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How do you govern a new country?
Running a quickly growing economy isn't as easy as it sounds
Its safe to say the China of 1980 and the China of 2000 were completely different countries. But the transition from a planned economy to a market economy is very hard, and its not always clear how to change.
When you move from $300 billion in GDP in 1980 to $3 trillion in 2000, the transition is quite difficult. Old methods of governance don’t work, and the state has to revamp itself. This is exactly what happened in China.
Shanghai skyline. Source
A planned economy gives the state a lot of power. The words of the planners become law. Planners have almost unchecked power on the state economy. They can use varying amounts of coercion from nudges and winks to factory managers to forcing millions of people to work in forced labour camps. Most crucially, they don’t face external constraints. The Chinese government didn’t have an independent judiciary to hold it to its word, and the private sector (which barely existed) did not have the power to vote with its feet if policies were hurting them.
But when the same Chinese officials entered a market economy, they had to give up their initial instincts and restrict themselves from initially intervening in the market. Conservative officials were skeptical of the experiments, and tried to stop them where they started. Even reform minded officials had no idea of what to do because it was so alien to them.
So, they had teething troubles. Chinese officials had no idea of how markets worked abroad. At first, they charged prices that were wildly out of touch with market prices. The rates for electricity and land could be multiples above or below the prices in Hong Kong or Taiwan. Local officials who hadn’t ever faced the test of the market quickly learnt that those who kept their commitments got more investments, and those who didn’t got lesser. In the initial days of unregulated capitalism in China there was no effective legal system or judiciary capable of enforcing contracts.
If the late Thomas Schelling were to write a history of this transition, he would say that the presence of an independent judiciary is a pre-commitment to investors. Government officials constrain themselves so that investors have confidence that they will honor their commitments. But in China, governments could not constrain themselves. They could not tell investors that “come what may, you will have your property secured” which they could have done in a liberal democracy with an independent judiciary. So, the only way they could build trust was to actually honor their contracts and build a track record as reliable partners.
And over time, they got better at it. They slowly learnt that investors preferred localities and local officials who kept to their word. It was always better to have officials who could get work done, than officials who would be by the book and were distrustful of businesses.
But as reform minded as local officials were, they constantly faced opposition from conservatives in Beijing. Part of this was that Deng had picked one of the most economically liberal governors Ren Zhongyi to head Guangdong province where the largest SEZs were there. Ren was committed to the SEZs more than any other leader in China. When he was criticized in Beijing for breaching the 50 million Yuan limit for projects, he changed the project to make it look like many small projects in one and not one large project. When Party officials were concerned with corruption in the SEZs, he swiftly maneuvered the discussions to put the blame on specific incidents rather than the idea of SEZs themselves.
But, by 1981 this was getting harder and harder to do. Conservatives in the CCP like Chen Yun were concerned that the lack of discipline in the CCP would lead to the collapse of China. For people who had spent their living years decrying capitalism and reading Marx, the presence of what was getting closer and closer to a market economy scared them. At a meeting of province secretaries, Chen Yun declared
“Four special economic zones are sufficient. We should not establish any more.” A month later, he said, “Now every province wants to set up special economic zones. If they are allowed to do so, foreign capitalists as well as domestic speculators at home will come out boldly and engage in speculation and profiteering. Therefore, we should not do things this way.”
Some of the concerns raised by the conservatives were legitimate. Along with economic growth, there was large-scale corruption at the lower levels in the Chinese government. When investors with cash had met underpaid government officials, it was extremely likely that some cash was exchanged. It was also hard to know what the limits were because this was the first time government officials were in contact with businesses. Among them itself there was variation on what was right and wrong. Is accepting a New Year’s dinner invite wrong? “Red envelopes” containing cash? Trucks and cars for personal use?
So while momentum was building in Beijing against the reformers, Deng Xiaoping stepped in. While criticizing the specific incidents of corruption, Deng pacified the conservatives but didn’t give up any of the principles that guided the SEZs. He put the officials under the bus while keeping his idea of the SEZs. Over the next 4 years, from 1980 to 1984 as abuses of power were cleared by the State Disciplinary Commission, the Chinese government announced that they were extending the SEZ model to 14 more cities.
How to win companies and attract investment
It seems obvious in hindsight that local governments compete for investment from firms. Local officials hold meetings all over China - in bars, karaoke bars and restaurants. Since 1992, various industrial parks have come up across China. After the extension of the SEZ policy in 1984, 14 other cities had SEZs. Then, in the 90s the government opened up “National Economic and Technological Development Zones”. As of January 2012, there were 128 “National Economic and Technological Development Zones” in China. These are undoubtedly a success. The growth rate of Economic Development Zones is 3 times the national average,
An industrial park works like this: the local government sets up all the amenities like electricity, land, internet and water. Then its staffed with two teams. The first office is run by the local government which provides all the permits and ensures they comply with regulations. Instead of running from office to office to get approvals, they can get it all at one place. The second office looks after the daily operations of the industrial park, and provides services to the residents of the park.
The separation between governance and management of the industrial parks is what makes them successful. Local governments can specialize in attracting businesses and regulating them. And managers of parks can specialize in maintaining the parks. But these offices are far from normal business development departments. They actively solicit investment from firms and try to provide them with what they need to set up business. Sometimes this might mean negotiating with suppliers, getting skilled labour - even from other cities, and securing bank loans. They do this because it generates tax revenues for the local government.
Across the country, local officials realized that the only way to attract investment was to specialize. Just like how new startups in the US might choose to move to a tech hub like Silicon Valley (or more recently Miami), local governments realize that the external economies of scale from having companies of the same industry in the same place add up. So, industrial parks pick an industry and get firms from that industry to be there. The positive aspect of this is that they specialize, and this leads to higher incomes across China because specialization leads to higher incomes.
The negative aspect of this is that it leads to duplication of industries. Many cities across China have the same industries they specialize in. Ronald Coase and Ning Wang in How China Became Capitalist where they identify this are unable to explain the phenomenon. Take the example of the automobile industry. By the 1980s there were multiple joint ventures producing cars, and three major cities for cars were established - Guangzhou, Nanjing, and Shanghai. But even when capacity utilization levels were just around 30% for trucks and buses and 65% for cars, the government of Shanghai decided to set up the Shanghai Automotive Industry Corporation. Then the government of Changsha started an industrial park for automotive parts. This leads to overcapacity and underutilization of resources.
Regardless of the consequences of duplication of investment, it has led to the boom of the manufacturing sector in China. While in the 70s, Chinese factories could not produce watches or cassette players, by the 80s manufactured exports finally took over textiles to become the leading export category. By 2000, 90% of exports were manufactured goods.
The moral of the story is this
Experimentation in the early stages of reform was key. Without that, we would have never known if the SEZs worked, and it would not have gained political capital to convince the rest of the CCP.
Both local government competition and cooperation are necessary. Competition keeps local officials nimble and leads to higher government quality. But cooperation in the form of sharing ideas that work, and especially those that don’t.