer segments of the society, and also had a negative effect on vulnerability. This chapter analyzes the effects of fiscal decentralization on public service provisions and user fees. The first section, “History of decentralization and regional inequalities”, presents an overview of the different waves of decentralization and centralization in China. The second section, “Fiscal administration and the introduction of user fees”, highlights the internalization of costs and “marketization” of public goods leading to the introduction of user fees. The third section, “The ‘helping hand’ and protectionism of local government”, focuses on incentive structures created by fiscal decentralization that resulted in a sub-optimal solution. The fourth section, “Fiscal decentralization and political centralization”, discusses the control mechanisms of the center in the context of decentralized administrative structure states. This system also led to a perverse incentive structure, which is particularly relevant with respect to the massive 2008

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stimulus package in which local governments contribute about 70 percent of the additional spending. The fifth section, “User fees and inequality in public service provisions”, emphasizes the inter-relationship between these elements. Finally, the “Main observations of chapter” summarize the most important issues of this chapter.

6.1 History of decentralization and regional inequalities Since the founding of the People’s Republic of China in 1949, the state structure shifted several times between decentralization and recentralization. This started in 1950, when the Soviet model of centralized planning was introduced and the State Council was allocated a central role vis-à-vis local government. The central authority exercised direct administrative control over local governments through three central planning instruments: the physical planning of production, the centralized allocation of materials and the budgetary control of revenues and expenditures (Feltenstein and Iwata, 2005). During this period the central government assigned revenue sources and expenditure responsibilities to regions (including strict jurisdiction over tax rates), set mandatory spending targets for certain major budgetary categories and determined the total size of provincial budgets. The overall fiscal framework consisted of a budget surplus being remitted to the center and budget deficits being eliminated by transfers from the center. This institutional framework allowed the central government to redistribute fiscal resources so as to equalize fiscal capacity across provinces and smooth provincial spending across time. In 1957 there was a shift back from centralization to decentralization. This time the reform focused on SOEs which, with their profits or losses, were transferred to provincial governments. Some authors suggest that this fiscal decentralization exercise led to an increase in disparities in per capita expenditure across China (Donnithorne, 1973, 1976). They argued that fiscal autonomy led to a fall in inter-regional transfers and therefore to a decrease of remittances from rich provinces to poor provinces. However, another study highlights that this was not necessarily the case for poor provinces that were dependent on transfers from the center as they had a larger increase in social services and investment (Tochkov, 2007). The period of decentralization was short lived as in the early 1960s control over all large and medium-sized state enterprises were returned to the central authorities. This was linked to the start of the Cultural Revolution. After this event, there was a new movement of decentralization providing provincial entities more discretion over their budgets. This was necessary because the continuing turmoil caused by the Cultural Revolution that ended in 1969 (Feltenstein and Iwata, 2005) had a disruptive

Fiscal decentralization and public service provision reforms 87 effect on the economy as well as society at large. In this context, fiscal decentralization was a way to provide economic incentives to public companies so as to overcome the economic decline caused by the Cultural Revolution. Some authors argue that this period was accompanied with growing disparities in per capita spending (Oksenberg and Tong, 1991). In the beginning of the 1980s, the relationship between the center and provinces changed again, this time through the introduction of fiscal contracts. These fiscal contracts were not standardized over the country. Some provinces had different kinds of conditions for remittances, lump-sum transfers and revenue sharing with the central government (Knight and Li, 1999). In the second half of 1980, local provinces started offering tax concessions and exemptions to local enterprises with the objective of generating revenues provided by FDI in their jurisdiction (Ma, 1997). This was linked to the creation of four Special Economic Zones (and subsequently a tranche of “open cities”) to allow foreign enterprises, in new joint ventures with Chinese counterparts, special privileges including a relaxed regulatory and bureaucratic environment as well as tax holidays. Besides these tax-concessions, provinces channeled revenue from local fees, surcharges and other sources into extra-budgetary funds that were not subject to central control. All these factors undermined the authority of the central government and eroded its fiscal position. The correlation between fiscal decentralization and inequality was again debated during the period of market reforms in the 1980s. Some research indicates (Ma, 1997) that the redistribution role of the fiscal system weakened between 1983 and 1991 due to tax evasion by provincial governments causing the amount of interregional transfers to decline. This was also suggested by Raiser (1998) who demonstrated that fiscal transfers exacerbated regional disparities, because they were allocated by the central government to selected provinces based on political networks rather than equity considerations. The inter-governmental relationship has also been addressed by Knight and Li (1999) who investigated provincial budgets over the 1983–91 period and concluded that net transfers destabilized provincial expenditure. Furthermore, Bahl (1999) observed that expenditure equalization across provinces declined between 1990 and 1995. In 1994, the system of fiscal contracts was abolished and replaced by a uniform sharing formula requiring all provinces to remit 75 percent of their revenue from the Value-Added Tax (VAT) to the center (Bahl, 1999). This fiscal reform was referred to the Tax Sharing System (TSS) and reforms were completed at the end of December 2002. Although the TSS strengthened fiscal powers of the center and harmonized relationships with the provinces, it is mainly based on revenues generated from VAT collection, which depends on the size of the economy. Therefore, this fiscal arrangement most likely did not address inequality.

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Another challenge of the TSS was that this fiscal arrangement created problems for rural governments that lacked revenue from VAT to support basic service provisions. In response to this problem, the central government introduced amendments to the TSS in 2003 and introduced the “three rewards and one subsidy” in 2005. The former initiative explicitly holds provinces responsible for supporting public finances in rural areas as well as improving quality of public services within their jurisdiction (World Bank, 2007). The latter initiative aims at assisting local rural governments: through additional fiscal transfers to lower tier governments (county and township) on the condition that these jurisdictions expand their revenue base; and to provinces that increase transfers to counties in difficulties within their jurisdiction, and cut staff (Dong, 2006). Although these initiatives from the center are commendable, it is unlikely that they had a significant effect on inequality through the transfer of funds for two reasons. First, the funds from the center were relatively limited in size as the central government contribution to social service expenditures is less than 10 percent of budgetary expenditures on social service provisions in the areas of health, education and social relief (Wong, 2008). This is also the case for targeted programs such as the “three rewards and one subsidy” which accounts for 15 billion Yuan in 2005 (World Bank, 2007). Secondly, and more fundamentally, there is a political economy problem, as rural communities lack political clout to lobby for central funds from the center, in particular compared to the urbanized eastern region of the country. This would be a serious long term challenge to the pro-rural fiscal transfer policies which the central government is pursuing (Wong, 2007).

6.2 Fiscal administration and introduction of user fees Prior to the reform of 1979, the fiscal relation between the central and provincial governments could be described as one of “unified revenue collection and unified spending”. Basically, the provincial governments collected most of the revenue generated from within the province, which was on average over 80 percent, including taxes and (most) profits from SOEs. In this context, China never had a central tax administration system, as all taxes, with the exception of Customs and Excise, were collected by local governments and then transferred to the central government. From a fiscal point of view, China’s budgetary policy essentially consisted of collection of taxes and profits by the center that were subsequently redistributed to the provinces. This system was also referred to as “eating from one pot” (Feltenstein and Iwata, 2005). In the early 1980s, China adopted a fiscal contract system (Oi, 1992; Wong 1997). Under the new system, the central government codified a set

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of tax laws and regulations that defined tax bases and tax rates, but left the implementation of these policies to local state entities. Locally collected taxes were shared between the central and local governments according to pre-negotiated sharing contracts. Given the stipulated high tax rates, many local governments opted to use their discretion to give special tax concessions to enterprises and foreign investors so as to encourage FDI as well as general investment in areas under their jurisdiction. This effectively allowed local governments to set their own tax rates, with little interference from higher level governments. The central and provincial fiscal relationship was therefore nicknamed “eating from separate kitchens” or Fenzao chifan. This metaphor is used in terms of fiscal decentralization as local governments expanded their taxing authority, without a clear mandate on duties and obligations of the various tiers of government. This let to duplication of efforts between the five tiers of government, which are: (1) central; (2) provincial; (3) prefecture; (4) county; and (5) township. The duplication of efforts can also be considered one of the negative effects of decentralization. The next chapter will highlight that fiscal decentralization leads to fragmentation of social security assistance with particular negative impact on the migrant “floating population” and the rural poor. Under the fiscal contracting system, provincial governments entered into five year fiscal contracts with the central government. Because of their experimental nature, the contractual arrangements varied between provinces and over time. The fiscal contracting system could be described as follows (Wong, 1997; Bahl, 1999). First, “central fixed revenue” was defined to consist of customs duties, direct tax or profit remittance from the central government supervised SOEs. All other revenue fell under the heading “local revenue”. Secondly, local revenue was divided between central and provincial governments according to pre-determined sharing schemes. The fiscal contract system placed the central government at a relative disadvantage in revenue sharing and led to a steady decline in central government’s share of national tax revenue. To halt the erosion of fiscal authority as well as to further clarify the definition of tax rights, in 1994 China introduced a new fiscal arrangement based on a clear tax assignment between central and local governments (Hsu, 1999). Under the new system, the personal income tax and the corporate income tax on locally owned state enterprises and non-state enterprises were assigned to the local government, while the income tax on centrally owned enterprises was assigned to the central government. The value-added tax was shared (75 percent central and 25 percent local). The government also created a nationwide State Administration of Taxation, separate from the Local Administration of Taxation. This new fiscal system represented an additional improvement in the definition of tax rights because it assigned

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to each level of the government its own tax base. In general, the contract system worked and it was more common to have extra subsidies than extra revenue remittance. This suggests that, for the central–provincial relation in China, the “soft budget constraint” problem (Kornai, 1988) constituted a greater problem than the “predation” of local government. Under the new system, “local revenue” was redefined as revenues from local taxes and the local portion of the shared taxes (Bahl, 1999), which was referred to as the Tax Sharing System (TSS). The local taxes now constituted the income tax from all enterprises other than central government enterprises, the business tax from the sales of services, and personal income tax. The most important shared tax remained the VAT of which 25 percent belonged to the provincial government. The post-1994 phase also eliminated the variations of the revenue sharing rules from the 1980s, which meant that relationships between the central and local governments were streamlined. However, the TTS favored richer locations as it was based on VAT revenues within the local government’s jurisdiction. This increased inequality as poor regions would receive less revenue compared to rich regions (World Bank, 2007). The advantage of the introduction of the TSS in 1994 was that revenue collection increased to about 20 percent of the GDP, a level similar to the pre-reform period (Wong, 2008). Although the central government created an additional and, more importantly, stable revenue stream, it had difficulty channeling these resources for the purpose of social services to the local level such as through the “three rewards and one subsidy” program. This was because the central government’s primary instrument is the use of legislation or regulations to mandate local government spending on services. The central government does not “manage” or implement reforms. Due to this public administration structure, the incentives of the central government were not aligned with that of local government. This means that additional funding from the center, which was earmarked to assist poor peasants in rural areas, could be allocated to salary increases as local government generally employed more staff than the number of approved posts (World Bank, 2007). Consequently funds from the center, which are allocated for poverty reduction and service delivery at village level, have a high “leakage” rate. This has been one of the main hurdles to improving the lives of peasants in rural areas. The result of the TSS was also that revenue streams were centralized, while financial responsibilities were shifted to lower tiers of government (Bahl and Martinez-Vazquez, 2003). The fiscal pressure of local government led to the increase in informal and formal fees. In 2002, the Rural Fee Reforms (RFR) were introduced which were used to generate half of the revenues in rural local government through agricultural taxation and fees. As such the RFR were meant to address the increase in extra-budgetary

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fees starting in the late 1990s by bringing them into the budget as much as possible (World Bank, 2002). However, it is estimated that the central government only compensated for about one-third to two-thirds of previous revenue levels (World Bank, 2007). This led to a gradual “hollowing out” of local government, in particular at the township and village level (Kennedy, 2007). In essence, there will still be significant fiscal pressure on local government to maintain service fees, while funding from the center does not arrive at end users. In urban areas the TTS focused on the “extra-budgetary revenue”, which consisted of tax surcharges and user fees levied by central and local government agencies, as well as some earnings from SOEs. The extrabudgetary revenue emerged in the 1950s but only became institutionalized after the reform. Unlike the budgetary local revenues, the extra-budgetary local revenues were not subject to sharing with the central government. While about 70 percent of the extra-budgetary funds were earnings retained by SOEs and by their supervisory government agencies at the central and local levels, about 30 percent were used for government expenditure to supplement the budgetary funds (Fan, 1996). The reliance of local government on revenues by SOEs created vested interests and led to protectionist measures which will be discussed in the next section of this chapter. In sum, the Chinese central government’s post-reform was to provide fiscal incentives to individual provinces, both for budgetary and extrabudgetary revenue. The center provided “space” at province level to experiment, but at the same time made provinces responsible for their own expenditures. However, at the village and township level, where service delivery would be the most effective (Oates, 1972), the local government was “hollowed out” (Kennedy, 2007) as they lacked the revenue base for tax collection and were prohibited from collecting fees, although informally there were still various formal and informal fees. This could be considered the “internalization of costs” which would ensure that fiscal decentralization would not lead to negative externalities. This had a negative effect on the poor and marginal segments of society as they are the most dependent on these services. The central government has tried to address this issue through initiatives such as “three rewards and one subsidy”, although due to the misalignment of incentives in the public administration structure and leakages, these funds were not always used for enhancing service delivery in rural areas. Thus there remain significant challenges for creating adequate and affordable services for the majority of peasants in China.

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6.3 The “helping hand” and protectionism of local government In pre-1978 China, various bureaucrats in both central ministries and local government (often referred to as “grandmothers-in-law”) controlled a typical enterprise. These bureaucrats exercised not only control rights, but also rights to manage cash flows and to extract in-kind resources from enterprises under their jurisdictions. Property rights of enterprises were also ill-defined and involvement by local officials could “protect” these companies. In addition, local officials could provide useful networks to ensure essential inputs for production as well as organize export channels. The role of local officials was reinforced by the reform in 1978, which transferred the administration of the vast majority of state enterprises to local governments. It granted state enterprises autonomy in determining output, pricing and, increasingly, investment decisions, and also gave enterprise managers and workers financial incentives (Li, 1997). The reform gradually liberalized production and encouraged the massive entry of profit-oriented non-state firms, which were often TVEs producing consumer goods that were scarce in the 1980s. Before the reforms of 1979, firms and industries had no incentive to perform, nor to maximize profit. However, this changed significantly with the fiscal 1979 decentralization reform. Reforming SOEs became a priority for the Chinese government. The objective was the establishment of a “modern enterprise system” which would improve performance as well as economic growth in general. With this in mind, managers of SOEs were given more and more responsibility on daily decision making (Naughton, 1995). In addition, SOEs would also compete with township and village enterprises. However, many SOEs had difficulty becoming profitable and government resources were needed to support these companies. This was provided by state-owned banks and led to the increase of Non Performing Loans and, consequently, transitional debt. In the 1990s, China was on the road to integrate SOEs with the growing private sector so as to emulate the apparent development success of the South Korean Chaebol model. This refers to a South Korean corporate governance structure in which many companies that cover a wide range of activities (banking, heavy industries, telecom, etc.) are clustered around one parent company. In emerging economies this corporate governance structure is sometimes beneficial, as conglomerates can thrive in countries with weak institutional frameworks as well as a lack of financial intermediation and a weak banking sector. In such an environment, advantages of conglomerates like the Chaebol might include production synergy, economy of scale, efficiency allocation of internal resources, diversification of risk between sectors and increased debt capacity (Masson et al., 2009).1

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In the context of China, it was proposed that SOEs would be taken over by private firms in the same sector so as to create national champions. However, after the Asian crisis of 1997, which laid bare the weak corporate governance structure of the Chaebol model in many of these Korean national champions, the Chinese government opted to introduce hard budget constraints, which in combination with the market entry of private sector companies led to massive lay-offs of state workers. This was the first step to privatization and public listing of companies on stock exchanges. Despite the introduction of hard budget constraints, the link between SOEs and local government remained and is sometimes referred to as “bureaucratic integration” (Bai, et al., 2007). The close relations between local government and state-owned enterprises were directly related to private benefits gained by local officials from industries under their jurisdiction as well as by the reliance on local firms and industries for building support for their reappointment. Besides these private benefits there were often legitimate political motivations to support industries in their jurisdiction, such as providing employment protection, ensuring fiscal revenues for local government and social security as well as introducing regional import substitution policies so as to create national champion industries. This latter is essentially an infant industry argument (Poncet, 2005). Methods of protectionism included tariffs, health certification standards, dumping charges and other administrative measures (Li et al., 2003). This could be justified as it maximizes the benefits at local level, although this is a sub-optimal solution at national level. As a consequence, direct subsidies from central and local governments could be reduced, while other fiscal devices, such as tax relief, government contracts and protectionism, could increase. The case of local protection demonstrates the limitation of Oates’ decentralization Theorem for the following three reasons. i

The negative externalities of economic protectionism, as local entities enjoy protection benefits while the negative effect would be felt by the country as a whole. ii The lack of economic of scale in production, as protectionism and retaliatory actions would lead to market segmentation and thus block optimal allocation of production resources. iii The impediment of inter-jurisdictional competition leads to less economic growth in the long term. As such, WTO accession, which at least in a theoretical sense requires an equal playing field, would not only benefit foreign enterprises, but also companies from different regions which wish to operate nationally. Fiscal decentralization also had an impact through the development

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and massive growth of TVEs. Originally, local officials were more effective at launching new enterprises than private entrepreneurs, especially in the beginning of the reform period when the market was underdeveloped (Ody, 1992). As local leaders had political, social, and personal connections, they could find capital resources through the state banking system (Che and Qian, 1998). In addition, local leaders had the advantage of networks when they interacted with agents outside their jurisdiction. In general, local officials were given the incentive to initiate rural enterprises and were in a unique position to furnish key services that others would not have been able to provide in a transition country. The result of the close relationship between local bureaucrats and TVEs was that officials were “bought into” the development process and got a stake in further marketization. This is referred to as the “helping hand”. A key element in this development was that local government could keep a significant portion of the increased tax revenue resulting from their policy decisions (Jin et al., 2005). However, there appears to have been a shift from the “helping hand” in the beginning of the transition phase when networks were important in gaining access to key resources, to the “grabbing hand”, which inhibited private sector development and economic growth (Chen, 2004) through protectionism, corruption and cronyism. In this context, the fiscal recentralization, which forced provinces to seek revenue from off-budget taxes, could be socially more costly by creating pressure to charge users fees as well as pursing protectionist policies at the local level.

6.4 Fiscal decentralization and political centralization As discussed in the previous section, China’s policy shifted several times from decentralization to centralization and back over the last 50 years. Decentralization to lower tiers of government was particularly evident from its fiscal contract system (1980–93) and revenue assignment system (1994 to present). Under the fiscal contract system, each sub-national government level contracted with the next level up to meet certain revenue remittance targets, which could be either a nominal amount or a percentage share. Therefore, China’s fiscal system is largely decentralized while its political governance structure is rather centralized with strong top-down mandates and a homogeneous governance structure (Zhang, 2006). By providing more freedom through a fiscal decentralized structure to take initiatives, local officials pursued their own agenda, which is compatible with the Oates Theorem of decentralization that states a decentralized system is always more efficient than a centralized system for supplying public goods as local government knows what the “preference” is of their constituency (Oates, 1972). However, and unlike democratic countries on

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which the Oates Theorem was based, that emphasized the importance of accountability of local government to its own constituency, the career track of Chinese officials was controlled by the center through appointment and promotion as well as through the membership of the Chinese Communist Party (Huang, 2001). Therefore accountability of local government is “upward” and not “downward” as advocated by Oates’ theorem. Through the cadre management system as well as the target responsibility system, the central government steered local cadres towards the national agenda, with explicit targets ranging from economic growth to fertility control. China therefore has a decentralized fiscal system within a centralized political system. In combination with the target responsibility system, a policy framework was created with yardstick competition among local officials through rewarding or punishing them on the basis of performance (Zhang, 2006). This competition between civil servants was supported institutionally through standardized statistical data and accounting systems. This was demonstrated by analyzing the turnover of top provincial leaders in China (Li and Zhou, 2005) which showed that the internal political market also serves as a disciplinary mechanism for local officials to promote economic growth. This finding also suggests that the governance structure is important to economic growth in China. However, the combination of fiscal decentralization and political decentralization can also lead to irregular incentives, as was the case in the 1990s when local government undertook efforts to implement the Eighth and Ninth Five-Year Plans (1991–95 and 1996–2000). These plans emphasized the development of heavy industries in a range of “pillar industries” such as machinery, automobiles and the production of petroleum and chemical products (Lu, 2002). Naughton (2003) argues that local government entities responded vigorously to these central initiatives by developing and implementing industrial plans in these sectors, which led to massive overcapacity and overlap in these “pillar industries”. As local governments were directly involved and derived income from these investment projects, they had vested interests in providing protection to these industries, thereby hampering competition and longer term restructuring of the industrial sector. This perverse incentive structure, created by a fiscal decentralization with a political centralized system, is highly relevant as the Chinese government launched a massive fiscal stimulus package in 2008, which corresponded to roughly 4 trillion Yuan (i.e. US$586 billion), which is about 2 percent of China’s GDP. However, the central government will only contribute 1.18 trillion Yuan, equivalent to about 30 percent, while the remaining 2.22 trillion Yuan, about 70%, would be funded by local government (China Daily, 2009b). The strong emphasis on local government

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contribution in regard to the stimulus package could lead to a similar pattern described by Naughton during the Eighth and Ninth Five-Year Plans, in which local government will pour in funds to develop energyintensive, heavily polluting and repetitive projects to boost local economic growth, although on a national level this will lead again to massive over-capacity and overlap industrial production structures. Moreover, vested interests at local government level could hamper industrial restructuring at a later stage.

6.5 User fees and inequality in public service provisions Fiscal decentralization has led to the growth of extra-budgetary financing, which was a result of decentralization of tax collection as local government sought more fiscal autonomy. A perverse reaction to the budget centralization process was the growth of off-budget discretionary spending of local tax revenues. As such, fiscal decentralization shifted the burden of education and health funding to the local level, which often translated into the introduction of user fees. These particularly affected poor and rural counties that have difficulty generating the necessary revenues (Park et al., 1996), and resulting in increased inequality (Brown and Park, 2002). The introduction of user fees impeded schooling, which were mostly funded at local level. This means that rich provinces tend to produce more human capital per capita than poor provinces. Resource constraints affect education of individuals in different parts of China, especially in rural areas and in the western region. Despite high enrollment fees for households, the budget for schools in rural China was insufficient to pay the salaries of all teachers on time as well as to buy essential supplies and undertake necessary maintenance. As a consequence, classrooms could lack basic infrastructure, such as desks, chairs and electricity. Moreover, the best teachers were often assigned to schools in urban regions, while rural areas tended to attract less qualified teachers (Sargent and Hannum, 2005). Consequently, students in rural China attended poorly equipped schools with lower quality teachers, and therefore faced additional educational hurdles (Brown, 2006). The household location therefore became one of the most important determinants of a person’s adult skill level (Knight and Song, 1999). This source of inequality was reinforced by the hukou policy which limited movement of households. A similar trend manifested itself in the health sector as China gradually stepped back from providing free, or subsidized, health services. With the public health responsibilities decentralized to provincial level, which in turn transferred responsibilities to the counties and municipalities, many sub-national entities could not afford supporting such services. The effect

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was that by 1998, according to the Health Services Survey, 87 percent of the rural population and 44 percent of the urban population had no health care benefits and had to pay out-of-pocket for all medical costs (Banister and Zhang, 2005). Thus payment for medical and pharmaceutical treatment could also drive families into dire poverty. Another phenomenon of health sector decentralization was that in rural areas some 50 percent of the village clinics were privately run, with most of the remaining public facilities reliant on fees charged directly to patients. Particularly in urban areas this has led to an increase in insurance premiums (see Figure 6.1). A particular issue was the unwillingness of both private and public clinics to provide preventative care without payment. Furthermore, preventative services administered by the public health institutions have seen a steady decline in their level of government funding. The emphasis on income generation shifted the focus of public health away from prevention towards treatment and cure. As a result, some 700 million rural Chinese pay out-of-pocket for virtually all health services. The lack of social insurance reduced preventative care services such as prenatal care, immunization and sanitation. Moreover, medical expenses led to deferral of care, untreated illness, financial catastrophe, and poverty (Chow, 2006). To address health care challenges would require public sector intervention as the free market system is unlikely to provide them due to lack of purchasing power by rural peasants. In addition, the provision of health care can be considered a public good2 with high positive externalities. For

Figure 6.1 Growth of insurance premium by GDP (RMB mn). Source: China Insurance Regulatory Commission (CEIC).

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example, the market system would under-produce immunizations because if people at risk get immunized, others enjoy the protection and therefore see no need to pay for immunization. This makes such activities unprofitable for private enterprises. The recent SARS, Bird Flu and Swine Flu scares underscore the importance of government investment in disease monitoring and surveillance systems. As predicted by theory, decentralization led to greater inequality between provinces and regions, not only in wealth but also in services delivery in the social sectors. This has led to large differences in public spending on education and in teacher quality across regions. This is evident from the World Bank (1999) which reported that the recurrent per-pupil expenditure in 1997 in the wealthiest 10 percent of counties was more than 4.5 times that in the poorest 10 percent. This source of inequality is reinforced by the vestiges of hukou policy that made it difficult to move to another region, or at an additional cost. There are two key issues in the discussion of public services provisions and user fees. First, the accountability of local government to its local constituencies requires local political participation. The decentralization theory highlights that this is best undertaken at the lowest tier of government, which in China is at the village and township level (Oates, 1972). This is in line with official policy to strengthen village-level institutions (Fock and Wong, 2008). However, this lower tier of government lacks accountability to its citizens and to the central government. Secondly, the minimum amount of revenue needed to actually provide effective public provision is a challenge, as low tiers of government lack the resource base for taxation, and fees-for-services which constituted a large part of the local government’s budgets are limited. In addition, fiscal transfers from the center often have marginal impact at village level, due to high leakages.

Main observations of chapter In the last fifty years China has varied several times from central to decentralized state structures and visa versa. In general, fiscal decentralization affected provincial level governments in various ways, ranging from providing a “helping hand” (such as the “buying in” of local bureaucracy that had a stake in the successful development of TVEs) to market sector experimentation with policies, resulting in economic development and massive poverty reduction. The downside of fiscal decentralization, combined with privatization, led to “marketization” of public goods. In practice, this meant that previous free and accessible health and education services became commodities for which citizens had to pay through the introduction of user fees. Although this can be considered “internalization

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of costs” it also reduces the accessibility of public services to the poor, which increased vulnerability. This was particularly the case for the lowest tiers of government (village and township level). In addition, the rural poor also lacked the purchasing power for a comprehensive medical insurance. Therefore, the public sector would have to provide some sort of subsidized health care as this is considered a public good with high externalities. The fiscal decentralization experience in China also had its limitations as local entities pursued their own interests at the expense of the whole country, in particular in the field of economic development and industrial policy. From a political economy perspective, this could be explained by the economic benefit of the established local bureaucrats who have vested interests in the success of the companies within their jurisdiction. However, the negative effects for China as a whole could be through negative externalities, the lack of economies of scale in production and the impediment to inter-jurisdictional competition. It is in this context that WTO accession could be beneficial because, at least in a theoretical sense, this international agreement requires an equal playing field, not only between foreign companies, but also among national enterprises from different regions within China. Another downside of fiscal decentralization was that inequality increased, both at the interregional level as well as within regions. The former was caused by the reduction of inter-provincial transfers while the latter was caused by the introduction of user fees both in health and the education sector at the lower tiers of government. Although this has somewhat been remedied through “three rewards and one subsidy” initiatives launched by the central government, often these fiscal transfers do not arrive at the lowest tiers of government due to the mismatch of incentives. Therefore, and despite the RFR, there was still fiscal pressure to maintain some user fees, which increased the barrier to public services access for poor households. This again could have a negative effect on poverty in several ways as higher user fees: i

lead to higher vulnerability, as “out-of-pocket” health care expenditures rise; ii increase Inter-Generational Transmission (IGT) of poverty as poor households lack the resources to finance education of their children; and iii in combination with the hukou system and lack of local participation, confine households to (poor) jurisdictions that have inferior public services. Finally, it is important to note that the current incentive structure

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created by a fiscal decentralized structure with a political centralization is not optimal. In the past this has led to local officials vigorously implementing Eighth and Ninth Five-Year Plans, which on a national level led to massive overlaps between industrial structures. In addition, these newly created industries became vested interests as local governments were directly involved, as well as being a source of income from these investment projects. Therefore local governments were inclined to provide protection to these industries in their own jurisdiction. These perverse incentive structures are particularly relevant as 70 percent of the 2008 massive 4 trillion Yuan (i.e. US$586 billion) will be financed by local government and could lead again to massive over-capacity and overlap industrial production structures.

7

Establishment and expansion of social security

Introduction Although China originally established its social security system to soften the impact of State-Owned Enterprise (SOE) privatization on urban industrial workers, a comprehensive safety-net is considered fundamental in creating a stable society and reduce inequality within a capitalist market system. Moreover, a basic social security system is key for shifting from an export oriented development strategy that China pursued for the last three decades, to an internal demand-driven economic growth strategy based on domestic consumer spending. This is particularly important in the wake of the 2008 financial crisis that has translated into an economic downturn resulting in a large number of redundancies. This will mainly affect the already vulnerable migrants who lack both job and social security guarantees. Addressing this challenge requires the creation of an overarching national social security system, which would replace the current fragmented safety-net provisions that provide inadequate coverage. This chapter is organized as follows. The first section, “Privatization of the iron bowl”, describes the social security system provided by SOEs and the subsequent reforms. The second section, “Challenges of the social security system”, highlights the deficits of the current social security system. This is key to reducing vulnerability during the present stage of China’s development. The third section, “Demographics and fiscal sustainability of pensions”, emphasizes the impact of the one-child policy on the family based support network as well as on the long term fiscal sustainability of pensions. The fourth section, “Fiscal stimulus package and social security reforms”, describes the importance of a comprehensive safety-net program in the shift from an export oriented development strategy toward a domestic demand-driven strategy that is based on consumer spending. Finally, the “Main observations of chapter” summarizes the most important issues of this chapter.

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7.1 Privatization of the iron bowl Before discussing the issue of social security in China, it is important to remember that vulnerability during the pre-reform period of 1978 was not linked to market price volatility as is the case in market based economies. In communist countries, prices were set centrally and rural communities as well as urban SOEs had to meet production specific targets. Therefore the “sources” of vulnerability were different and often related to natural disasters (floods, earthquakes, droughts, etc.), although the resilience of peasants was limited due to poverty in the countryside. At the macro level, an important “source” of vulnerability consisted of politically motivated initiatives such as the “Great Leap Forward” and “Cultural Revolution”, which caused widespread economic hardship for large parts of the population. During this period social insurances could not cover the destruction caused by these initiatives and management of social funds became impossible, which led to retirement payments being seriously delayed or cancelled (OECD, 2007). Therefore, social security could not compensate for the economic consequence and losses of the politically motivated vulnerability, as often the administrative structure that managed social security were affected by these upheavals. Traditionally, social security provisions in China were linked to production entities, which were SOEs in urban areas and communes in rural areas. In this sense, pre-reform China had a dualistic economic system whereby rural peasant communities had less extensive safety-net provisions than urban industrial workers. This dualistic employment system was created during the introduction of an orthodox Soviet-type development strategy in the 1950s. As part of this system, the cost of rapid industrialization was artificially kept low by suppressing urban wages and agricultural food prices, which overall had a negative effect on the income of peasants. In other words, rural farmers were in effect financing the industrialization process in urban areas. Although the negative effect of suppressing food prices was partially compensated by the provisions of basic social security, rural communities still lagged behind in type of coverage and, in general, were much poorer than urban industrial workers. This segmentation of society was reinforced through the hukou system that limited the flow of rural labor to urban areas as well as protected the employment and welfare of people living in the city (Fang and Chan, 2000). For rural communities social security was composed of the following: a minimum guarantee for people unable to work, health insurance through the Cooperative Medical System (CMS) and social relief for poverty caused by natural disasters. This social security, complemented by family and community, played a critical role in rehabilitating the livelihood of

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rural people after many years of civil war and turmoil, which was particularly necessary as peasants constituted the backbone of the communist revolution. An example of visible improvements was the regular visits of the “barefoot doctors” in rural communities who provided basic preventive health care. The newly established communist government also provided primary education services and adult literacy courses, thus improving basic literary rates in rural areas. After the transition, it was this basic human capital that enabled rural residents to take advantage of new farming techniques and improve access to off-farm jobs which required literacy or basic calculation techniques (Unger, 2002). Moreover, for individuals with secondary education or university, it become easier to attain a residence permit (Wu and Treiman, 2004). The most extensive social security was reserved for the urban industrial workers, who were employed at SOEs and constituted a minority of the population. In general, this group of workers had higher living standards than rural peasants, although urban wages hardly increased over a long period and consumer goods were limited. Just as in other communist countries, living standards were considerably influenced by “secondary” benefits (pension, housing, health care, food rations, etc.), which were often more valuable than the actual wages. This was because income of urban industrial workers did not translate into an increased purchasing power as there was a chronic lack of consumer goods. In these circumstances, secondary benefits raised the living standard of the urban poor and were part of Mao’s “iron-bowl” employment policy. This meant that China’s 110 million urban industrial workers had a cradle-to-grave welfare system that included an old-age pension and hospital care, although the actual level of benefits varied widely as different regions and SOEs had a diverse set of policies and coverage. However, the “iron bowl” was about to break as reform of the SOEs started to progress at the end of 1980s. During that period, China was already experimenting with social security reform on a small scale, just as it had with the abolition of the household responsibility system and with the establishment of Export Processing Zones (EPZs). These reforms went back as far as 1986 when some regions explored new methods of financing pensions by raising funds from society as well as from individual contributions (Ma and Zhai, 2001). Moreover, some regions experimented with the integration of social pooling, which were meant to create a common pool of funds by employers and employees, and coverage included private joint-venture enterprises (OECD, 2007). The most radical change to the social security system occurred when the government decided to privatize SOEs at the beginning of the 1990s. For urban areas, the privatization of SOEs meant a tightening of the social security provided by companies as they had a hard budget constraint.

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These companies therefore focused on their core business of manufacturing products, and not on providing secondary benefits to their employees. To some extent this was an economically sound development as there was large under-employment or hidden employment within the SOEs, which disappeared during the transition process. Privatization therefore meant that Mao’s “iron bowl” system was abandoned, although a 1995 Labor Law emphasized that Chinese companies must provide medical benefits and pensions to their employees. In rural areas, economic reforms meant the transfer of production units from a collective responsibility to individual households. This also included the disbanding of the social security provided by the commune system which resulted in a drop of the CMS coverage to just 40–45 percent of China’s villages in 1983 (Zhou, 1991). The degradation of rural social economic indicators has been recognized by central government and the latest reforms emphasize improvement of social security in rural areas. This is evident from China’s Human Development Index (HDI) which in 2003 was estimated to be 0.81 for urban and only 0.67 for rural areas (UNDP, 2005). Addressing these issues not only aimed at developing a harmonious society, but also at balancing economic growth opportunities. This is the reason why the central government has prioritized rural communities through the “new socialist countryside” in the Eleventh Five-Year Plan (2006–10). This plan includes programs in the health and education sector such as “two exemptions and one subsidy”, free rural compulsory education, the New Rural Cooperative Medical Scheme (NCMS) and rural dibao (minimum living stipend) (World Bank, 2007). This led to a steady increase in expenditure and revenues from the social security fund (Figure 7.1). However, and as explained in the previous chapter, due to the misalignment of incentives, funds from the center are likely to have a high leakage. Another challenge to providing social security and service delivery in rural areas is the lack of capacity at the village level (Fock and Wong, 2008). Moreover, from a political economy perspective, rural communities lack the political clout to lobby for funds from the central government (Wong, 2007). Besides urban and rural residences, a third group, the “floating population”, consisting of 130 million migrant workers (Li, 2007), emerged during the transition process. This group was covered neither by rural safety-nets, nor by urban social security. This is because migrants live semi-clandestinely as they do not have official registration papers, are not part of the formal economy and lack official social security protection. In addition, migrants have to pay additionally for essential social services such as education for their children, which can be relatively high for migrants with low-paying jobs (Liang and Chen, 2007). In sum, post-1978 transitional reforms have led to additional vulnerability as responsibility of managing risks shifted from collective and state

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Figure 7.1 Expenditures and revenues of Social Security fund by GDP. Source: Ministry of Human Resources and Social Security (CEIC).

level to individual households. This is all the more important as the nature of exposure changed dramatically and economic volatility is the major risk factor. In addition, vulnerability of rural communities is the most serious in absolute terms, although it was the previous privileged urban industrial workers that lost the most in relative terms from the dismantling of the cradle-to-grave social security system. The social safety-net of urban workers was further undermined by a large influx of migrant workers competing for low-paid jobs, without benefiting from social security provisions.

7.2 Challenges of the social security system Many countries have introduced various kinds of social security systems as part of establishing a welfare state in the course of their industrialization process. This is because the process of industrialization dramatically changes the “needs” and “risks” compared to traditional rural peasant society in which the community and family networks provided a safetynet. There is therefore a close relationship between the industrialization of a society and the development of a social security program (Song, 2003). This explained the emergence of a welfare state in Europe and North America at the end of the 19th century and beginning of the 20th century. The establishment of social security was emulated by Newly Industrialized

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Countries (NIC) in Asia in the second half of the 20th century, although their welfare provisions are generally smaller as measured by social expenditures compared to Europe and the United States. This is because NIC countries had to spend more funds on economic development than social welfare (Miyamoto, 2003). In the near future, the development of a welfare state in China will likely follow in the footsteps of NIC. Social security programs were established for the purpose of smoothing consumption in times of distress, distributing income as well as poverty alleviation. As with other policies, the central government in China often established the basic parameters, while the administration of services was executed by sub-provincial level and municipalities (Betcherman, 2004). The disadvantage was that the social security system became highly fragmented and that in poor regions with high unemployment, social security was fiscally unsustainable as liabilities are higher than payment contributors. This increased spatial disparities between regions as well as between urban and rural areas. The central government of China has recognized that establishing an effective safety-net program is key to maintaining social stability and promoting development for three reasons. First, an effective social security program can provide limited support to households which might otherwise fall back into poverty due to the cost of medical treatment or due to loss of income as result of a work related accident. Besides the immediate positive social impact, the social security program would also avoid the inter-generational transmission of poverty and ensure human capital accumulation of the next generation. Secondly, from a macroeconomic perspective, social security can function as a “stabilizer” in particular in times of economic downturn such as during the severe recession in the wake of the 2008 financial crisis. Therefore a safety-net program would reduce the risk of civil strife and social instability. As such, a social security fund may accumulate wealth during an economic boom, but reduce its asset holdings during an economic downturn as benefit payments increase and contributions decrease.1 In the context of China, social security also smoothed the transition for previously privileged workers that had lost their jobs. Finally, a social security system could promote more equality in income distribution, which is necessary as China suffers from high inequality. This would reduce polarization between the poor and rich, thereby avoiding a twin-peak growth scenario whereby economic growth and inequality simultaneously increase. The social security system in China has three main pillars. First, government contributions mean that the state is providing full coverage. To some extent this can be considered a pay as you go system. Secondly, social pooling (funded through a combination of contributions

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of employers and employees), and thirdly the individual accounts, which are contributions by workers and are built-up over time. China has traditionally provided social security through the first pillar, although after transition the government has introduced reforms that combine the second and third pillars. As a socialist country, China has in the past emphasized a wide range of social security services (in particular for urban workers), including social relief, housing, medical insurances, special care, old-age insurance, unemployment insurance, medical insurance, work-related injury insurance, disability support and maternity insurance. As an analysis of all these social security programs falls outside the scope of this book, this section will focus only on areas critical to reduce vulnerability for a large part of the population. Briefly described in this section will be, respectively, medical insurance, unemployment benefits and the pension system. Medical insurance Medical insurance is critical to reduce vulnerability as medical expenditure and ill-health are main factors which cause households to fall back into poverty (Jalan and Ravallion, 1999; Sen, 2003). As indicated in the previous section, disparities are particularly large between urban and rural areas with respect to health coverage and medical insurance. Overall, health coverage and insurance were replaced by a Fee For Service (FFS) system as the CMS was abolished in rural areas and privatized SOEs could not provide social services in urban areas. This resulted in a huge burden on the majority of the uninsured population who were in the rural and urban population, respectively, 79 and 44.8 percent of the total population (Hassan et al., 2008). To address the problem of un-insurance in urban areas, the government in 1998 introduced a new insurance system based on a social pool fund. Besides government financial contributions, employers and workers pay, respectively, 6 and 2 percent of their wages into this pool for medical insurance. The insurance coverage can be extended through individual voluntary contributions which cover normal relatively small expenditures. Large expenditures are covered by the social pool. This medical insurance was set-up for both state and non-state enterprises (Chow, 2006) and led to the steady increase of medical insurance expenditures and revenues (see Figure 7.2). As such, the insurance system was created for the urban population, while the rural population had to rely on their own financial resources to incur out-of-pocket expenditure themselves. To provide medical insurance to rural communities, the government launched a New Rural Cooperation Medical Scheme (NCMS) in 2003. The objective was to prevent households falling into poverty due to high

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Figure 7.2 Medical insurance by GDP. Source: Ministry of Human Resources and Social Security (CEIC).

medical expenditures. Under this voluntary system, the farmer needs to pay 10 Yuan (about 1 US$) for medical insurance, while the government contributes a similar amount (Brant et al., 2006). Although the rural insurance scheme is commendable, there are still three challenges with the system: i

less rich regions have limited capability of paying for the premium for coverage (Hassan et al., 2008); ii the scheme over-emphasized protecting farmers from poverty caused by catastrophic disease, while it neither addresses preventive health care such as immunization, nor the floating population of migrant workers (WHO, 2004); and iii the voluntary nature of the insurance scheme encourages adverse selection (i.e. only the sick will seek insurance, while the healthy people would avoid paying for insurance). As such, the role in reducing vulnerability for a large section of the rural population would be limited. It would therefore be recommendable to make participation in the medical insurance mandatory, as is the case in urban areas.

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Unemployment benefits Unemployment did not exist until the late 1990s as privatization of SOEs led to breaking of the “iron bowl” and mass lay-offs. As such, unemployment is thus a relatively recent phenomenon and urban in nature. In contrast, rural households are either under-employed or migrate to urban centers. To mitigate the impact of the newly unemployed in urban areas, which were referred to as xiagang, SOEs had to establish re-employment service centers and provide basic living subsidies at 60 percent of the worker’s final wage in addition to health insurance and pension contributions. Cash-strapped companies could not comply with this law and some could not even provide severance packages due to financial constraints. In turn, this meant that the unemployed could not receive social security payments. If a company survived the challenges of privatization, after three years, the redundant worker would lose their benefits (Betcherman, 2004). This meant that as reforms progressed, former SOEs became less responsible for their former employees and laid-off workers that did not find a job. The Chinese government provided several programs to ensure social stability in urban areas, which were mainly basic livelihood guarantees for laidoff workers from SOEs, unemployment insurance and minimum living standard guarantees for urban residents. The establishment of these public programs was meant to ease the adjustment of labor-force reforms although they were often considered incomplete to provide social protection. Vulnerable groups having difficulties finding a private sector job, such as women, less-educated people, and older workers, were largely dependent on these safety-net provisions (Giles et al., 2006). Pension system Often pension schemas are a combination of compulsory contributions by individuals as well as by the state. From an economic perspective, pension contributions should be mandatory as this would avoid unfair competition between various sectors and companies. In addition, such a system would enhance labor market mobility and flexibility. This system is essential to meet the needs of migrants who frequently change job and location. In addition, during an economic downturn, a pension system could provide a basic safety-net as all members of a household could benefit from pensions provided by one family member. However, since the redesign of the pension system in 1997, urban coverage is below 50 percent, while the rural population is mainly excluded from any old age provision and remains dependent on the family network for support. Despite these challenges, the number of contributors paying into pension programs had grown from 84.8 million in 1998 to 131.2 million in 2005. The number of recipients of

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pension benefits has also increased from 27.3 million to 43.7 million (OECD, 2007). As indicated in Figure 7.3, this led to a steady increase of expenditures and revenues from the pension funds by GDP. The pension system in China has three main challenges. First, the social security system is highly fragmented and is available to only a relatively limited group of urban dwellers, who are mainly employed by newly privatized SOEs and foreign affiliation companies. This fragmentation is caused by the fact that various regions and cities have different policies, while individual companies have a wide variety of benefits. This fragmentation leads to small municipalities, particularly in rural areas lacking the fiscal tax base to provide any viable pension system. Secondly, current pension obligations exceed contributions. As a “temporary” short-term solution, local governments use contributions from individual accounts to provide payment of pensions, although this will likely make the problem worse in the future. These individual accounts are therefore “empty” as the funds have often been utilized by local government and SOEs to replenish social pool funding which is estimated to have deficits of 100 billion Yuan, corresponding to US$ 12.1 billion (Chen, 2004). Another pending problem behind the imbalance between social security payments and contributions is demographic in nature. As described in the next section, this is mainly caused by the one-child policy which dramatically changes the dependence ratio (the ratio of

Figure 7.3 Expenditure and revenues of pension funds by GDP. Source: Ministry of Human Resources and Social Security (CEIC).

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retirees to workers) between (younger) people that contribute, and (older) people that receive retirement benefits. Thirdly, the introduction of individual accounts, which means that the cost of retirement is “front-loaded” as current benefits will have to be paid without contributions from the younger generations, through a pay as you go system. This problem is compounded by the previously mentioned “empty” accounts and highlights the lack of organized financial investment opportunities, as normally funds are used to invest in low-risk assets with limited returns and assets such as government bonds. A possible solution to the “front-loading” problem as well as the empty national accounts could be for government to “replenish” individual accounts with government bonds, while worker contributions would continue to finance the ongoing payment of pensions. This would mean that the government would take over the debt of national entities which are not in position to fulfill long term pension obligations. To overcome these challenges will require central government involvement. As China has a long track record on experimenting with policies at local level before implementation nationwide, the experience of pension restructuring in Jilin and Heilangjiang could form the future blueprint for national pension reforms. In these two provinces the government is replenishing, respectively, 70 percent and 80 percent of the funds for individual accounts (Zheng, 2006) so as to ensure social stability. The role of central government Although the social security system in China is still at an embryonic stage, it is evident that it has to be expanded and that central government needs to play a more prominent and active role in the near future. This will have several potential advantages. First, the issue of spatial as well as rural– urban inequality could be addressed with interregional fiscal transfers between more affluent and poor regions. This would avoid a “race to the bottom” syndrome whereby social security payments will be reduced due to competition from other regions that provide less protection to their workers. Secondly, social insurance systems need to be reformed to improve their financial sustainability, including current and future liabilities. Local government authorities often lack the fiscal space to address this issue. This applies particularly to poor regions and smaller municipalities that have a limited tax base. These liabilities could be considered “transitional debt” as they are related to the transition from a planned economy to a market based oriented economy and should therefore be transferred to the central government. These “transitional debts” could be partially funded through the revenues generated by privatization, which could be considered “transitional assets”. Thirdly, participation in social

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security should be compulsory for all individuals as this would avoid adverse risk selection, in which, for example, only the chronically ill will seek health insurance, while the healthy workers would choose not to be covered. Mandatory participation would therefore encourage “riskpooling” at national level. In the long term, if social security funds become financially sustainable with the support of central government, the social security funds could become a means to channel savings toward productive investments. This is the case in mature markets in which pension funds are institutional investors and channel savings through the stock market. Finally, a stronger role for central government might help to address the main challenge to implement a nationwide social security system that will also cover the informal sector and migrant population, which lack residence permits. The problem of providing insurance to migrants does not only stem from their legal status, but also from the high job rotation rate, which means that this group can switch employees quickly and across regions. As each municipality has various contribution rates or formulates different schemes, it is difficult to make social security “portable” and therefore migrants will only benefit when building-up their individual accounts. The involvement of central government in managing social security could strengthen the “universality” of providing a safety-net to highly mobile parts of the population.

7.3 Demographics and fiscal sustainability of pensions Demography is a key factor that influences the development of a social security system in China as it affects the fiscal sustainability of pension liabilities. This is relevant in urban areas which have a pay as you go system and therefore depend on contributions from younger generations to finance pension payments of the elderly. In essence, the pay as you go system is financed from pension benefits that are paid directly by contributions from the current workforce as well as company contributions. In addition, a large portion of the elderly was offered early retirement as part of the privatization process and therefore could be considered part of transitional debt. Although estimates vary widely, it is believed that pension liabilities are between US$300–350 billion (He, 2001). Secondly, demographic factors are key in determining the capacity of households to provide a safety-net for the elderly who receive support from their children. Such family-based support networks appear to be weakening through the change of employment patterns in households arising from the economic reforms (Uchimura, 2005). However, inter-family transfers, which on average are only 4.4 percent, seem to increase to 20 percent if retirees are very poor (Hu, 2006). This inter-family support is also found in non-monetary areas as 90 percent of elderly live with their

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children (Cai and Wang, 2006). Although it is difficult to predict the future trends in regard to supporting the elderly once households are affluent, a study in Chinese Taipei indicated that in 1995 more than 52.3 percent of elderly depended on their children (Li, 1999). As this area is culturally similar to the mainland and much wealthier, this could predict that family-based support networks would remain important in the near future. Demographic changes in China can be attributed to population planning policies, in particular the “one-child-only-rule” that started in 1979. This was an accumulation of policies that between the 1950s and 1970s aimed at lowering the growth of the population through education campaigns, and by providing contraception and abortion services (Chan et al., 2006). Finally, this resulted in the current one-child rule, although this was implemented unevenly across China, and there are exceptions for ethnic minorities or households depending on a second child for economic reasons, which is often the case for rural poor peasants (Feng, 2005). Proponents highlight that the main achievement of the one-child policy was the reduction of population growth, thereby enhancing development prospects through improved human capital accumulation and reducing the stress on environmental resources (i.e. agricultural land, energy, water, etc.). The downside of this policy included the resulting high sex imbalance, with males outnumbering females, and the funding of the formal pension program. In addition, the informal safety-net within a household would also be negatively affected. The sex ratio at birth (defined as the proportion of male births to female live births), ranges from 1.03 to 1.07 in industrialized countries (Davis et al., 1998). Before the implementation of the policy in 1979, the reported sex ratio in China was 1.06 nationwide. This grew to 1.11 in 1988 and 1.17 in 2001 (Kang and Wang, 2003). Two possible solutions might be considered to address the demographic factors that underpin social security. First, the relaxation of the one-child policy would shift the demographic balance and provide a broader fiscal basis to support pension payments. In addition, the proposed two-child policy would have an additional positive effect on inter-generation income opportunity as it is likely that more girls will be born. Although there could be a wide debate on the impact of gender in terms of providing care for the elderly within a household, in general it could be stated that women take a larger role of providing for the elderly. Unfortunately there is limited research on gender dimensions of social security in China and it might be an avenue for further research in the future. Secondly, the reforms in China changed the household employment pattern. With a buoyant economy it is relatively easy to find employment as well as to increase earnings, which could supplement pension benefits. In fact, it is highly likely that many pensioners have already supplemented

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their retirement income by working in the informal sector or by being self-employed (Betcherman, 2004).

7.4 Fiscal stimulus package and social security reforms Although social security was initially established to provide a safety-net for newly redundant workers of SOEs in the 1990s, the Chinese government has recognized that a comprehensive and effective social security program is key to the development of a harmonious society. The issue of introducing such a comprehensive social security system for the whole country has been placed at the forefront in the wake of the economic crisis, which was triggered by the 2008 financial crisis in the United States of America. This crisis caused a severe slump, with labor intensive manufacturing exports dropping by about 20 percent in the first quarter of 2009 (International Herald Tribune, 2009g). A consequence was the redundancy of about 20 million people, which mainly affected migrants as they lack both job and social security. In addition, 30 percent of the graduate students could not find a job (Financial Times, 2009). The combination of unemployment for both migrants and students could relatively easily translate into civil strife without a comprehensive social security system. As discussed in the first part of this book, China’s macroeconomic vulnerability is related to its reliance on exports for economic growth and therefore to an economic downturn in developed countries such as the United States of America and the European Union. However, the 2008 financial crisis could shift the political and economic momentum toward stimulating domestic demand for consumer goods on a sustainable basis. In the short term, the government of China is already stimulating domestic demand by launching a massive stimulus package with the aim of achieving an economic growth rate of 8 percent, which is considered the make-or-break threshold for sustaining both employment levels and social stability. This stimulus package is estimated at 4 trillion Yuan (US$586 billion), which corresponds to about 2 percent of the GDP in China. This package is mainly focused on infrastructure, as this is considered a “typical” labor intensive investment with a strong multiplier effect and long term benefits. The stimulus package of the government has been complemented by encouraging banks to provide another 5 trillion Yuan (US$732 billion) in fresh bank loans. The expansion of credits will be supported by low interest rates with deposit rates at just above 1 percent (China Daily, 2009c). However, lending might not necessarily be allocated toward productive investments as has been the case in the past. As such, it could contribute to Non Performing Loans which are already estimated at around 2.7 trillion Yuan (International Herald Tribune, 2009h). As part of the stimulus package, consumer spending is encouraged (in

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particular in rural areas), by providing a 13 percent rebate on the purchase of consumer goods like TV or household appliances. As with other initiatives in China, this policy was first piloted at local level, and if successful could be applied to other regions of the country.2 The cost related to providing 13 percent rebate was split 80–20 between the central and local governments respectively. It is envisaged that this rebate program could increase rural consumption by about 920 billion Yuan and could promote growth of the refrigerator sector by 20 percent, the washing machine sector by 19.5 percent, and the color TV sector by 14 percent (China Daily, 2009d). However, this rebate program encourages consumption only temporarily and low income and the lack of social security services hamper the purchasing power of rural farmers on a sustainable long term basis. Long term recovery will depend on a permanent increase in consumer spending without the need for massive fiscal stimulus packages or microeconomic consumer goods rebate programs. An advantage of increasing consumer spending would be to rebalance economic growth toward domestic demand as opposed to the export oriented development. This is all the more important as it is unlikely that the economic demand in the developed markets in the United States of America and Europe might pick up substantially in the near future. To ensure sustained consumer spending would require a comprehensive safety-net as households need to keep a relatively large financial reserve so as to be able to “cope” with outof-pocket medical or other emergency expenditures. This could be part of the US$123 billion plan to provide universal health care to all Chinese (International Herald Tribune, 2009b). Another major concern of the stimulus package is that of the 4 trillion Yuan, central government will only pledge 1.18 trillion Yuan, equivalent to about 30 percent. The remaining 2.22 trillion Yuan, equivalent to about 70 percent, would be funded by the local government (China Daily, 2009b). The strong emphasis on local government contribution to the stimulus package will exacerbate already high levels of regional inequality as well as urban–rural inequality. This is because a major portion of the funding will be undertaken by rich provinces and cities. In addition, poor regions might have an additional fiscal burden, which might crowd-out recurrent expenditures such as salaries for teachers and doctors. Again, this emphasized the importance of a stronger involvement of central government in providing safety-nets, including through inter-regional fiscal transfers.

Main observations of chapter This chapter highlights past developments and future challenges of establishing a comprehensive social security program. This is key to ensuring a stable society, addressing inequality issues and reorienting the source of

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China’s economic growth from exports to domestic demand. The main challenge is to broaden the coverage of a social security system that was originally introduced for a relative small number of laid-off employees of newly privatized SOEs to the wider population. This would also require addressing the fiscal sustainability and providing broadly based coverage and adequate protection to all citizens. This is particularly important for the migrant population that has been excluded from the social security system as they often lack official residence permits and frequently change jobs between different regions. This hinders participation in company level as well as in public funded programs administrated at regional or municipality level. An additional problem is that the capacity between regions and municipalities to fund social security programs varies widely, with some having a limited tax base as well as considerable liabilities from (former) SOEs. This could be considered “transitional debt” as it was necessary to ensure a smooth transition from a state planned economic structure to a market oriented system. Finally, the rural areas are still under-served as the social security system is not fully developed and participation is voluntary, compared to urban areas where it is more extensive and participation is mandatory. These challenges of developing an effective social security program can only be addressed by centralizing and harmonizing the social security system. This would ensure that migrants could benefit from the social security program, equalize income distribution between regions and ensure that the issue of “transitional debt” is addressed.

8

The impact of public sector reforms on vulnerability

Introduction China’s public sector has changed dramatically during the last three decades of transition. During this period, China undertook fiscal decentralization reform and restructured public service provisions. Fiscal decentralization led to the expansion of spending mandates by lower tiers of government without provision for adequate financial resources. This has particularly been a problem for poor rural areas with a limited tax base. At the same time as fiscal decentralization reform was undertaken, public service provisions were restructured and previously free education and health care programs were abolished. These provisions were replaced by public services in which formal and informal fees became essential for the financing of local government. This had a negative effect on equality in public service provision and excluded the poorest segments of society from essential services. This chapter focuses on the impact of fiscal decentralization and public service provision on food expenditure, which is a guide to vulnerability (Barrett, 1999; Christiaensen and Boisvert, 2000). Fiscal decentralization is measured by four variables (provincial budgetary expenditures as share of total national budgetary expenditures; provincial budgetary revenues as share of the total national budgetary revenues; provincial extra-budgetary expenditures as share of the total national budgetary expenditures; and provincial extra-budgetary revenues as share of the total national budgetary revenues). Public service provision is measured by three education variables (number of students per teacher in primary education, number of students per teacher in secondary education and number of students per teacher in higher education) and two health variables (number of doctors per bed and the number of beds per health institution). The methodology consists of applying a standard OLS and Fixed Effect (FE) regression in which food expenditure is the dependent variable while fiscal decentralization and public service provisions are independent variables.

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A robustness test is applied by introducing lags of respectively 1 and 2 years. Fiscal decentralization enhances service delivery, according to the Oates Theorem, as local government is more responsive to the needs of their constituency compared to centralized states (Oates, 1972). Another consequence of fiscal decentralization is that costs of local government will be “internalized”, which should lead to gains in efficiency. However, the Oates Theorem assumes “downward” accountability to local constituencies through elections; while in China local government officials often have “upward” accountability as the career track of civil servants are controlled by central government and the Chinese Communist Party (CCP). In this context, user fees can be introduced without suffering from the political consequences and costs of local government can be “internalized”. In such a public administration structure, grievances of local citizens can be addressed by petitioning the central government (Zou, 2006). Public service provision in the education and health sectors is critical to reduce vulnerability. This is because education leads to human capital accumulation, which is a key factor to increase capacity to seek employment or engage in productive activities as well as to recover from crises (Adam and Jane, 1995; Campa and Webb, 1999). The health sector is important to reduce vulnerability because households that descend into poverty often have income shocks arising from ill health (Jalan and Ravallion, 1999; Sen, 2003). Therefore the quality of both the education and health sectors is key to reducing vulnerability. The remainder of this chapter is organized as follows. The first section, “Fiscal decentralization and public service provision reforms”, analyzes the effects of fiscal decentralization and public service provision during the last three decades of transition. The second section, “Data description and methodology”, defines the data and presents the OLS and Fixed Effect regressions. The third section, “Results and robustness test”, presents the outcome of various regressions including time lags of 1 and 2 years. Finally, the section “Main observations of chapter and policy implications” highlights the limitations as well as practical recommendations of this research.

8.1 Fiscal decentralization and public service provision reforms During the period of transition China has transformed from a state planned oriented economy to a modern market based allocation economy. The reform of the public sector during this period had a direct impact on fiscal decentralization and public service provisions, which is elaborated below.

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Fiscal decentralization Since the founding of the People’s Republic of China in 1949, the Chinese public sector has been decentralized and recentralized several times. Before the transition in 1979, the fiscal relationship between the central and provincial governments could be described as one of “unified revenue collection and unified spending”. In practical terms this meant that provincial government collected nearly all government revenues, which were then transferred to the center (Feltenstein and Iwata, 2005). After 1979, China adopted a fiscal contract system (Oi, 1992; Wong, 1997). Under this arrangement, local government collected and shared taxes with the central government according to pre-negotiated agreement. The contract system was not a uniform tax structure and different provinces had different arrangements with central authorities. These decentralization efforts are referred to as Fenzao chifan, which means “preparing meals from separate stoves”. Another consequence of the contract system was that various local governments used their discretional authority to provide tax and other concessions so as to encourage FDI in areas under their jurisdiction. The introduction of a fiscal contract system weakened the central government revenue authority (as they were dependent on local government to collect taxes) as well as led to a wide range of agreements between central and provincial authorities. To strengthen the role of the central government as well as to harmonize relations between the provinces, the fiscal contract system was replaced by a uniform sharing formula, which is also referred to as the Tax Sharing System (TSS). This required all provinces to remit 75 percent of their revenues from the value-added tax to the center (Bahl, 1999). Although fiscal decentralization was somewhat reversed by the TSS, fiscal transfers between provinces still remained limited (Jin and Zou, 2005). This meant that inequality issues could not be addressed through fiscal transfers as TSS is mainly based on VAT and therefore on the size and wealth of the local economy (Kanbur and Zhang, 2005; OECD, 2006). Revenues were therefore dependent on the wealth of individual provinces. Fiscal transfers between provinces, which are necessary to reduce inequality between the rich eastern coastal provinces and the poor western interior provinces, were thus limited. This created fiscal pressures on provincial government which were caused by an internalization of costs. Moreover, poor rural regions often lack a wide fiscal tax base and thus had to rely on formal and informal service charges, which had a detrimental effect on accessibility of essential services in the health and education sectors. Although the Oates Theorem indicated that service delivery at the local level is more efficient and effective compared to centralized states (Oates, 1972), this is not necessarily the case in China as

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political accountability is “upward” to the central government and not “downward” to its constituency. This is because the career track of Chinese officials are not controlled by local elections, but by the central authorities through appointments and promotions as well as through membership of the Chinese Communist Party (Huang, 2001). This was institutionalized through the target responsibility system, which created yardstick competition among local officials through rewarding or punishing officials on the basis of performance (Zhang, 2006). Competition between civil servants was supported institutionally through standardized statistical data and accounting systems. As such, there was an internal political market within the public sector (Li and Zhou, 2005). In this context, petitioning, or xinfang, is a form of expressing grievances directly to the central government as it bypasses local government (Zou, 2006). To address the negative effects of service fees, the government introduced Rural Fee Reforms (RFR) in 2002, which officially limited the taxation power of local government. However, this reform resulted in additional fiscal pressure on local government, particularly in poor rural areas, and resulted in further degradation of service delivery. To enhance the fiscal position of lower tiers of government, the central government implemented the “three rewards and one subsidy” program in 2005 (World Bank, 2007), which focused on financial support to local rural governments through fiscal transfers (Dong, 2006). Although these kinds of central programs are noteworthy, the overall effects of central government intervention at the local level were limited due to several reasons. First, in a federal decentralized state such as China, the central government has no implementation authority and therefore has difficulty tracking funds so as to ensure effectiveness. Secondly, funding from the center consists of only 10 percent of the total funding on social services at village level, and this is too limited to impact poverty (Wong, 2008; World Bank, 2007). Thirdly, in terms of political economy, rural regions lack political clout to attract funding from the center, in particular in comparison with wealthy urban regions in Eastern China (Wong, 2007). Public provisions reforms The reform of public provisions during transition also led to an increase in inequality in health and educational services. Before the transition, these public service provisions were linked to production entities, which were communes in rural areas and SOEs in urban areas. With the abolition of rural communes and privatization of the SOEs, public service provisions were drastically changed. In the health sector this had a dramatic effect in rural areas as “barefoot” doctors, which were essential for preventive care, were abolished. Since then the health care system in rural

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areas seems to have degraded substantially and preventable diseases such as tuberculosis are reappearing (Dummer and Cook, 2007). The privatization of the Cooperative Medical System (CMS) also led to a reduction in health insurance coverage, which resulted in 87 percent of the rural population and 44 percent of the urban population having no health benefits and thus having to pay for all medical costs directly out-of-pocket (Banister and Zhang, 2005). Access to health care is important to reduce vulnerability as many households that fall below the poverty line were actually health-stricken rather than poverty-stricken (Gustafsson and Li, 2004). In addition, health care expenditures also had a strong crowdingout effect on other goods and services, which included human capital investment, physical capital investment and investment in development of human well-being (Wang et al., 2006). In the education sector the government has significantly stepped up expenditure to improve education in the semi-urban and rural areas. This led to an increase in the share of the educational budget in total government expenditure from 6.8 percent in 1978 to 18.8 percent in 1998 (Min-Dong, 2006). Unfortunately, this trend coincided with the rapid rise of tuition fees, especially for higher education, although the Education Law in March 1986 stipulated free education for all for the first nine years of schooling. Another negative consequence was that students in rural China attended poorly equipped schools with lower quality teachers, and therefore faced additional educational hurdles (Heckman, 2005; Brown, 2006). This resulted in opportunity costs for the poor as drop-out children could be more productively employed on the farm (Connelly and Zheng, 2003). Finally, migrants in the urban areas faced additional financial education costs as they had to pay “education endorsement fees” (jiaoyu zanzhu fei ), a heavy burden for those in low-pay occupations (Liang and Chen, 2007). In short, fiscal decentralization shifted the burden of school and health funding to the lower tiers of government. This process is part of the “internalization of cost”, although this was not accompanied with “downward” accountability to its citizens. On the one hand this led to fiscal pressure which was a particular problem for poor and rural counties that struggled to generate revenues from a weak tax base (Park et al., 1996). On the other hand, excessive user fees were introduced, as fiscal decentralization was not accompanied by political decentralization. This is the reason why fiscal decentralization and public services provisions are closely linked (Luo et al., 2007). The user fees led to the exclusion of the vulnerable and poor segments of society. Such an outcome would be contrary to the objectives of developing a harmonious society.

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8.2 Data description and methodology The objective of this research is to measure the impact of fiscal decentralization and public service on food expenditure. The panel dataset covers 28 provinces of China and is measured annually from 1982 to 2003. Tibet is excluded for lack of data. The provinces of Guangdong-Hainan and Sichuan-Chingqing were merged to make the datasets compatible. Urban food consumption expenditure as well as rural food consumption expenditure are weighed with the urbanization rate (see equation 8.1), which is referred to as Weighed Food Expenditure and is the dependent variable. In total there are nine independent variables: four fiscal decentralization and five public service provision variables (i.e. respectively three in the education sector and two in the health sector). The description of the data as well as the sources is as follows. Weighed Food Expenditure (WFE) Food expenditure is used as a proxy for vulnerability in the food insecurity literature (Barrett, 1999; Christiaensen and Boisvert, 2000). In this chapter, the Weighed Food Expenditure is urban food consumption weighed by urban population as well as rural food expenditures weighed by rural population (see equation 8.1), deflated by Consumer Price Index (CPI). Although using a weighed average is discouraged as this destroys information, this was undertaken so as to make the various datasets compatible. A person is counted as rural if he/she was born in rural areas or has at least lived in rural areas for one year. This variable is based on the China Statistical Data Compilation of Michigan University.

WFEpt =

冱冱 t

p

Urb*UFE +

冱冱 t

p

(1 − Urb)RFE

(8.1)

Where WFE is the deflated Weighed Food Expenditure, Urb is the percentage of urbanized population, UFE is the deflated Urban Food Expenditure, RFE is Rural Food Expenditure, p is one of the respective 28 provinces, t is the respective individual year starting from 1982 until 2003. To measure fiscal decentralization as well as public service provisions in education and health sectors, the following nine independent variables were used: 1. Fiscal Decentralization (FD1, FD2, FD3 and FD4)

In the literature it

The impact of public sector reforms on vulnerability

123

is noted that fiscal decentralization could lead to more effective social programs (Oates, 1972). This assumes “downward” accountability, while in China there is “upward” accountability in terms of political appointments. Without adequate accountability, fiscal decentralization therefore could lead rent-seeking by lower levels of government. Fiscal decentralization is measured by provincial budgetary expenditures as share of total national budgetary expenditures (FD1); provincial budgetary revenues as share of the total national budgetary revenues (FD2); provincial extrabudgetary expenditures as share of the total national budgetary expenditures (FD3); and provincial extra-budgetary revenues as share of the total national budgetary revenues (FD4). This data was provided by Jing Jin and Heng-fu Zou of the World Bank. 2. Public service provisions in the education sector (Edu1, Edu2 and Edu3) Education is key to building human capital, resulting in higher productive activities which are essential to reduce vulnerability. The role of human capital in the reduction of poverty is well documented in the literature (Adam and Jane, 1995; Campa and Webb, 1999). The public service provision in the education sector is measured by the mumber of teachers divided by the number of students at this level of education in respectively the levels of primary education (Edu1), secondary education (Edu2) and higher education (Edu3). The data is from various issues of China Statistical Yearbook, which were provided by the China Statistical Data Compilation of Michigan University. 3. Public service provision in the health care sector (HC1 and HC2) Health care is important as illness, especially chronic illness and “out-ofpocket” medical expenditures, are a major factor in making people poor (Jalan and Ravaillion, 1999; Sen, 2003). The public service provision in health care is measured by the number of beds (per 10,000) per health care institution (HC1); and the number of medical personnel provincial divided by number of doctors provincial (HC2). The data is from various issues of China Statistical Yearbook, which were provided by China Statistical Data Compilation of Michigan University. The Ordinary Least Squares (OLS) and Fixed Effect (FE) were used to measure the impact of fiscal decentralization and public service provisions. The FE regression is described as followed: WFE = β0 + β1FD1,pt + β2FD2,pt + β3FD3,pt + β4FD4,pt + β5EDU1,pt + β6EDU2,pt + β7EDU3,pt + β8HC1,pt + β9HC2,pt + χt + δpt

(8.2)

Where WFE is Weighed Food Expenditure (equation 8.1); FD1 is provincial budgetary expenditures as share of total national budgetary expenditures; FD2 is provincial budgetary revenues as share of the

124 Public sector reforms, fiscal decentralization and social security total national budgetary revenues; FD3 is provincial extra-budgetary expenditures as share of the total national budgetary expenditures; FD4 is provincial extra-budgetary revenues as share of the total national budgetary revenues; Edu1 is public service provision in primary education sector as measured by the amount of teachers divided by the amount of students; Edu2 is public service provision in secondary education sector as measured by the amount of teachers divided by the amount of students; Edu3 is public service provision in higher education sector as measured by the amount of teachers divided by the amount of students; HC1 is public service provisions in health care as measured by the amount of beds (per 10,000) divided by per health care institution; HC2 is public service provisions in health care as measured by the amount of medical personnel provincial divided by number of doctors provincial; p is one of the respective 28 provinces, t is the respective individual year starting from 1982 until 2003, α is the constant, β1, . . . 9 are the respective coefficients of the independent variables, χ is the fixed effect and δ is random error. The advantage of the fixed effects method is that it offers control for all stable characteristics of the observations and therefore isolates the effects of fiscal decentralization and public service provisions in the health and education sectors on food expenditure. The F-test will measure the significance of the Fixed Effect, thereby taking advantage of what the panel data offers. The next step is to apply a robustness test by introducing lags of 1 and 2 years. The reason for this is that it could take 1 or 2 years when reforms are initiated to actually have an effect on vulnerability. This could be a “policy lag” in which a change in policy could take several years to have an effect on the dependent variable. A practical example could be that food consumption due to human capital accumulation could take a few years to have an impact on food expenditures.

8.3 Results and robustness test This section presents the results of the OLS and Fixed Effect regressions as well as the lags of 1 and 2 years. The results are presented in Table 8.1. The following three observations can be made. First, budgetary revenues (FD2) and extra-budgetary revenues (FD4) are significant in almost all time lags and have a negative impact. This means that if provincial budget revenues and extra-budgetary revenues increase, food expenditure is reduced. This could be explained as the increase in budget revenues is caused by raising local taxes and this would have a negative effect on food expenditure. In addition, extra-budgetary expenditures (FD3) are significant and have a positive impact in time lags of 1 and 2 years which

Observation Significant

F-test

R-square

Constant

Health2

Health1

Edu3

Edu2

Edu1

Fiscal Dec4

Fiscal Dec3

Fiscal Dec2

Fiscal Dec1

35.74 (0.00)

0.07

4.621 (5.982) −12.268*** (2.758) 21.260 (15.716) −22.240* (12.907) −41058.78*** (11015.99) −18315.88** (9092.336) 216420.4*** (29616.29) −34.057 (57.772) 57.729* (32.815) 236.235*** (87.144)

T0 FE

0.10

1.861 (5.676) −7.389*** (2.829) 29.569* (16.230) −35.252** (13.363) −51004.37*** (10985.04) −15818.62* (9222.249) 215433.3*** (30085.15) −25.833 (42.934) 54.935** (27.681) 265.572*** (73.453)

T1 OLS

39.32 (0.00) 424

0.1

−3.131 (5.942) −4.306 (2.953) 29.402* (16.974) −33.220** (13.971) −53898.98*** 11463.05 −9143.59 (9578.492) 249499.1*** (31228.08) −12.743 (44.967) 67.338** (28.872) 229.992 (76.982)

−0.8480 (6.086) −9.502*** (2.801) 29.902* (15.949) −37.561** (13.101) −47418.89*** (11198.71) −19112.31** (9241.187) 221411.2*** (29996.26) .0118 (58.666) 83.647** (32.914) 216.008** (88.264) 0.06

T2 OLS

T1 FE

421 421 423 423 * is significant at 10%, ** is significant at 5% *** significant at 1%

0.11

5.616 (5.551) −10.237*** (2.783) 20.481 (15.984) −20.409 (13.15516) −46456.56 (10764.87) −15879.78 (9047.522) 208819 (29658.95) −40.789 (41.228) 36.022 (27.145) 274.296*** (71.142)

T0 OLS

Table 8.1 Regression on weighed food consumption

424

39.45 (0.00)

0.07

−5.711 (6.389) −6.290** (2.931) 30.204* (16.730) −35.674** (13.74) −50108.01*** 11711.74 −12142.24 9622.956 257535.2*** 31228.81 19.231 (61.395) 99.672** (34.328) 168.21** (92.511)

T2 FE

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Public sector reforms, fiscal decentralization and social security

indicates that expenditures, either through additional infrastructure or social services provisions, have a positive impact on food expenditure. This raises the question of a possible trade-off between additional taxation, which would reduce food expenditure, and enhanced public provisions, which would increase food expenditure. Secondly, public service provisions in the education sector are significant in most time lags. Improved public service provisions in primary education (Edu1) therefore lead to a reduction in food expenditure. To a lesser extent this is also the case for secondary education (Edu2), although this variable is not significant with a lag of 2 years. This is somewhat surprising as it is expected that education at the lower level would have a more direct impact on food expenditure. Although this might be the case in the long term, in the short term the enrollment of a child might lead to lower food expenditure as they cannot contribute to family income, especially in rural areas (Connelly and Zheng, 2003). For example, a child might contribute to the family income by working on the farm, instead of going to school. Education at higher level (Edu3) has a positive impact on food expenditure. Besides that, additional education leads to higher income, and another channel of transmission is that higher education has positive externalities. Thirdly, the results for public service provisions in the health sector are less clear cut. Only Health Care 2 (HC2) is significant and has a positive impact. This means that, to a certain extent, improvements in health care lead to additional food expenditure. Although insurance coverage and “out-of-pocket” medical expenditures are not included in the paper, this result indicates that improvements in health care are effective in increasing livelihood opportunities. The explanation for this is straightforward as health care can reduce chronic illness as well as encourage human capital accumulation (Jalan and Ravaillion, 1999; Sen, 2003). Finally, the F-test demonstrates that all Fixed Effect regressions are significant.

Main observations of chapter and policy implications This research focused on the relationship between, on the one hand, food expenditure which could be a guide for vulnerability, and on the other hand, fiscal decentralization and public service provisions. The conclusion is fivefold. i

ii

Fiscal decentralization of revenues leads to a reduction of food expenditure of households. This is likely as local revenues are often financed through additional taxation and therefore lead to a reduction in food expenditures. Fiscal decentralization of extra-budgetary expenditure leads to additional food expenditure. This means that extra-budgetary expenditures

The impact of public sector reforms on vulnerability

127

are allocated to improvements in infrastructure or social services, thereby enhancing food expenditures. iii Improvement in public service provisions of the primary and secondary education sector leads to reduction in food expenditure. Although somewhat controversial, this result could indicate that there is substitution effects if children attend school instead of contributing to the family income by working on the farm or in the informal sector. The education cost is also a challenge for migrants which face additional costs in gaining access to public services such as through the “education endorsement fees”, which could be a relatively large share of income for this group (Liang and Chen, 2007). In the short term the cost of education could lead to a reduction in income, although in the long term this will likely increase productive and income earning capacity of children. iv Public service provisions in higher education have a positive impact on food expenditure. This is likely explained as this segment of society already has high enough income to support their children’s education without a negative impact on food expenditure. v Public service provisions in the health care sector increases food expenditure. This is in line with poverty literature which emphasizes the importance of health care both to avoid ill health as well as to build human capital. The results of this chapter should be interpreted with caution for the following reasons. First, fiscal decentralization, and the manner in which extra-budgetary revenues and expenditures are accounted, have changed during the course of the transition period. This would make intertemporary comparisons more challenging. Secondly, inequality between rural and urban areas is significant. Unfortunately, the dataset does not allow separation into urban and rural regions. Thirdly, the issue of insurance has not been adequately addressed, which is especially relevant for the health sector. Despite these limitations, this chapter does present a clear relationship between food expenditure, which is a guide to vulnerability, and fiscal decentralization and public service provisions. The policy implications that could be taken into consideration are as follows. 1

Introduce a conditional cash-transfer system, which would pay a monthly allowance to the female head of the household if children attend regular schools and health check-ups. Although the conditional cash transfer system was originally set-up in Mexico and Brazil, it has become an effective tool to reduce poverty in many developing countries (De Janvry and Sadoulet, 2006). It would be particularly useful in countries like China, which have social service institutions in place to

128

2

3

Public sector reforms, fiscal decentralization and social security provide health and education services to the poor (Son, 2008). Therefore, the cash transfer system will have a double advantage of increasing food expenditure, with all its social-economic benefits, as well as ensuring that inter-generational transfer of poverty is limited. Integrating the migrant population into the social security system, which is estimated at 130 million Yuan (Li, 2007). Currently, this group has to pay additional education costs and has been excluded from health care coverage due to the hukou system. In combination with the conditional cash transfer system advocated in this chapter, this could be added to the massive fiscal stimulus package of 2008, which corresponds to roughly 4 trillion Yuan (US$ 586 billion), is about 2 percent of China’s GDP. This fiscal stimulus package was introduced to mitigate the effects of the economic downturn. The spending increase could also subsidize basic medical coverage and overhaul hospitals. These kinds of safety-net policies are particularly critical as poor migrant workers often switch jobs. Centralize some of social security expenditures at federal level. Currently, fiscal decentralization has led to high leakage of federal funds earmarked for poverty reduction as there is a misalignment of incentives between the various tiers of government in China. Additional centralization of a specific number of social expenditures in the health and education sectors could also reduce the fees-for-services (which currently hamper accessibility of the poor) as well as ensure effective implementation. This is particularly a problem in the health care sector, where insurance in rural areas is often non-existent, as well as for migrants.

With these measures, vulnerability would be reduced by increasing the resilience of the population. Moreover, these policy recommendations would contribute to stimulating the domestic economy and strengthening social cohesion. This is critical for the long term sustainable development as well as for the creation of a harmonious society in China.

Conclusion

China’s developmental successes in the last three decades resulted in an exponential increase in wealth and a decrease in poverty. At the beginning of transition in 1978, China had a poor state-driven economy with an autarchist development model and was still suffering from the aftermaths of the Cultural Revolution. At that time, it was by no means self-evident that China’s reforms would have such a positive impact, as it had to overcome transitional challenges (i.e. domination of the state sector, political economy of state-owned enterprises, lack of institution for “pricing”, etc.) as well as developmental challenges (i.e. largely an agricultural based production sector, lack of physical infrastructure, overpopulation, high rate of migration and urbanization, low education level, etc.). Despite these development and transitional challenges, China managed to implement policies that contributed to high growth rates and significant poverty reduction. A critical element in this success was the role of policy experimentation, whereby policies were first tested and refined at local level, and if successful, implemented at national level. A fiscal decentralized government structure assisted this process as the risk of policy failure at local level is manageable, while this is not necessarily the case at national level. Examples of successful policy experimentations were the de-collectivization of the rural commune system and the establishment of Export Processing Zones in the coastal regions of China. The policy experimentation process is also being applied to find solutions for the developmental challenges of the twenty-first century in China, such as the expansion of social security and the participatory decision making process. A negative aspect of transition was that both macroeconomic and household vulnerability increased. On a macroeconomic level, China gradually became more interdependent with the rest of the world. On the import side, it became vulnerable to energy insecurity and large fluctuations of commodity prices. To reduce exposure to these risks China has strengthened bilateral relations with resource rich countries in Africa,

130

Conclusion

Latin America and Asia. These were often accompanied by an increase in Chinese investment, trade and aid, which often lack social and environmental safeguards. This is contrary to traditional multilateral and bilateral development partners from Europe and North America. This model of Chinese development policy is sometimes referred to as the “Beijing consensus”. On the export side, China’s dependency grew as a result of the growth of the labor intensive manufacturing sector which was fueled by an aggressive export promotion strategy. This dependency led to additional exposure to international economic cycles. The first negative economic shock was the Asian financial crisis in 1997. This crisis could partially be absorbed by a dualist system in which the public sector functioned alongside the rapidly growing private sector. The second negative economic shock occurred with the 2008 financial crisis that was triggered by the default of the sub-prime mortgage lending in the United States. This time the subsequent economic downturn could not be absorbed by the dualist system as this was dismantled as part of the overall privatization process and WTO accession requirements. Therefore the government opted for a massive stimulus package of 4 trillion Yuan in additional spending, accompanied by another 5 trillion Yuan in soft loans from the banks. This stimulus package led to projected growth of 6.5 percent in 2009, which is still below the 8 percent benchmark that is perceived as the threshold for social stability. The relatively low growth rate led to 20 million migrant workers becoming unemployed and 30 percent of the graduate students not finding a job. This combination could lead to social tensions and would be contrary to the development of a harmonious society. The 2008 stimulus package will also be used to expand social security programs, in particular in rural areas as part of the “new socialist countryside” initiative which was proclaimed by Premier Wen Jiabao. This includes improving basic public service provisions in the health and education sectors and expanding social security such as the New Rural Cooperative Medical Scheme (NCMS), which provides subsidized health coverage for rural households. These public service provisions should lead to a reduction of vulnerability, thereby encouraging households to reduce saving as families are less exposed to financial risks caused by ill health or accidents. This would stimulate domestic spending and shift the sources of growth and poverty reduction from export industries to internal consumption. However, one of the remaining challenges is how to provide social security to the 130 million migrants who frequently change jobs and work in different locations. In terms of industrial development, the 2008 stimulus package could lead to unproductive investments. This is also linked to a fiscal decentralized public administration structure with a political centralized authority.

Conclusion

131

In this context, local government could allocate these financial resources to industries in their own jurisdiction so as to encourage local employment and tax revenues. This leads to the creation of vested interest groups, which would be protected by local government through regulations and taxation. In essence, such a decentralized investment program would strengthen local protectionism and hamper competition across China. Another downside of the 2008 stimulus package is that banks are “forced” to increase their lending which will likely increase the Non Performing Loans in their portfolio and subsequently the growth of transitional debt. Finally, it should be emphasized that central government will likely have to be more involved in providing public services provisions as well as in implementing social security programs. Although this would be somewhat contradictory to the fiscal decentralized nature of the state in China, more central government involvement could address a wide range of issues which are currently difficult to address due to a weak tax base or inadequate capacity at local level. Furthermore, local government has an additional burden of “transitional debt”, which was created by supporting loss-making SOEs and continuously providing social security to urban workers even if the original company went bankrupt. A centralized approach would also facilitate providing a basic safety-net for the migrants, who frequently change jobs and work in different regions of the country. This is critical for the development of a harmonious and stable society in China.

Notes

Chapter 1 1

This stems from requirements of the WTO which include: “(i) nondiscrimination; (ii) market opening; (iii) transparency and predictability; and (iv) undistorted trade, and preferential treatment for developing countries” (World Bank, 2004). 2 At that time, South Korea was devastated by a bitter war that had seen its capital and major industrial center, Seoul, change hands four times. Its savings rate was low. Its exports were low. More than half of imports in the late 1950s were paid for by US assistance, either foreign aid or the expenditures to support the US military presence in South Korea. In the 1960s Korea’s development strategy shifted from import substitution to export led industrialization. The consequences were that growth rate of income per capita averaged more than seven percent of GDP for the three decades after 1960. Exports grew from three percent of GDP to forty percent of GDP. 3 Two other candidates for inclusion in any East Asian model, Hong Kong and Singapore, have been excluded as they are city-states without agricultural sectors. 4 As such, various forms of export promotion were adopted, including quotas used to provide protection from import competition, local firms encouraged to buy or license foreign technology, marketing support for absorption of risk exchange, etc. Chapter 3 1

It should be noted that the vulnerability framework presented by Guillaumont is applied to Small Island Developing States and Least Developed Countries. 2 These theoretical underpinnings are reflected in the structuralistic theories of the post World War II era, like Rosenstein-Rodan’s “big push”, Albert O. Hirschman’s “unbalanced growth”, Raul Prebisch’s “periphery model”, Lewis’s “dualistic model” and Myrdal’s “institutional approach” (Streeten, 1990). 3 For this purpose developing countries had two instruments: (i) buffer stock, with instructions to buy the commodity when its price is low enough and to sell it when the price rises; and (ii) a system of production quotas limiting the supply of each producing country, policed by certain authorities. 4 First generation currency crises was originally developed by Krugman (1979) and in the literature on exchange rate instability, one approach – often referred

134

Notes

to as first-generation or exogenous-policy models–views a currency crisis as the unavoidable outcome of unsustainable policy stances or structural imbalances. 5 The interaction between expectations and actual outcomes is at the core of the second generation models of crises, in which market expectations directly influence macroeconomic policy decisions. Second-generation models (perhaps best represented by Obstfeld, 1994), require three ingredients. First, there must be a reason why the government would like to abandon its fixed exchange rate. Second, there must be a reason why the government would like to defend the exchange rate – so that there is a tension between these motives. Finally, in order to create the circular logic that drives a crisis, the cost of defending a fixed rate must itself increase when people expect (or at least suspect) that the rate might be abandoned. 6 China’s foreign aid is difficult to quantify. The Chinese Government does not release or explain Chinese foreign aid statistics. In addition, foreign aid does not appear to be accounted for in academic literature on foreign aid. Chapter 4 1

These treaty ports were the results of “unequal treaties” signed after the first and second opium wars, in which Western powers required China to open-up trade, secede sovereign territories and pay large amounts of compensation.

Chapter 5 1

This definition combines two elements: (i) the risk to an event in which a bad outcome could move the household into poverty (Alwang et al., 2001); and (ii) the identification of a geographical area which is more vulnerable than other areas (Downing, 1991; Guillaumont 2006).

Chapter 6 1

2

Besides the opportunities that conglomerate corporate structures provide, there are also potential costs such as additional overhead costs and channeling resources to unproductive units. The criteria of a public good is that it is non-excludable and non-rivaled, which respectively means that nobody can be excluded from the good and that consumption by one person would not reduce availability to another person.

Chapter 7 1

2

Although asset values drop during recession, often the wealth from social security and pensions are invested in low risk governments bonds and can be liquidity easily with limited loss. Therefore drawing on these assets would not have limited repercussions for the social fund. This initiative was first piloted in provinces of Shandong, Henan and Sichuan, as well as Qingdao City from December 2007 through May 2008 and was then expanded to 14 provinces, autonomous regions and municipalities, which covers 53 percent of the rural population.

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Index

Accumulation, human capital 18, 80, 118, 126, 160 Acid rain 58, 61 Asia, developing country 1, 2, 5, 10, 11, 17 Asian Development Bank (AsDB) 59, 64 Africa 1, 10, 38, 42, 45, 46, 49–52 Agriculture,farmers, products, sector, taxes 4, 5, 15, 20, 21, 25, 64, 70, 72 AIDS 30 Air pollution 35, 58, 59, 60 Anhui 14, 73 Avian flu 30 Bank for International Settlement (BIS) 40 Bank of China 46 Bank, State owned enterprises 92 Banking recapitalization, capital adequacy 34, 46, 47 Banking sector 37, 38, 46, 47 Banking system 13, 20, 34, 47, 48, 94 Banking system, state owned, fresh loan 34, 94, 114, 130, 131 Bankrupt, State owned enterprises 131 Beijing 65, 73 Beijing, Consensus 13, 49, 130 Biomass, bio energy 44 Bond, issue, US Treasury 11, 48, 111 Brazil 10, 17, 33, 127 BRIC 47 Budget, education, health 31, 57 Budget, hard budget constraint 7, 27, 93, 130 Budget, soft budget constraint 90

Budget control, surplus, deficit, local, extra, taxes, userfees, expenditure, revenues 86–8, 91, 94, 96, 98, 117, 123–8 Capital, financial, state banks, investment, market, account 4, 7, 15, 30, 32, 35, 40–1, 48, 64, 71, 77, 94 Capital, human, education, social 17–8, 22, 24, 26, 30–2, 34, 54, 56–7, 65, 69, 72, 77, 79–81, 96, 103, 106, 113, 118, 121, 123–4, 126 Capitalism, crony 40, 48, 65, 94, 101 Central Asia 10 Central government 7, 9, 14, 16, 24, 27, 48, 65, 67, 83–90, 95, 98–9, 104, 106, 111–5, 118–20, 131 Centralization, political, recentralization 83, 85–6, 94–6, 100 Chaebol 92–3 China Daily 44, 61, 95, 114–5 Chinese Communist Party (CCP) 7, 67, 83, 95, 118, 120 Chongqing 62, 73 Climate change 56, 58–9, 61 Coal 37, 44, 59, 61 Coastal, areas, development strategy, provinces 2, 8, 18, 22, 24, 26, 129 Competition, private sector, foreign banks 17, 47, 50–1 Competition, yardstick, local officials, inter-jurisdictions 14, 95, 99, 109, 111, 120, 131 Competitiveness, state sector 12 Compulsory education 18, 31, 81, 122 Construction, industries 25, 63–4, 80

152

Index

Control, state, direct, local officials 4, 6, 15, 20, 28–9, 41, 46, 60, 67, 74, 83, 85–7, 92, 95, 118, 120, 124 Corporate governance 13, 40, 53, 92–3 Corruption, userfees, informal fees 29, 33, 50, 65, 94 Countries resource-rich 13, 45–9–50 129 Crises, financial Asian, global, currency 1, 4, 9, 10, 35–42, 52–4, 58, 80, 93. 106, 114, 130 Cultural revolution 3, 5, 63, 87, 102, 104, 129 Death rate 23 Decentralization, fiscal, political 14, 19–20, 57, 78–9, 83–128 Deforestation 59 Democracy, limited Hong Kong 36, 67 Desert, desertification 58–9, 61 Developed countries, industrial, Western 1, 4, 9–11, 45, 114 Developing countries 3, 4, 17–20, 37–42, 49–50, 59–60, 64, 113, 127 East Asia 52 Economies of scale 99 Education, human capital 17–18, 22, 24, 26, 30–2, 34, 54, 56–7, 65, 69, 72, 77, 79–81, 96, 103, 106, 113, 118, 121, 123–4, 126 Efficiency, economic, public sector 15, 29, 33, 57, 92, 118 Elections, local 66–7, 70, 118, 120 Emissions 58–60 Employment, life time, dualistic system, migrant, local 1, 12, 14–15, 22, 25–7, 54, 58, 93, 102–3, 112–13, 114, 118, 131 Energy, efficiency 44 Entrepreneurial activities 64 Environmental, degradation, vulnerability 11, 30, 33, 35, 54–7, 58–62, 67, 70 Environmental regulation, safeguard 21, 49–50, 54–7, 58–62, 67, 70, 130 Environmental resources 113 European Union 114 Expenditure, consumption, health, food 29, 30, 33, 55, 57, 61, 69, 71–81, 86, 88, 98–100, 106–9, 117–27

Export oriented development 17–18, 35, 83–4, 101, 115 Farmers 23, 30, 33, 40, 57, 58, 62–4, 102, 108 Fees, user, informal, formal, service, education, rural 2, 22, 29, 32–4, 57, 64, 66, 77–81, 86–90, 97, 99, 107, 117–18, 120–1, 127 Financial crisis, Asian, 1997, 2008 9, 10, 37, 40–2, 46, 51–4, 58, 70, 101, 106, 114, 130 Fiscal reform 66, 87 Five-Year Plans 2, 8, 25, 44, 60, 95, 100, 104 Foreign banks 47 Foreign, enterprises, investors, companies 87, 89, 93, 99, 110 France 19 Gansu 62, 91 GDP 6, 38, 44, 46, 59, 80, 90, 95, 110, 114, 128 Glaciers 58 Global, affairs, level, financial architecture, economic downturn, stability, institution, currency, liquidity, reserve 1, 2–4, 8–11, 21, 37, 44, 47, 58, 70 Gobi desert 59 Governance, monetary, corporate, participation 13, 40, 47–9, 53, 53, 54, 66, 92–3 Greenhouse gases (GHG) 58–60 Guangxi 73 Guangzhou 66, 70 Guizhou 73 Harbin 59 Harmonious society 48, 54, 63, 67, 69, 80, 81, 87, 104, 114, 116, 119, 121, 128, 130–1 Health, care, expenditure, insurance, service, sector 2, 7, 22, 23–4, 26, 29–33, 130, 148 Hebei 36, 66, 73 Heilongjiang 24, 59, 73 HIV 30 Hong Kong 36, 41, 47, 63, 67 Household Responsibility System (HRS) 1, 6, 12, 14, 25, 29, 103

Index Human capital 17–18, 22, 24, 26, 30–2, 34, 54, 56–7, 65, 69, 72, 77, 79–81, 96, 103, 106, 113, 118, 121, 123–4, 126 Hunan 73 Import substitution 39, 93 Incentive structure, perverse 48, 85, 95, 100 Income, disposable, distribution, family, inter-generational, opportunities, tax 7–8, 15, 23–8, 30–4, 43–4, 49, 51, 54–8, 62, 64, 69–70, 89–90, 95–8, 100, 102, 103, 106, 113–115, 118, 126–7 India 10, 17, 32 Industrialization 5, 21, 24, 26, 36, 44, 60, 102, 105 Inequality, multi-dimenstional, twin peak, Theil 2, 7, 8, 11, 16, 18, 21–34, 54, 57–8, 67–82, 96, 98, 99, 101, 106, 111, 115, 119–20, 127 Infrastructure, rural 1, 7–8, 18, 25, 33, 41, 43, 57, 63, 65, 77, 80, 96, 114, 126, 127, 129 Inner Mongolia 73 Institution, domestic bank, framework, global governance, health care, village level, international, investors 1, 5, 10–11, 14–16, 19–21, 25, 33, 40, 48, 52, 61, 67, 72, 81, 95, 117, 120, 123–4, 127, 129 Interest rate 114 Interior regions 77 International Monetary Fund (IMF) 1, 10–1, 40, 46–7, 50, 52–3 Inter-Generational Transmission 31, 99, 106 Japan 4, 5, 11, 17–19, 21, 41–2, 46, 52, 63 Jiangsu 24, 73 Jiangxi 73 Jilin 73

153

Leadership, central, global, party 5, 60, 65 Liberalization, market, dual track 8–9, 12–3, 16, 40–1, 49, 66, 83 License, land use, business 12, 15 Liquid assets 36, 55, 68, 70, 72, 74–5, 77 Livelihood, rural, opportunities 28, 33, 35–82 Loan, soft, non performing, collatoral 10, 15, 23, 45–7, 50–1, 71, 92, 114, 130, 131 Local government, Township Village Enterprise 5, 9, 14–6, 19, 26–7, 31, 48, 48, 57–8, 61–2, 69, 83–6, 88–93, 95–8, 100, 110, 111, 115, 117–20, 130–1 Low income developing countries 49, 51, 56, 57, 62, 115 Mao, Maoist 23, 30, 65, 103–4 Market, developed, based allocation system, capital, credit, competetive, domestic, economy, export, liberalization, freemarket, stock market, oriented reform, reform, price world, political 3–4, 6, 8–9, 12–13, 15–22, 25–9, 32, 37, 39–41, 43, 47–9, 52, 56, 63, 71, 87, 93, 95, 97–8, 101, 102, 109, 111–12, 115–16, 118, 120 Marketization 85, 94, 98 M-form organization, structure 5, 9, 14, 18, 39, 66 70 Migrant, children, workers, rural, population 2, 10, 26, 28, 30–2, 41–2, 58, 62, 64–5, 77, 81, 83–4, 89, 96, 101, 104–5, 108–9, 112, 114, 116, 121, 127–8, 130–1 Ministry of Environmental Protection 61

Kazakhstan 45 Kyrgyzstan 45

National champions 50, 93 New rural Cooperation Medical Scheme 30, 107 New socialist countryside 2, 30, 104, 130 Non performing loans 47, 92, 114, 131

Latin America 1, 38–40, 45–6, 49, 130 Law, education, labor, rule of, tax 15, 18, 20, 31, 44, 66, 70, 81, 89, 92, 104, 109, 121

Oil 37, 43–5, 50, 52 Overcapacity 95 Ownership, asset, government, private, foreign, structure 4, 7, 13, 18–20, 26, 55

154

Index

Peasant, rural 7, 16, 23, 25, 59, 61, 90–1, 98, 102–3, 105, 113 People’s Bank of China 46 Performance, economic, poor 15, 27, 92, 95, 120 Policy exchange rate, experimentation, economic, employment, industrial, monetary, space 2–3, 5–8, 14, 18, 20–2, 24–5, 33, 36–8, 39, 41–2, 44, 49–50, 52, 57–8, 66–8, 70–1, 79–81, 83–5, 88, 94–6, 98–9, 110, 113, 115, 118, 124, 126, 128–30 Political system 14, 65–7, 95 Pollution, air, water 35, 58–61 Population, over, floating, rural, China, urban 1–2, 6, 17, 23–5, 28–9, 31, 35–6, 55, 63–4, 67–8, 71–4, 80, 83, 89, 97, 102–4, 107–9, 112–3, 121–2, 128–9 Poverty, absolute, analysis, rural, reduction, urban 2–4, 6, 11, 17, 19, 21–3, 25–36, 38, 55–7, 63–4, 68–9, 71–2, 80, 83, 90, 97–9, 106–8, 120–1, 123, 127–30 Private sector 13, 16, 19–20, 92–4, 109, 130 Privatization process, SOE 2, 7, 12–13, 15, 22, 25–7. 29, 33, 40, 57, 71, 80, 83–5, 93, 98, 101–2, 104, 109, 111–12, 120–1, 130 Productivity, total factor, marginal 5, 19, 61, 64 Profit, after tax, oriented 15, 86, 88–9, 92, 98 Property rights, private 12, 13, 15, 20, 62, 92 Provincial, budget, fiscal relationship, goverments, level spending 14, 70, 72, 79, 86–90, 95–96, 98–9, 106, 117, 119, 123–4 Public goods, local, provision 15, 57, 85, 94, 98 Public–private structure, owned companies 1, 19 Railway 50, 80 Recentralization 86, 94 Reform, political, process, public provisions, state sector 1, 2, 4, 6–7, 12, 16–17, 22, 26–7, 33, 36, 40, 48–9, 57, 66–7, 71, 78–9, 83, 84–9, 93–130 Regional, government, decentralization, equality, markets,

development banks, dispartities inter-regional 5–9, 14, 16, 22–5, 36, 43, 45, 49, 52, 61, 68–82, 85–7, 93, 96, 99, 111, 115–16 Regulation, WTO, laws 18, 21, 31, 40, 89–90, 131 Remittances, migrants, flow of 26, 28, 56, 64–5, 79, 86–7, 89–90, 94 Rent seeking 8–9, 15–16, 26, 123 Road, rural 50, 57, 80, 92 Rural areas 88 Russia 16, 40, 45, 59 SARS 98 Sen capacity 55–6 Shaanxi 62, 73 Shandong 24, 73 Shanghai 63, 73 Shanghai Cooperation Forum 45 Shanxi 73 Shenzhen 14, 24, 66 Sichuan 62 Sichuan-chongqing 73, 122 Singapore 41 Social unrest 38, 48, 64 Society harmonious 48, 54, 63, 67, 69, 80, 81, 87, 104, 114, 116, 119, 121, 128, 130–1 Soil salinization 59 South Korea 4, 5, 11, 17–21, 41–2, 47, 52, 92 Soviet Union 4, 12–17, 20, 39, 41, 63 Special Economic Zones 7, 24, 42, 87 State Environmental Protection Administration (SEPA) 58, 61 State-owned banks 15, 19–20, 92 State-owned enterprises (SOEs), loss-making; management, network 1–2, 5, 7, 12–3, 15, 19–20, 22, 48, 80, 83, 85–6, 88–9, 91–3, 101–4, 109–10, 114, 116, 120, 129, 131 Stock market 40, 48, 112 Sustainable, development, livelihood, economic growth, environmental management, financially 21, 57–8, 60, 106, 112, 114–15, 128 Swine flu 30, 98 Tax, base, concessions, export rebate, holiday, sharing system, rate 7, 15, 44, 86–91, 110, 116–17, 119–21, 124, 126, 131

Index Theil index; of health care; of human capital; of liquid assets; of vulnerability variable 73–5 Tianjin 73 Tibet 73, 122 Total factor productivity 19 Township village enterprise (TVE) 1, 5, 6, 15–16, 22, 23, 25–6, 83, 91–2, 97–9, 104 Transition, countries 4, 10, 12–3, 20, 26, 40, 48, 94 Trick-down 7, 24, 70 Twin peak, scenario 2, 22, 32–4, 69, 106 UNDP 4, 104 Unemployment, hidden employment, underempoyment 10, 26–8, 70, 102–4–107 109, 114 Union United States, of America 1, 4, 9, 10, 35, 40, 42, 44, 52, 106, 114, 115, 130 Unrest 2, 10, 38, 48, 64 Upgrading, technology, industry 27, 42, 61 Urban areas, food expenditure 2, 5, 7, 22, 25–8, 30, 33, 35–6, 42, 54, 57–8, 60, 64–5, 71, 77, 91, 97, 102–3, 107–9, 112, 116, 120–1, 127

155

Uzbekistan 45 Value added tax 87–8, 90, 97 Value chains 39, 42, 52 Village, committee, level 26, 29, 36, 64, 66, 70, 104, 120 Washington Consensus Water management, shortage, system, resource, pollution 21, 44, 58, 59, 61, 64, 113 Wen Jiabao 30, 42, 52, 130 World Bank 1, 6, 10–11, 26, 30, 32, 40, 52, 53, 58, 61, 71, 88, 90, 91, 98, 104, 120, 123 World Health Organization (WHO) 30, 56, 108 World Trade Organization (WTO), accession 1–3, 8–9, 19, 21, 38, 41–3, 47, 52, 93, 99, 130 Xinhua, New Agency 47, 64 Xinjiang 73 Yunnan 62, 73 Zhejiang 24, 73