(Reprinted from HKCER Letters, No.39, July 1996)
The China Miracle
Editor's Notes: It has been almost 18 years since China first embarked on economic reform. In the process, the Chinese economy has made great achievements and at the same time faced certain difficulties. An economic analysis of the China experience will be helpful for understanding the intricacies of the reform process as well as where the Chinese economy is heading. A recent publication by the HKCER, The China Miracle, is an in-depth study of this topic. The authors, Justin Yifu Lin, Fang Cai, and Zhou Li, discuss the three major characteristics of the pre-reform economy, the steps undertaken and their consequences during the reform, and the lessons to be learned regarding what has been done rightly and wrongly. The following is the executive summary of the publication in which the main arguments of the study are clearly presented.
Since the institution of reform and the implementation of the open-door policy in the late 1970s, China has become the fastest-growing economy in the world. Its average annual growth rate of GNP in the 1980s was almost 10 percent, which is comparable to the annual growth rate of the four Little Dragons Singapore, Taiwan, Hong Kong and South Korea, which during their most productive years gave rise to what is known as the East Asian Miracle. In particular, China's coastal region, which has an area and population, respectively equal to five and four times that of the four Little Dragons combined, has maintained an annual growth rate of nearly 12 percent, surpassing the Little Dragons' growth rates during their most rapid development period. Moreover, current favorable internal and external conditions are likely to make China once again the largest economy in the world by early in the 21st century. The first chapter of this book gives a brief overview of the above achievements and predicts the point at which China will once again become the world's largest economy. This chapter also introduces the four questions the book attempts to address: Why has China's economic performance changed so dramatically since the implementation of reform? Why, despite the amazing achievements which have been witnessed since the reform, has a cyclical phenomenon -- in which liberalization leads to vigor, which in turn leads to chaos, which then leads to the adoption of a retrenchment program, which goes on to cause sterility, which leads to further liberalization, or, in short, the vigor/chaos cycle -- become endemic to the Chinese economy, and how can this pattern be broken? How can China--having been a sleeping lion for several hundred years--perform the miracle of climbing to the apex of human civilization from the trough into which it has fallen? Lastly, what are the general implications of China's economic reform for other countries undergoing reform?
Chapters two to four of this book primarily conclude that a country's rate of economic development depends on its government's choice of development strategy. The conclusion is reached through theoretical investigations of different types of development strategies and through empirical comparisons of development experiences resulting from different development strategies.
Following the founding of the People's Republic of China (PRC) in 1949, and particularly after the completion of the so-called socialist transformation in 1957, decision makers within the Chinese government were determined to pursue a heavy industry-oriented development strategy in order to become competitive with advanced economies. China at that time could be characterized as an underdeveloped, capital-scarce, agrarian economy. In order to accelerate the development of capital-intensive heavy industries, it was necessary for the government to artificially suppress the prices of capital, foreign exchange, energy, raw materials, labor, and other inputs so that capital formation within the area of heavy industry could be achieved. Even in such a distorted macroeconomic policy environment, however, heavy industry, which was inconsistent with the comparative advantages of the Chinese economy, still could not obtain scarce resources through market competition. For the purpose of allocating scarce resources to the priority sector, the government had to adopt a planned resource allocation mechanism which was completely different from the market mechanism. Moreover, to ensure that the surpluses produced by microeconomic management units would be expended in a way which complied with the requirement of the strategic goal, the government had to create a micromanagement institution that would ensure the government's control of surpluses. As a consequence, the agriculture sector was communalized so as to facilitate the implementation of the monopolized procurement and marketing system in agricultural produce, and nonagriculture sectors were nationalized so that the government could have firm control of the surplus created by the distorted macroeconomic environment and planned allocation system. Moreover, there was a danger that the distorted macroeconomic policy environment might give rise to serious problems of managerial discretion. Therefore, in order to prevent managers and workers in state enterprises from appropriating profits and state-owned assets for their own use, the government deprived state enterprises of any managerial autonomy.
From the above discussion, we can see that the distorted macroeconomic policy environment, planned resource allocation mechanism, and puppet-like micromanagement institution were all endogenously-determined institutional arrangements. They were the results of the adoption of a heavy industry-oriented development strategy in a capital-scarce economy. These three endogenous institutional arrangements formed an organic whole and were characterized by their inseparability. Under these institutional arrangements, the prices of factors and products could neither reflect their relative scarcities nor perform the function of fine-tuning supply and demand and directing the allocation of resources. The consequence was a distorted industrial structure. Moreover, under these institutional arrangements, the profits of an enterprise ceased to be a measure of its managerial and production efficiency. Therefore, the link between return and effort level disappeared. Workers received identical wages, regardless of how hard they worked. The consequence was a low incentive mechanism. The distorted industrial structure and the low incentive mechanism contributed to the observed inefficiency of China's traditional economic system.
As early as the 1960s, the government had recognized these problems and had tried to improve the situation by introducing a more decentralized administrative system. However, because the trinity of the traditional economic system--the macro-policy environment, the resource allocation mechanism, and the micro-management institution---was not broken, the problems remained. The result of maintaining this low-efficiency economic system was the widening of the economic gap between China and more advanced economies. The situation did not change until economic reform was instituted in the late 1970s. Since the implementation of reform, the comparative advantage of the Chinese economy has been given more attention, and it has played an increasingly important role in China's economic development.
The basic conclusions obtained from the analysis described in chapters two to four are as follows:
(1) The determination to adopt an anti-comparative advantage development strategy (from now on to be referred to as the leap forward strategy), which treated capital-intensive heavy industries as the priority sector in a capital-scarce economy, and the implementation of the resulting distorted macro-policy environment, planned resource allocation mechanism, and puppet-like micro-management institution, not only failed to relax the constraint of comparative disadvantage but also distorted the production structure. In addition, the absence of a link between performance and return in the micromanagement institution failed to provide the labor force with appropriate incentives, leading to a deterioration in the efficiency at the firm level. The income and living standard of workers did not improve for a long time, and the low standard of living might have further lowered workers' incentive. Consequently, the national economy became increasingly less vital.
(2) Japan and the four Little Dragons enjoyed rapid economic growth after World War II. The main reason for their success is that at every stage of their development, their economies succeeded in exploiting the comparative advantages of their endowment structure. As such, they were able to rapidly accumulate capital, both physical and human, and to upgrade their production structures according to the dynamic changes of comparative advantage. The most important element allowing these economies to make such strides was a price system which accurately reflected the relative scarcities of factors and products. Under competition pressure and with a profit motive, such a price system ensured that producers fully utilized the relatively abundant and thus relatively cheap factors, and saved on relatively scarce and thus expensive ones. The resulting production and technological structure of the economy would correspond to the comparative advantage of the economy's endowment structure. Consequently, the national economy became more competitive and achieved rapid growth.
(3) Countries adopting a leap forward strategy--including those with socialist economies such as China, Eastern European countries, and the former Soviet Union, and those with capitalist economies such as India and Central and South American countries--have not realized their goal of accelerated economic development. On the other hand, economies which have better utilized their comparative advantages have achieved remarkable success in the area of development. This contrast suggests that the key to successful economic development is the choice of a development strategy. In the several decades preceding the recent reforms, China adhered to a leap forward strategy and had a poor development record. In the last 15 years, however, China has made better use of its comparative advantages, and has achieved rapid economic development. This sharp contrast further illustrates that the key to sustained and rapid economic development in China is to complete the shift in development strategies.
The fifth chapter of this book summarizes China's reform process. The ex post analysis shows that, though there have been many rough spots along the road to reform, it has been moving forward in a logically consistent manner. The reforms began with the decentralization of managerial authorities and the allocation of part of the profits to micromanagement units in order to improve the incentive mechanism, thus prompting the creation of a new stream of resources. With follow-up reforms in the resource allocation mechanism, the newly created stream of resources was increasingly often allocated to sectors which had been suppressed under the traditional economic system. Thus, the preliminary goals of adjusting the production structure and realizing the acceleration of economic growth were achieved. When reforms resulted in conflicts between the reformed micromanagement institution and resource allocation mechanism and the traditional macropolicy environment, the reforms were extended to include the various aspects of the macropolicy environment. The process can be summarized as follows:
The first move was to change the micromanagement institution in order to give workers and farmers more incentives to work. In the nonagricultural sectors, a profit-retaining system was introduced so that workers could be awarded bonuses according to the new profits they had helped earn. In the agricultural sector, the household responsibility system--a fixed rent-like system--was introduced. Under this system, farmers became the de facto residual claimants. They were allowed to keep all remaining outputs for their own use once adequate amounts of output had been sold to the state and retained in the collective. The improvement in the incentive mechanism induced workers and farmers to work harder. Therefore, with the same amount of input, a greater amount was produced. This reform resulted in a new stream of resources and set growth at a higher rate than before.
Next, the rigidity of the planned resource allocation mechanism was relaxed. This reform granted micromanagement units the right to allocate part of the new stream of resources. Before reform was instituted, the government could not but suppress the development of nonpriority sectors, such as agriculture, light industries, and service, in order to accelerate the development of heavy industry. The suppressed sectors were in fact more consistent with the economy's comparative advantages. Driven by profit motives, the micromanagement unit had high incentives to allocate the resources newly under their control to the previously suppressed sectors. Therefore, reform in the resource allocation mechanism created favorable conditions for the growth of nonpriority sectors. This change alleviated the structural imbalance and improved the efficiency of resource allocation. Economic growth was therefore further accelerated.
The third component of reform was to modify the macropolicy environment and gradually develop an economic system that relied on market signals to allocate resources. Relaxation of the resource allocation mechanism gave micromanagement units the right to allocate some resources outside the administrative plans. At the beginning, only barter was allowed. But as a consequence of bartering, shadow prices reflecting the scarcity of resources started to exist alongside the planned prices. With the emergence of shadow prices, dual-track systems of product prices, factor prices, foreign exchange rates, and so on, came to exist. The government gradually allowed the formal use of market prices for exchanges which took place outside the plan. As economic growth occurred mainly in areas outside the plan, the market track in the dual-track system played an increasingly important role. The government also gradually adjusted the plan prices according to market prices. The expansion of the market track and the narrowing of the gap between market prices and plan prices have made "crossing a chasm in two steps" possible.
Chapter six sums up the achievements of economic reform in China. The main conclusions are as follows: (1) The improvement in the microincentive mechanism greatly enhanced workers' motivation to produce, which significantly increased labor's contributions to economic growth. (2) Driven by market competition and profit motives, an enterprise's choice of product and technology became more and more consistent with what would have been observed in a market economy. The negative total factor productivity and the reliance on increasing the amount of input as the sole way of increasing output under the traditional economic system were reversed. (3) Prices of products, energy, raw materials, and foreign exchange were gradually liberalized, and restrictions on labor's markets were lifted. As a result, non-state enterprises, which better utilized the comparative advantage of relatively abundant labor, expanded rapidly. The problem of changes in the employment structure lagging far behind changes in the structure of production was mitigated. (4) The rapid pace of economic development in China after the reform illustrates that even a large socialist country can adopt the comparative advantage development strategy as a way to realize the potential of its economy.
Chapter seven provides a systematic analysis of the causes of a number of problems that appeared in the process of reform, such as the vigor/chaos cycle, the difficulties of reforming state enterprises, and regional disparity.
The traditional economic system was made up of a set of mutually dependent and supportive institutions. The reforms initiated in micromanagement institutions pushed for reforms in the resource allocation mechanism and called for changes in the macropolicy environment. Nevertheless, because the state has not entirely given up the heavy industry-oriented development strategy, it still has to protect big and medium-sized state enterprises, which were created according to the state's strategic goal. As a result, price reform, particularly that of factor prices, has lagged far behind reforms in the micromanagement institution and the resource allocation mechanism. The interest rate, exchange rate, and prices of energy and raw materials have been controlled and suppressed. The internal inconsistency between reformed and unreformed institutions has become increasingly serious. Enterprises' demand for expansion has frequently encountered the limitation of infrastructure--energy and transportation, for example--which often become a bottleneck constraining the speed of economic growth. Moreover, whenever the state relaxes the direct control of credit rationing, non-state enterprises, by way of rent-seeking, are able to obtain the low interest rate credit that was earmarked for state enterprises. However, the state has to guarantee the supply of loans to state enterprises. The only way to do so is to increase the money supply. The result is inflation. The dual-track system of resource allocation and prices give enterprises, whose profit motives had increased as a result of reforms, a strong desire for rent-seeking. Corruption becomes inevitable. And when the phenomenon of yifangjiuluan (liberalization leads to chaos) becomes so serious that the economic operation as a whole is adversely affected, the government often resorts to the traditional planning measures which retrench economic activity and suppress the expansion of non-state enterprises. The vigor/chaos cycle endemic to the reform process is a result.
The series of problems that emerged after the implementation of reform was due to the lack of coordination between reforms in the macropolicy environment, and those in the resource allocation mechanism and the micromanagement institution. In other words, reform in the former lags behind reform in the latter. The serious lag in the reform of the macropolicy environment has left enterprises to compete without a level playing field, society unable to avoid the grave waste caused by rent-seeking, and the market economy incompletely established because of various kinds of noneconomic intervention. Therefore, reforms making the macropolicy environment consistent with the reformed micromanagement institution and resource allocation mechanism are the fundamental solution to the series of problems which have appeared in the process of reform.
Chapter eight discusses the difficulty and urgency of accelerating the change in China's development strategy. The fundamental solution to the series of economic problems which have appeared during the reform process is to make the macropolicy environment consistent with the reformed micromanagement system and resource allocation mechanism. However, a few constraints make the implementation of this solution problematic.
Firstly, changing the macropolicy environment would inevitably alter the existing structure of vested interests. Nevertheless, every time economic problems are exposed and the economic condition deteriorates, conflicts in economic interests become acute. To carry out the reform of the macropolicy environment in such a situation, the government must bear greater political risks or costs. This is particularly true when large and medium-sized state enterprises whose development has been given priority under the earlier leap forward strategy become the losers.
Secondly, the vigor/chaos cycle occurs because credit and other key factor markets have not been liberalized. But as a result of the underdevelopment of those factor markets, there is insufficient information to prove to economic decision makers that, through liberalizing those markets, economic chaos would be replaced by discipline, and the root of chaos could be eliminated.
Thirdly, among economists in China, one predominant view is that, even under a market economy, the proper role of government is to use conventional control and adjustment measures to retrench and consolidate the economy when macroeconomic problems appear. Therefore, until the market economy system is perfected, it is considered reasonable for the government to adopt traditional methods of regulation.
The existence of the above constraints illustrates the difficulty in thoroughly carrying out macropolicy reform. Making a switch from the leap forward development strategy to a pro-comparative advantage development strategy remains difficult. Nevertheless, in light of the goal of China's reform and the international environment she faces, it can be argued that the task of accelerating the shift in China's development strategy is an urgent one. The following three reasons explain this urgency.
First, the development of the Chinese economy began on very shaky ground. Although development over the last 15 years has been rapid, basic living conditions, the level of scientific and technological education, the total amount of economic growth, per capita output, and per capita income are all far below those of advanced and newly industrialized economies. China has to complete a series of formidable tasks before becoming an advanced economy.
Second, formerly planned economies, such as the former Soviet Union and Eastern European countries, have made thorough changes in their economic systems. There are signs that latecomers, such as Poland and Hungary, might end up at the forefront. Although still trapped in political and economic chaos, Russia is likely to become a giant economy once it escapes its current state of stagnation. Regarding industrial infrastructure, energy conditions, human capital, and so on, the former Soviet Union and Eastern Europe are in a better position than China. Therefore, China should not ignore the fact that it must actually and potentially compete with these countries.
Third, in Asia, in addition to the four Little Dragons, Thailand, Brunei, Malaysia, and Indonesia have achieved rapid economic growth in recent years. Vietnam has shown great potential for economic growth after undertaking far-reaching economic reforms, particularly after a thorough factor and product price reform. The comparative advantages of these Asian economies are very similar to China's. Therefore, in capturing the opportunities arising from the international transition of dynamic comparative advantages, China will face keen competition from these countries.
Chapter nine summarizes China's experience with reform and the contribution of this experience to economic theory. The conclusion is that the success of reform depends on the approach to reform. China is a large country in which differences between regions in terms of development are obvious, and where dramatic policy changes have frequently occurred. Particularly in the last 15 years, with expansion in local autonomy, every locality has tried to adjust central policies according to its own needs. Some have even carried out a number of reforms on their own. China's experience provides an invaluable opportunity for testing existing economic theories or generating new theories. Generally speaking, the reasons behind the success of China's reform can be outlined as follows:
1. Making the Cake Bigger
From the very beginning, economic reform in China resulted in economic growth. The aim of each reform measure--managerial decentralization and profit retention in the state enterprises, the introduction of the household responsibility system in agriculture, and opening the door to the outside world--was to improve incentives so as to increase total economic output. The increase in total economic output available for distribution make Pareto improvement or Kaldor improvement possible for each reform measure. The costs and risks of reforms were thus minimal.
2. Reform at the Incremental Margin
So-called reform at the incremental margin is one which allows the market mechanism to operate entirely in the allocation of newly created resources, but not in the reallocation of the existing stock of assets. The main reasons for the success of this reform approach are as follows:
(a) To achieve the goal of correcting the biased production structure, reform at the incremental margin can prevent the occurrence of a J-curve type of growth path; that is, a decline in the national income proceeds before positive growth begins. Economic reforms will have the greatest support and policy continuity if they lead to immediate benefits, cost as little as possible, and result in sustained growth of national income.
(b) Reform at the incremental margin creates favorable conditions for maintaining, within the reform process, a balance between the requirements of stability and speed. In the process of implementing reform at the incremental margin, the economy as a whole comprises a dual structure. In other words, one sector of the economy was formed with newly created capital, and is governed by the market mechanism, while another sector was formed by the traditional development strategy and is governed largely by the planning mechanism. The latter sector performs the function of maintaining stability. Although maintaining the latter sector incurs some losses in efficiency, its existence prevents rampant unemployment and the resulting social conflicts. Moreover, when hyperinflation occurs, the stabilization policy works best in this sector. On the other hand, the production activities and technical structure of the former sector correspond more closely to China's comparative advantages, and its management mechanism is more flexible. Therefore, when the government implements a stabilization policy of a non-reform nature, the former sector can still grow continuously, and thus the economy maintains an acceptable rate of growth during the adjustment process.
3. Experiment and Extension
In China, every reform measure was first tried on a small scale, and then gradually extended to a larger area after the success of experiments and following repeated evaluations. The advantages of this reform method are as follows:
(a) It reduces the risk of reform. Any reform will encounter the problem of inadequate information before implementation, and the consequence of reform may be uncertain. To proceed with reform on a small scale can reduce the cost of errors and the likelihood of fatal mistakes.
(b) Over time, the combination of experimental reform and reform at the incremental margin can provide information about what kind of reform is most beneficial. This type of experiment and extension mechanism allows reform to move in a fruitful direction, and makes it self-reinforcing.
(c) It satisfies the time required for the development of market institutions. The process of market development involves forming a series of market regulations, customs, and a hardware environment. It takes time to complete this process. The experiment and extension approach allows for enough time to form the above market institutions.
4. Non-Radical Reform
First of all, in implementing non-radical reform, the existing resources for organization can be fully utilized, and relative institutional stability and effective links in the institutional renovation process can be maintained. The effectiveness of any institutional arrangement depends on the functions of other institutional arrangements in the institutional structure. Any single radical reform will not achieve its intended goal because the incompatibility between the new institutional arrangement and the old institutional structure is too extreme. Incremental reform must take place at a rate which allows the process to remain controllable. In other words, the government should be capable of controlling the rate of the process and the steps it involves, evaluating advantages and disadvantages, adjusting the process, and achieving the intended results. Only with stable links in the institutional transition can the government, on the one hand, control the reform process and, on the other hand, alter its own roles to meet the requirements of a market economy.
Second, through non-radical reform, it is possible to avoid serious social unrest and welfare loss. Radical reform will necessarily hurt the vested interests of various social groups, thus resulting in strong opposition. A considerable amount of social welfare loss is inevitable in the struggle. Non-radical reform can mitigate the above problems.
Thirdly, non-radical reform does not focus on privatization. It prevents the unfairness and conflicts that can arise in the process of redistributing existing resources. The approach thus maintains a pattern of income distribution consistent with the goal of bringing prosperity to all. Every social group can gain from the reform in the short and long run. The reforms are thus supported by the majority, and become irreversible.
Chapter ten concludes the book and provides answers to the four questions raised in the first chapter.
(1) Upon the founding of the People's Republic of China, the government adopted a heavy industry-oriented development strategy for the purpose of forging ahead and catching up with advanced economies. The development strategy gave rise to the trinity of the traditional economic system, namely, the distorted macropolicy environment, the planned allocation mechanism, and the puppet-like micromanagement institution. This system resulted in an economy unable to utilize its comparative advantage and avoid its comparative disadvantage, which in turn caused a distorted production structure, inadequate production incentive, and low efficiency. As a result, the economy stagnated and the living standard of the people did not improve. Since the late 1970s, economic reform has proceeded from the micromanagement institution to the resource allocation mechanism and then to the macropolicy environment. The reform broke the trinity of the traditional economic system and enabled China to experience phenomenal economic growth and achieve the miracle of maintaining an average annual growth rate of around 10 percent since the early 1980s. The experience suggests that the fundamental reason behind China's slow economic growth prior to the implementation of reform was the heavy industry-oriented development strategy, and the key to rapid economic growth following the implementation of reform has been the transformation of the trinity of the traditional economic system, which has allowed the comparative advantages of the Chinese economy to be more fully exploited.
(2) The traditional economic system is a set of organically interlinked institutional arrangements which were formed to implement the heavy industry-oriented development strategy. Reforms initiated in the micromanagement institution can push forward reforms in the resource allocation mechanism and will call for reforms in the macropolicy environment. However, unless the state gives up the leap forward development strategy, reforms in the macropolicy environment will always lag behind and will never be completed. With reforms in the macropolicy environment trailing behind, the relative prices of basic industries' products and services, such as the prices of energy and transportation, cannot reflect their relative scarcity. Consequently, the supply of these products and services cannot meet their demand. But these industries are not able to attract enough investment, and are unable to release the bottleneck's constraints on the rate of growth. In the low interest rate environment, when the state relaxes the control of credit rationing, non-state enterprises are more successful in obtaining credit than are state enterprises. Yet the state has to guarantee loans to state enterprises. Therefore, its only option is to increase the money supply. As a result, inflation becomes endogenous. Moreover, in order to protect large and medium-size state enterprises, whose survival depend on the implicit subsidies of low interest rate loans and other low price inputs, the state has repeatedly missed opportunities of transforming the dual-track price system into a single-track market price system. Consequently, corruption and rent-seeking activities arising from the dual-track resource allocation and price system will not disappear. When these activities become so serious that the economic operation as a whole is impaired, the government usually adopts the traditional planned measures to retrench the economy and mandatorily suppress the expansion of non-state enterprises. The consequence is the vigor/chaos cycle of the reform process. From the above discussion, we can see that the way to halt the vigor/chaos cycle is to accelerate reform in the macropolicy environment and to completely forgo the leap forward development strategy.
(3) Although there have been many ups and downs in the process of China's economic reform, in general, it has moved the economy closer and closer to the market system. Three characteristics of the reform illustrate how this happened. First, in the last 15 years, one reform has followed another, from reform in the micromanagement institution to reform in the resource allocation mechanism to reform in the macropolicy environment. The traditional trinity formed endogenously by the heavy industry-oriented development strategy has disintegrated. Second, driven by the market mechanism, non-state enterprises represented by township and village enterprises have been responsible for an increasingly large portion of China's total economic output. Correspondingly, the opportunity cost of maintaining the traditional economic system has become higher and higher, and the opportunity cost of establishing the market economic system has become lower and lower. This contrast enhances the prospects for accelerating the shift of development strategy. Third, China's reform approach is characterized by Pareto improvement or Kaldor improvement. All members of society benefit from reform. The further reform goes, the more members of the society benefit. Moreover, each time the government reverts to traditional economic measures, society suffers more. Therefore, reform becomes irreversible.
It is because the incremental approach allows for the possibility of increasing the depth and scope of reform and because its internal logic is irreversible, that China's reforms are able to overcome difficulties, keep on the right track, and effect sustained and rapid growth. Therefore, by the next century, China's economy may surpass that of the United States and Japan, becoming the largest in the world.
(4) The government has three ways of winning a society's support for economic reform: 1) It can win support through redistributing the existing wealth so as to benefit more people. 2) It can win support through making various political and economic promises and through striving for international aid to increase people's expectations for the future. 3) It can win support through a biased distribution of newly created wealth so that more people benefit from the reform. China chose the third way.
The implementation procedure is as follows: First, the government introduced reforms to improve the microincentive mechanism in order to increase workers' enthusiasm and enhance productivity, thus creating more new resources, and to liberalize the planned resource allocation mechanism in order to grant the right of allocating newly created resources to micro agents. The relaxation of the planned resource allocation mechanism, on the one hand, provided opportunities to develop the sectors which were suppressed under the traditional strategy, hence adjusting the distorted economic structure at the margin. On the other hand, the relaxation of the planned resource allocation mechanism, together with the competition pressure from the economic entities which had newly emerged in the market, pushed towards further reform of the micromanagement institution. On this basis, the emphasis of the reform was gradually extended to the macropolicy environment, and it became increasingly far reaching. China's incremental approach to reform, which has focused on improving the microincentive mechanism and reforming at the incremental margin, has general implications for other economies that have implemented a development strategy similar to China's. It is not exclusively applicable to China's situation.
Economies that have adopted an anti-comparative advantage leap forward development strategy--whether they are socialist countries that implemented a heavy industry-oriented developed strategy, or Central and South American countries that implemented an import substitution strategy--have experienced two common problems: structural imbalance and low microincentive. All could increase their productivity by improving the incentive mechanism, liberalizing the planned resource allocation mechanism, and allowing newly created resources to flow continuously to the sectors which were suppressed under the traditional system. They could also depend on the growth and pushing effects of the suppressed sectors to make reform self-reinforcing.
All these economies could use incremental reform to lower the cost of readjusting their production structure. Shock therapy, which depends on reallocating the existing stock of capital and resources to adjust the production structure, will inevitably have a J-curve in the growth path during the reform--that is, the GNP will first decline sharply and may recover and start to increase later--because during the transition period, some equipment and resources are idle for a period, transferred workers need time to learn the new skills, and the development of new market institutions requires time. If the structure is adjusted through the use of incremental resources, newly created resources will increasingly be allocated to sectors with comparative advantages, thus marginally correcting the distorted production structure and at the same time further increasing output. Therefore, this type of adjustment will lead to an ever-increasing growth path. Besides, incremental reform has the advantage of maintaining a balance between stability and speed of reform.
All developing economies could reduce the risk of reform by taking an incremental approach. Any reform measure invariably encounters the problem of inadequate information before its implementation, and its consequences are more or less uncertain. An incremental approach to reform can make possible the avoidance of fatal mistakes, and allow the maintenance of relative stability and effective links between the institutions in the institutional innovation process. It is also conducive to the government's transformation of its own functions and simultaneous fulfillment of its duty to adjust and control the reform process.
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