What went right in China?

What changed for China to become the world's largest economy?

This is the first post in a four part series.

Part 2 is here

Part 3 is here

Part 4 is here

In 2021, China is the world’s largest economy. Its citizens enjoy a standard of living unparalleled in Chinese history. Shanghai is one of the top 10 most powerful cities in the world and Shenzhen is the world’s 4th most competitive city. 

Shenzhen Skyline. Source

This wasn’t always the case. In 1975, China’s economy was just a quarter of America’s. In 2000, it was 45%. And in 2018, it finally became larger than America’s.

Source: Maddison Project Database

Throughout the 60s and 70s China faced grain shortages, famines and political purges. Over 15 million people are estimated to have died due to the Great Leap Forward from 1958 to 1962 - a failed experiment to create a communist society by creating people’s communes in villages. It died out when officials realized how horrible the situation was. Right when things were getting back to normal, Mao Zedong launched a violent political purge where millions of people were sent to forced labour and anyone deemed as a threat to him was removed. Nobody was spared - not even the President of China Liu Shaoqi or Mao Zedong’s top aide Deng Xiaoping.

After Mao died there was a brief power struggle where four radicals who supported him (called the Gang of Four) made noises of a coup but Mao’s chosen successor Hua Guofeng arrested them immediately. On paper from 1976 to 1981 Hua was the leader of China, from 1981 to 1987 Hu Yaobang was the leader and from 1987 to 2002 it was led by Zhao Ziyang and Jiang Zemin. 

In reality, one person held an important role in China from 1978 to 1992. Deng Xiaoping whose highest formal title was the Chairman of the Chinese Military Commission was China’s paramount leader. He had a huge task in front of him.

China in 1978 was no average country. It was still reeling from the chaos of the Cultural Revolution. The average Chinese citizen was poor, and grain shortages still plagued the country. To add to all of that, their neighbor the Soviet Union was being aggressive towards them. Just 9 years before they’d had a minor war with the Soviet Union, and then it was threatening their interests by signing a mutual defense treaty with China’s southern neighbor Vietnam.

And all of this understates the disarray China was in. The country was racked by widespread violence, and intellectuals were discarded. The top leadership of the country was continuously in flux and radical politics dictated economic management. To quote from How China Became Capitalist by Coase and and Wang

Unlike the Great Leap Forward when the political elites were largely sheltered from the disaster, the Party veterans were squarely at the center of the political struggle during the Cultural Revolution. The whole political structure and administrative machine was severely weakened. A rigid, centralized bureaucracy staffed with strictly disciplined but dispirited bureaucrats, which had been a defining feature of Stalinism, was certainly not among the assets Mao bequeathed to his successors.

The new generation of leaders had a challenge in front of them: they had to rebuild a nation.

Fixing Agriculture

Agriculture in China was done at the collective level. People’s communes were established in 1958 where around 4,000 households were a group. Private property was abolished, and jobs were given by commune leaders to individuals. And whatever was produced was shared equally among members of the commune - decided by the commune leaders. This meant that there was no incentive to work harder for reward. To quote one of the farmers to end the system: 

"Work hard, don't work hard — everyone gets the same," he says. "So people don't want to work."

Across China villages were facing the problem of low harvests, and grain shortages. This wasn’t unnoticed by Communist Party officials either. Wan Li, an official who was posted to Anhui was shocked at how bad living conditions were. After investigating, he realized that the problem was with the lack of individual incentive and presented a proposal to decentralize production to the household level and that grain in excess of the quota be allowed to be sold in local markets. At the same time in Pengxi county in Sichuan, the local Party committee agreed to try private farming where produce in excess of the quota could be sold in private markets.

In one way, this was a continuation of Maoist policy. Before production was at the commune level, and now the responsibility for production was shifted to households instead. But in other words this was a radical change in policy because it allowed households to keep what they produced. This was a radical change because it was in effect private property and “restoring capitalism”. 

The proposal made conservatives in the CCP nervous. Newspaper articles attacking household farming came out and the Party Congress affirmed that it was still illegal. Deng Xiaoping was also forced to go along with Party opinion, as he would have been called as “pursuing the capitalist road” as he was during the Cultural Revolution. But in private, he admitted that the experiments in Anhui and Pengxi were going well . Behind the backs of conservative CCP members he encouraged other reform-minded province governors to allow private farming. By the end of 1979, over half the production teams in the country were distributing work to small teams and a quarter had made contracts with households. To placate conservatives in the CCP, he said that it would be allowed only in areas where there is serious starvation. Leftists in the government realized that he was introducing private farming by stealth but it was hard to argue against solving starvation.

In 1980, as support grew for the household responsibility system, Deng Xiaoping publicly supported private farming. In September, the Party reached a compromise with private farming being allowed only “in those remote mountainous areas and poverty-stricken backward regions and in those production teams that have long been relying on state-resold grain for food, loans for production, and social relief,” and only “if the masses have lost their confidence in the collective.”

The success of the system was clear. Between 1978 and 1982, peasant incomes doubled and chemical fertilizer production doubled. By 1982 communes were abolished. Party officials who did not support private farming were removed, even senior ones like the Chairman of the CCP Hua Guofeng.

The most important reason for the opposition to private farming was that it was Mao’s signature policy. In 1955 he announced it with great pomp. To quote from Ezra Vogel’s Deng Xiaoping and the Transformation of China:

Mao had proclaimed: “Throughout the Chinese countryside a new upsurge in the socialist mass movement is in sight. But some of our comrades are tottering along like a woman with bound feet. . . . The tide of social reform in the countryside—in the shape of cooperation—has already been reached in some places. Soon it will sweep the whole country.”

It was the policy that had made the Great Leap Forward, and was one of the planks of Maoist ideology. But it died with a whimper in 1982 when 98% of the country had accepted the results of private farming.

This had Deng Xiaoping’s signature all over it. Was Deng Xiaoping an ideological reformer, or was he cluelessly seeing which darts hit the board? The answer is neither. He did have his own ideas, but was willing to experiment. Along with that, he first got the work done behind the scenes and showed his results. Then he built political consensus and got a large number of  officials to agree with him.

 Again from Ezra Vogel’s Deng Xiaoping and the Transformation of China

Deng had no ideological commitment to household farming. He allowed it because it solved the grain problem and the problem of rural livelihood. To reach this goal, he had to de-collectivize agriculture. He accomplished that politically difficult task without a debilitating split in the party and without personally becoming a target of attack by conservative officials. 

But what happened after the communes were abolished? They reinvented themselves by selling on the open market.

Township and Village Enterprises

China had a unique institutional environment. The country was on paper against private property, with a conservative bureaucracy and middle management which enforced it. But at the top, and at the local levels, there were people who supported private property and wanted to start businesses. What was the solution to this?

It came when the communes were abolished. They didn’t die out. They were replaced with Township and Village enterprises or TVEs. TVEs were enterprises collectively owned by the residents of a town or a village. In theory, they were the same as the communes which were owned collectively and run by the local government. In practice they sold on the open market, faced the same budget constraints as private enterprises and were able to respond to market demand faster than state owned enterprises. 

The way a TVE worked was that the local government had complete ownership of the company. It was in name a “collective” and so faced no ideological restriction on its size or scope. This meant that they could proceed without any hindrances from conservatives in Beijing. 

The local government would borrow to fund the TVEs expenses from either the Agricultural Bank of China or Rural Credit Cooperatives that were present in China at the time. The local government would use its own assets as collateral for the loan and assume risk of payment if the TVE failed.

Then the local government would select the managers. Typically, the managers would be entrepreneurs who were unsure of their property rights being secure if they ran the company on their own name. These managers would be promised a share of the profits making them effectively shareholders of the business. Both Coase and Wang in How China Became Capitalist and Yingyi Qian in How Reform Worked in China report that these were designed in such a way that they incentivized higher profits and linked rewards to contributions.

A survey by the Chinese government in 1994 revealed that 83% of TVEs were private companies in all but their name.

The TVE would begin operations by selling its produce in the open market. TVEs sold what was underserved by State Owned Enterprises (SOEs) in China. Usually they produced construction materials, did small residential construction, transportation services and light industry. A key component of this is that they used their advantage of having higher labor by entering labor intensive industries. The labor to capital ratio of TVEs was 8 times that of SOEs.

TVEs were typically more constrained than SOEs. They faced actual hard budget constraints unlike SOEs which had access to state money regardless of performance. TVEs had no support in Beijing while SOEs were owned by the central government. On the contrary, conservatives in Beijing like Chen Yun were upset that they were using materials that could have been used by SOEs and recruiting labour that could have worked for them. 

The main advantage TVEs had was they didn’t have the red tape and bureaucracy that stalled SOEs. And because of their budget constraint, they actually had to provide goods and services the market wanted. They were able to change production according to consumer demand and enjoyed a great deal of flexibility. State Owned Enterprises also served as a de facto welfare state in China for their workers.  They had to pay healthcare, schooling and medical costs along with retirement expenses. 

TVEs on the other hand didn’t have any of that.  They hired and fired workers as the demands of the business asked for. And they improved employment by a great deal. In 1978 communes employed only 28 million people. In 1992 when Deng Xiaoping stepped down, they employed 105.8 million people. 

TVEs increased the output from communes by 36x from  49 billion yuan in 1978 to 1.798 trillion yuan in 1992. By 1990, TVEs made up 42% of Chinese industrial output, up from just 9% in 1978. 

TVEs were a clear success. But what happened to all the money? Yingi Qian in How Reform Worked in China says that initially in 1985 around half the money was reinvested in the business and the other half was used for local government funding like infrastructure and other public expenditure. By 1992 this number had changed to 60% being reinvested and 40% being used for local government expenditure. 

Then in 1994 regulations changed allowing TVEs to be converted into joint stock companies. Along with that private enterprises were legal in China leading to increased competition and lower profits for TVEs. For reasons that none of the books make fully clear, TVEs were privatized and they lost their influence. 

But regardless of their end, TVEs were a precursor to another important change in Chinese institutions. They provided the example for the CCP that private property in China would not end in exploitation, but rather in economic progress. 

The TVEs were another example of how economic reform in China was gradualist. Instead of having big-bang reforms where socialism was transformed into capitalism in a day, it went step by step. Part of it was because a large portion of the CCP was conservative in nature and didn’t trust any form of what they called “bourgeois ideology”. But another part of it was because Deng Xiaoping himself realized that China didn’t have the institutions for capitalism - yet.

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