Skip to content

China’s Economic Reform: Under the Glamorous Surface

Where China’s economic reform is headed still remains to be seen.

In the almost three decades since China started its economic reform, China’s economic might and political clout have become hot topics in political circles worldwide. "Made in China" has become a way of life all around the world. China’s rapidly growing cheap labor force has both made China the "world’s factory" and emerged as a potential consumer market of dizzying proportions. China’s economy seems more open than most other transitional economies. China’s accession to the WTO further convinced the world that the Chinese Communist Party (CCP) is committed to making China’s economy open to and integrated with the world economy as a free market economy. Scholars and economists have been analyzing China’s economic issues, and providing suggestions and solutions for problems that have been plaguing China’s reform as if the CCP will ultimately make the right choices. For fear of missing out, businesses stumble over one after another seeking a share of China’s market. They have an optimistic outlook of what the reform will bring. Nevertheless, the world’s governments have very little concept of the creature that China is becoming, except that its power can no longer be ignored.

The Plan

When Deng Xiaoping visited Hong Kong and the United States, his grand plan — to build a modern economy under the iron fist of the CCP — was already set. Deng did not care much about Marxist ideology, but he had even less tolerance for political freedom. At the time, his colleagues either didn’t understand his plan or didn’t agree with it. The old guard wanted less economic reform while his new vanguard tried to push for political reform. It took the June 4 Tiananmen Massacre and Deng’s repeated urgings in the ensuing years for the CCP’s leadership to finally pick up on Deng’s idea.

From the outset, the concept was clear: The CCP wanted only the science, the technology, and all the technical stuff that made a market economy work and to deflect any Western ideas and values from entering China. Not only that, the CCP also shielded China from any Western financial, monetary, and economic forces that could significantly influence or affect China’s own system. The CCP also didn’t intend to genuinely change the foundations of its power such as property ownership, its commanding power over the economy, or its other power over the society.

With little resistance from ideology, the CCP reformers have had quite a free hand in transforming the economy. The CCP created and showcased "special economic zones," which seemed at the time improbable both to the world and to the people inside China. China’s economic gate seemed more open than ever before. The CCP also allowed foreign banking, communication, legal services, and other industries to set up shop in China. Meant to be experiments, these foreign entities could operate only under very restrictive conditions, even though the CCP had no intention of letting them become material. The CCP even created a special environment and community for foreign expatriates to enjoy even more "freedom" than in their home countries. All these strategies helped the CCP to create the illusion from very early on that the leadership was determined to carry reforms all the way to the end, that is, to the establishment of a free market economy, and that anything else was just "technical" and a matter of time. Combined with China’s cheap labor, blazingly fast pirating and copying of foreign technologies and products, low overall consumption, a nonexistent distribution network and other infrastructure for foreign companies to market and sell their goods, and the governmental control of China’s trading companies, China has been able to appear very open, more open in fact than other transitional economies as far as trade barriers are concerned. This, in turn, further enhanced the illusion of the CCP leadership’s reform resolve. This illusion reached its climax when China signed the WTO accession agreement.
Of course, the economic genie released by the CCP will eventually consume it no matter how hard the CCP tries to prevent such a scenario. But there is no indication so far that the CCP is even willing to reduce or limit its power. On the contrary, there is every indication that the CCP will use whatever force or brutal measure necessary to crush any group and/or movement that is perceived as undermining the CCP’s rule. Obviously, the CCP needs to maintain its foundational roots— its Party branches — if it wants to keep its presence in society. The CCP needs to maintain its commanding power in managing the economy if it doesn’t want to reduce its economic role to that of Greenspan’s, [1] and the CCP needs to retain its supreme position in making and interpreting the law if it doesn’t want to become obsolete. Therefore, the plan started with these fundamental limitations.

The Practice

Ironically the CCP’s reform plan has never progressed very far. When the CCP started the reform, state-owned enterprises not only dominated the economy, they actually were the economy. They were also a major part of the CCP’s social and power base. If the CCP could plan anything, this was all it could plan for. This was indeed what the CCP really hoped for. By opening up to the outside world, the CCP hoped that the state-owned enterprises would then be equipped with modern technology, machinery, and production methods. By introducing and adopting certain market factors, the CCP hoped that the state-owned enterprises would have the incentive to perform. In addition, the CCP hoped that the state-owned enterprises would adopt modern and scientific management; be productive, efficient and competitive; become the power engine of the new economy and revenue source for the central government; and, more importantly, solidify the CCP’s vital social and power base.

The CCP tried, failed, tried again, failed again, tried once more, and failed once more. [2] The CCP first freed the managers from planned quotas to allow them to respond to the market needs and let them take responsibility for their production. It then changed "surrender of profit" to taxation to give the managers more incentive to outperform. The CCP tried to get private investors to take on a fraction of the ownership of those enterprises in hopes of shaking up the management. It later even tried to turn the enterprises’ debt to shares and sell them on the stock market. The CCP finally decided to let the smaller and weaker enterprises go and concentrated on protecting the bigger ones. But none of these strategies worked, even with the protection of a dual pricing system that gave room for the enterprises to catch up with subsidized financing from state banks. What was worse, every time a new strategy was instituted, it created a huge opportunity for the managers and Party officials to steal state assets. The opportunities were so lucrative and the pickings so easy that corruption soon became an institutionalized feature of the CCP and the economy. The enterprises’ property and assets have been disappearing under various schemes. Many of them, usually the better ones, simply changed their ownership from the state to the managers at little or no cost to the managers. The corrupt and money-losing state-owned enterprises have racked up huge bad debts, affecting all four major state-owned banks. Based on the internationally accepted Basel standard, these banks are now insolvent. The CCP’s latest move is to allow the enterprises to sell the previously restricted (non-salable) shares to the already drained stock market. If earlier attempts are any indication, a few will come out ahead, way ahead. But the enterprises themselves and the investing public won’t be among them.
Case One

A state-owned power plant in Changge City, Henan Province, went through privatization in 2003. At the time, the power plant was one of a handful of profitable, state-owned enterprises in Changge City with a total value of 101 million yuan (US$12.6 million) including a net asset of 32 million yuan (US$4 million). Strangely enough, the plant general manager, Liang Beiling, and several other managers were able to buy the plant for 15 million yuan (US$1.85 million) with a one-time cash payment using a method called "MBO" or "Management Buy-Out."

The new, privately owned company has 35 stockholders. Its chairman is still Liang Bailing. The only difference is that the power plant has a new name, the "Changge City Hengguang Thermal Power Co. LTD."

How did they do it? Liang Beiling, the plant general manager prior to the privatization, was also the principal buyer in the privatization process. By using his power as the general manager, he hired a firm to re-appraise the value of the plant. The result was shocking. A profit-making company was transformed into a company with a 36 million yuan (US$4.5 million) debt. Liang then devised a "reward policy," which gave the management buy-out group a 30 percent break on the purchase price. In addition, Liang instituted a policy providing a 25 percent price break if the buyers made a one-time cash payment. Management established one self-rewarding policy after another, with the result that a 101-million-yuan plant is now a private company controlled by former plant manager Liang Bailing, who owns 19.46 percent of the shares.

Case Two

In 1999, before privatization, the assets of the state-owned Dingxi County Department Store included a three-story office building near Dingxi Railroad Station, a new office building, and two residential buildings.

To prepare for privatization, the retail department store expanded this three-story railroad station building by adding four more floors. Wang Xueli, the store’s legal representative, did not provide any information about the expansion to the appraisers. Accordingly, the railroad station building was appraised at 45,785 yuan (US$5,500) as a three-story building.

In August 2000, the assets were finally transferred from the state to the new private company, which then had a total capital of 500,000 yuan (US$60,000), 490,000 of which was owned by Wang Xueli, the former legal representative of the state-owned department store.
The greed and deception continued. Wang forged a receipt showing that the new private company had paid a fictitious company for construction work. With that receipt, Wang obtained a title certificate showing that he owned the assets from the second floor to the sixth floor of the railroad station building. In May 2002, Wang Xueli sold these five floors to the new private company.

According to a Chinese government investigation, Wang misappropriated a total of 2,140,882 yuan (US$258,000) through the privatization of this state-owned department store.

Case Three

On October 28, 1999, as part of privatization, Anhui Mobile Communication Co., Ltd. (AHMCC) registered a private mobile phone company with two million yuan (US$241,000) in initial capital, 20 percent owned by AHMCC and 80 percent by the AHMCC Workers’ Union. The initial capital was paid via the following fund transfers:

AHMCC wired 400,000 yuan (US$48,000) to the new mobile phone company for its 20 percent. On October 13, 1999, AHMCC wired 1.6 million yuan (US$193,000) to its Workers’ Union. The next day, the Workers’ Union wired the 1.6 million (US$193,000) to the new private mobile phone company to pay for its 80 percent ownership.

Soon after, AHMCC requested that 1.17 million yuan (US$141,000) be raised from its top management and employees. Once the 1.17 million yuan was raised, on January 13, 2000, the new private mobile phone company returned 1.6 million yuan to the Workers’ Union, which forwarded the 1.6 million yuan to AHMCC that same day.

From the end of 1999 to early 2002, the private mobile phone company was so profitable that its shareholders received hefty dividends: The top four senior AHMCC managers each received dividends of 86,500 yuan (US$10,422), the 15 mid-level AHMCC managers 57,600 yuan (US$6,940), low-level AHMCC employees 28,000 yuan (US$3,373), and AHMCC retirees 18,700 yuan (US$2,253).

Why is this private mobile phone company so profitable? Through a Chinese government investigation, it was discovered that AHMCC diverted high revenue business to the private mobile phone company to benefit AHMCC’s own management and employees.

… … …
The real economic "genie" released by the CCP, the real impetus behind the reform miracle is the people, the people in the rural villages and townships, and the private entrepreneurs in the urban areas. The private sector struggled and succeeded, even under stringent restrictions and absolutely no bank funding and in the face of arbitrary bullying from CCP officials for more taxes and/or bribes. It is this private sector that attracted foreign merchants and manufacturers to China to purchase goods and set up factories to produce more goods. It is this private sector that started to fill the stores worldwide with "Made in China" labels. It is this private sector that has supplied the domestic market with abundant merchandise of all kinds and that has played a major part in raising the nation’s living standard. It is also this private sector that created sufficient wealth to enable the country to develop at a mind-boggling speed. Deng Xiaoping reportedly admitted that this was unexpected and not something he had anticipated. [3] Despite the CCP’s desire to boost the size of the private sector in order to claim market economy status, it is very likely that the private sector has already been responsible for more than 50 percent of the economy for some years. [4]

China’s export industry has overwhelmed the world and has paid its dues in helping to carry the reform this far. In 2004, total exports stood at US$593.4 billion, a 35.4 percent increase over 2003, which itself is an increase of 34.6 percent over the year before. [5] There is no doubt that it will continue to grow. But this only works well for labor-intensive industries, and China has already dominated most of them in product lines such as toys, apparel, footware, and household electronics. In the capital-intensive or technology-intensive industries, China’s chief advantage of cheap labor loses its critical value. Certainly China has and still is producing a very impressive number of engineers, but it is no comparison to the virtually unlimited supply of cheap manual labor. Furthermore, it will be harder to find willing foreign corporations to move their high tech development centers to China if they face the certainty of losing their technological lifelines. As for China, any indigenous effort will certainly be taken on by the state-owned sector, whose managers are questionable for such a challenge.

Another vital component of China’s economy that has kept the reform going this far is the dizzying speed and scale of capital spending and development. It certainly satisfies China’s ego to have the "largest, tallest, fastest," and other superlatives in the world. But the evidence of excess and waste is abundant. In 2003 and 2004, China built so many steel factories that the country’s needs won’t exploit their full capacity until 2010. [6] It is well-known that the return on China’s capital investments is extremely low and much of it is wasted. But this is the only way to keep the economy growing at a sufficiently high speed to generate enough jobs to absorb laid-off workers and migrant workers from the countryside. Since 2003, the fixed capital investment accounted for a whopping 47 to 51 percent of the GDP [7] and 75 percent of the GDP growth in 2004.
The Outlook

Western scholars and economists have long warned about the fragility of the Chinese economic bubble. To their astonishment, whenever the bubble seemed about to burst, the CCP was able to stave off catastrophe by slowing development temporarily and then speeding ahead to make the bubble even bigger. Under market economy conditions, this bubble would no doubt have burst long ago. But in China, the CCP controls all the financial institutions and owns all the major investment projects. It can ignore all these danger signs as long as people don’t rush to the banks to take their deposits out and inflation remains under control. The financial resource that has made it possible for the CCP to do this comes from the super high savings rate of Chinese household depositors and the large amount of seignorage (the amount of real purchasing power that a government can extract from the public by printing money). [8] Chinese household savers have put away large sums of money into the banks year after year. Total household deposits, as a percentage of GDP, rose from about two percent in 1978 to 22 percent by 1994. [9] From 1994 to 1998, household depositors pumped an average of 770 billion yuan (US$96 billion) a year into their bank accounts, doubling the amount of the previous five years. [10] The total household deposit hovered at around 60 percent of GDP from 1997 to 2001. The increase of the urban work force and household wealth, coupled with the lack of a personal credit/checking system, demanded increasing amounts of cash just to satisfy people’s daily needs, which enabled the CCP to print large amounts of cash with little inflation effect. In addition, the longer cash stays in people’s hands, the more it loses value due to inflation. This combination provided essentially free revenue for the CCP, which averaged an increase of 6.85 percent of GDP from 1986 to 1990 and an increase of 8.09 percent of GDP from 1991 to 1999. [11] These financial resources have enabled the CCP to use the sheer growth of the economy to mask the deeper and fundamental problems the CCP has created.

But these problems are real and growing more severe by the day. The CCP’s insistence on reviving its state-owned enterprises without genuine ownership change has resulted in the complete failure to transform these enterprises. As a result, much of these enterprises’ assets have been stolen by their managers and the collaborating CCP officials, making more and more of these enterprises unsalvageable. At the same time, corruption has become an institutionalized feature of China’s system— it is simply everywhere. These inefficient and money-losing enterprises have created such huge bad debts that the state banks are crippled and unable to perform their financial functions. Increasing numbers of workers are being laid off and pushed out into society. To alleviate this pressure, the CCP has resorted to massive, mindless capital investment projects, which can only make the matter worse over time. The unnaturally high growth rate, combined with poor planning and rampant corruption, has made the situation nothing short of disastrous.
Over the years of reform, the CCP has been able to hide these problems by high growth and high spending. But the growth rate of exports is unlikely to be sustained in the future, and the high growth in capital investment can only make the matter worse and the bubble bigger. The third component of GDP is consumption. If consumption increases, it will result in fewer deposits in the banks and may cause higher inflation.

It may be as futile to try to predict when this bubble will burst as to predict the same for stock markets elsewhere in the world. Even in an economy as free as in the United States, the last stock market bubble lasted much longer and reached a much larger size than many could have expected. As we have learned from China’s reform history, the Chinese bubble can get much bigger, but so will the damage when it bursts.

The private sector is still capable of cleaning up this mess. If the restrictions on the private sector are lifted, if they can be on the same footing as the state-owned enterprises in terms of growth and size and obtaining financing from banks, they will very likely and almost surely be able to grow and expand, to take over the weaker state-owned enterprises, to absorb workers who need jobs, and, finally, to start to improve the nation’s overall productivity and efficiency. In order for this to happen, the CCP has to accept genuine migration to private ownership, has to restrain itself from interfering and obstructing private enterprises’ business activity, and has to let an independent judiciary preside over the courts of commercial law. In essence, the CCP has to be prepared to wrap up and head to the exit. It is squarely confronting the very economic forces it released.

One group of scholars has long argued that economic reform should be but a small part of a constitutional transition. [12] Without reform, the constitutional system under which the CCP holds the monopoly of all political power, the CCP’s vested interests (its Party officials) will hijack the economic reforms and reap most of the benefits at society’s cost. Some of the scholars further point out that if such economic reform succeeds, China will be following in the footsteps of pre-Second World War Germany and Japan.

Given the history of the CCP’s willingness to use any means to keep itself in power, given the serious problems that are brewing with increasing intensity under the glamorous surface, given the more and more apparent fact that the CCP has become the proverbial "cow on the track" of the speeding reform train, and given the fact that the CCP has been increasingly relying on nationalism to rally its people, this warning should not be neglected— not by the world and especially not by the Chinese people.

1. Alan Greenspan is Chairman of the Board of Governors of the Federal Reserve System in the U.S. and Chairman of the Federal Open Market Committee, the system’s principal monetary policymaking body.
2. He Qinglian, China’s Trap, Chapter 3.
3. Fishman, Ted, China Inc, P. 74.
4. Chandrasekhar, C.P., Frontline, "How Large is China’s Private Sector?" Vol. 22, Issue 21.
5. World Bank, China Economic Indicators – Cumulative,
6. Macabe Keliher, "Red Lights Flashing for China’s Economy," Asia Times, http:://
7. World Bank, China Economic Indicators – Cumulative,
8. Lardy, Nicholas. China’s Unfinished Economic Revolution, P. 184.
9. Ibid, P. 14.
10. He Qinglian,
11. Ashima Goyal and A.K. Jha, Economic and Political Weekly, October 15, Vol. 39, 2004.
12. Jeffery Sachs, Wing Thye Woo and Xiaokai Yang, Economic Reforms and Constitutional Transition, Perspectives, Vol. 1, No. 6.

Hua Yi is a freelance writer based in New York.