Two decades of Dengism has moved China from leftism to economic development without major turmoil, quadrupling the living standard and laying the foundation for ongoing systemic reforms.

Dengism comprises pragmatism and gradualism. However, tight administrative controls are essential for gradualism to be successful since they prevent an economy that is halfway between a market system and a planning structure from being unraveled through arbitrage.

China must address the tough systemic reforms that are the legacy of Dengism. Such reforms are difficult to implement but must be pursued vigorously for development to be sustained, in our view.

The rule of law is the most important element for sustaining and protecting China's development. This requires China to shift from a personality-based system to one based on rules.

For China to safeguard economic and social stability, a large number of jobs will have to be created. This will require the economy to resume double-digit growth in the near future.

Details:

Deng's China

Twenty years ago China still lacked direction following the demise of Mao Tse-tung, with the country impoverished by the turmoil of the Cultural Revolution. At the third plenum of the 11th Communist Party Congress a newly reinstated Deng Xiao-ping assumed control of the country, promising to replace class struggle with modernization.

In the two decades since that pledge was made, China has been transformed both materially and culturally. Mobile phones are as ubiquitous today as Little Red Books were during the Mao era. Karaoke parties now take the place of class-struggle sessions. The number of high-rise buildings in China is possibly greater than in the rest of the world combined. Coastal cities look surprisingly like metropolises in any middle-income country.

Table 1 Indicators of Economic Development Pop Grain Elec Steel M. Vehicle (Mn) (Ton mn) (Kwh bn) (Ton mn) (,000) 1957 660 160 19 5 8 1977 950 256 223 24 125 1997 1,236 475 1,136 109 1,583

Export Import Refrigerators TV Tel Sets (US$ bn) (US$ bn) (,000) (,000) (Mn,total) 1957 2 2 2 0 1 1977 7 7 23 340 4 1997 183 142 10,444 36,372 101

Source: China Statistical Yearbooks

Official statistics show that the living standard has quadrupled over the past two decades. As China is still changing its national statistical system to reflect a market economy, there is bound to be a problem with the accuracy of statistics. However, the increase in physical indicators (Table 1) suggests that the living standard has probably improved to this extent. Indeed, China was industrializing at a similar pace previously, though from a much smaller base and, therefore, with less visible benefit for such a large population. No economy of this size has developed so rapidly in such a short period of time.

What is Dengism?

Deng is known for saying 'It doesn't matter if it's a black or a white cat, as long as it catches mice' and 'Feeling the riverbed one-step at a time when crossing a river'. Pragmatism and gradualism are the hallmarks. The intention of the former policy was to chip away at the stranglehold that leftist policies had on the economy by citing facts on the ground even though some 'facts', such as the success of special economic zones, were mostly a result of the enclave effect. Gradualism is difficult when an economy is in a transition from a planned to a market structure because arbitrage opportunities can easily unravel an economy in such a halfway state. This is why strong administrative controls, which would limit the impact of arbitraging, is essential for gradualism to be effective.

Building Blocks in the Success Story

There are three building blocks to China's success story.

First, the one-child policy was rigorously enforced. The population has grown by 28% in the past two decades compared with 47% in the previous two decades. The resulting decline in the dependency ratio is the foundation for China's rapid growth.

Second, peasants had become sluggish and inactive under the People's Commune system. When they were given back their land, this ignited a revolution in agricultural productivity.

Third, investment by the non-state sector, mainly by township-and-village enterprises (TVE) and foreign investors (mostly overseas Chinese), was encouraged around the mid-1980s, which sparked the most spectacular export boom this century. The strength of the export sector has generated the incentive and the requirement for China to be gradually integrated into the global economy.

The Challenges Ahead

The most important accomplishment of Dengism was its success in releasing the economy from the stranglehold of leftist policies without incurring massive social upheaval, which would have meant widespread starvation. For this, Deng Xiao-ping will be remembered as one of the giants in Chinese history.

However, the ad hoc approach of Dengism to reforms has left most systemic issues unaddressed. The post-Deng leadership has been tackling those very difficult and substantial issues.

First, the rule of law, the most important component of a modern market economy, has yet to mature in China. This is the most serious challenge facing China and will be the main determinant of the durability and sustainability of China's development. We discuss this issue separately in the following section.

Second, the incentive framework has become highly complex and has eroded the state's capacity to collect taxes. Deng's policy of pragmatism means that local governments have been encouraged to give special incentives for new investment since more investment is always considered good. On the other hand, local governments all have ambitious development plans of their own, which require additional funding. Fees and charges have, therefore, proliferated. The imposition and collection of such fees and charges are often ad hoc and susceptible to personal discretion, provoking a sense of injustice for many people.

This suggests China should standardize its tax system so that it can provide a dependable source of funds for development and is perceived by the people as fair.

Third, the separation of government and business is essential for creating a level playing field for investors, a critical factor in the development of a market economy. Businesses alone cannot take advantage of the arbitrage opportunities created by gradualism, but government-sponsored businesses can. The existence of such a system often undermines the effectiveness of government agencies in providing public services and creates a prevailing sense that becoming rich is only possible for the powerful.

Reform of the civil service is necessary for slimming down the government, delineating better the roles of government agencies, and vastly improving material rewards for civil servants.

Fourth, the state enterprise sector is in a critical condition as deflation has destroyed the cash flow of many industries. The chronic need for banks to prop up state enterprises has led to the banking system having a large amount of non-performing assets, making meaningful banking reforms difficult. As in other countries, state enterprises do not perform well because a government cannot effectively supervise a firm's management to ensure the best financial performance.

A stock market that can effectively discipline the financial performance of companies is needed. State enterprises should be sold or listed in such a stock market. The development of a fund management industry is essential to the disciplinary role of a stock market.

Fifth, the financial sector must be brought under control and cease to be a financing arm of the government, which blurs the distinction between taxes and deposits. A financial sector under the control of the government allows inefficiencies to be dumped into the financial system, threatening the stability of this system.

China must impose discipline on the extension of new loans based on the financial viability of investments. This would stop non-performing assets from being added to the already large stock in the financial system. The existing stock of non-performing assets should be sold to investors, who would apply these assets for productive use, improving economic efficiency.

Sixth, housing reform and the replacement of a state-sponsored system by an insurance-like social safety net should be completed. The uncertainties over the private cost of the new welfare system is a major reason for the rapid rise in the private saving rate, one of the main sources of deflation.

If the government made private housing more affordable, this would lessen people's emphasis on the need to save. Similarly, if the costs of healthcare and education were more predictable, the saving rate could be lowered.

Rule of Law: The Only Path to Modernity

The foundation for a modern market economy is the rule of law. This entails three components: (1) a set of rules and regulations that supports efficient market transactions, (2) a due process for disputes over contractual obligations, and (3) a judiciary that efficiently adjudicates disputes and has legitimacy.

However, China has always been ruled by personalities rather than a system. People are grateful if the emperor is benevolent. The society is highly hierarchical, based on one's official position. Social justice is achieved through an examination system that is open to all and selects high-caliber individuals to become mandarins and rule the country.

The superior-subordinate relationship between officialdom and the commercial class is the root cause for the historical underdevelopment of a commercial class and the main source of corruption. The modernization of China is essentially a process through which the country fights against its past to establish a new order based on the rule of law. Only the rule of law can safeguard the country's development.

How Many Jobs Does China Need to Create?

The most serious immediate challenge in economics and politics is the need to create enough jobs for (1) the large pool of rural surplus labor (over 150 million), (2) the laid-off state-enterprise workers (10-30 million), and (3) new entrants into the labor force (25 million). The numbers suggest that China cannot possibly create enough jobs in the formal economy to solve its employment problem over the next few years. This means that the wages in the gray economy will be constantly under pressure, exerting deflationary pressure on the formal economy.

It is important that China creates enough jobs to ensure social stability. Without an effective social safety net, the extended family remains the primary source of income redistribution. China will have to grow at a double-digit rate, eventually, to stem rising unemployment.