The Economics of Transition, 1(2):135-170, June, China's Economic Reforms Differ:The M-Form Hierarchy and Entry/Expansion of the Non-State SectorbyYingyi Qian and Chenggang Xu1China's thirteen years of economic reforms (1979-1991) have achieved an average GNPannual growth rate of 8.6%. What makes China's reforms differ from those of EasternEurope and the Soviet Union is the sustained entry and expansion of the non-statesector. We argue that the organization structure of the economy matters. Unlike theirunitary hierarchical structure based on functional or specialization principles (the U-form), China's hierarchical economy has been the multi-layer-multi-regional one mainlybased on territorial principle (the deep M-form, or briefly, the M-form). Reforms havefurther decentralized the M-form economy along regional lines, which providedflexibility and opportunities for carrying out regional experiments, for the rise of non-state enterprises, and for the emergence of markets. This is why China's non-state sectorshare of industrial output increased from 22% in 1978 to 47% in 1991 and its privatesector's share from zero to about 10%, both being achieved without mass privatizationand changes in the political system.1. IntroductionRecently, there has been a revived interest among economists in China's economic reforms. Since1979, economic reforms in China have generated a significant growth across the board: the overallperformance of the Chinese economy has been better than its own past record, better than most developingcountries at similar development levels, and also better than Eastern Europe and the former Soviet Union,
1 Stanford University and London School of Economics, respectively. We would like to thank PhilippeAghion, Masahiko Aoki, Patrick Bolton, Avner Grief, Athar Hussain, Carla Krüger, Nicholas Lardy, JohnLitwack, Eric Maskin, John McMillan, Paul Milgrom, Dwight Perkins, Louis Putterman, Gerard Roland,Anna Seleny, Barry Weingast, Martin Weitzman, Jinglian Wu, and an anonymous referee for helpfuldiscussions and comments. Qian's research is sponsored by the Center for Economic Policy Research(CEPR), the Hewlett Fund of the Institute of International Studies (IIS), and Center for East Asian Studies(CEAS) at Stanford University, and Xu's research is sponsored by the Center for Economic Performance(CEP) and the Suntory-Toyota International Center for Economics and Related Disciplines (STICERD) atLondon School of Economics.
both before and after their radical transformations in 1989. It appears that China had no coherent reformprograms, no commitment to private ownership, and no changes in the political system, and China'seconomy was still not fully liberalized. From both the theoretical and policy perspectives, China's differentreform strategies and outstanding reform performances are particularly interesting and economic reforms in China formally started in 1979 following the Third Plenum of theEleventh Congress of the Chinese Communist Party in December 1978. The starting time was later thanthat of Yugoslavia (1950) and Hungary (1968) and was about the same as for Poland (1980), and earlierthan the Soviet Union (1986). Between 1979 and 1991, China's GNP grew at an average annual rate of8.6%, or at 7.2% on the per capita basis.2 In 1992, the growth of GNP reached 12.8%.3 Exports grew at afaster pace, so that China's export-GNP ratio increased from below 5% in 1978 to nearly 20% in 1991.4
Also in this period, inflation was kept within a single-digit range except for three years (11.9% in 1985,20.7% in 1988 and 16.3% in 1989); the household bank deposits to GNP ratio increased from 6% in 1978to 46% in 1991; and the government budget deficit accounted for about 2-3% of GNP, about half of whichwas financed from bond issues (Table 1.1).Even more convincing evidence of the success of the reform is the increase in consumption andconsumer durable goods by an average Chinese consumer in physical terms. For example, between 1978and 1991, an average Chinese consumer increased his/her consumption about three times for ediblevegetable oil, pork, and eggs (Table 1.2). In the rural areas, which account for about 75% of totalpopulation, the living space per person increased about 130% between 1978 and 1991 (Table 1.3). The
2 Data sources in this paper are from Statistical Yearbook of China (various issues from 1985 to1992), otherwise noted.
3 Statistical Communique of the State Statistical Bureau on the 1992 National Economic and SocialDevelopment, February 18, 1992.
4 The export-GNP ratios are calculated based on the official exchange rate and are upward biased. Butthe dramatic increase of export share in GNP during the reform is unmistaken.2
average per household consumer durable goods, such as television sets, refrigerators and washingmachines, also increased dramatically. For instance, in 1991, on average, every two rural households hadone television set, and every urban household had more than one (Tables 1.4 and 1.5). There is no doubtthat China is still a low-income developing country, but the evidence reveals clearly a substantialimprovement in living standards due to economic Chinese economic performance is in contrast to that of Eastern Europe and the former SovietUnion. Even if the two-digit annual decline of GNP in 1990 and 1991 in these countries was largelytransitory, the magnitude was still too large to be ignored. What is more important, but tends to beneglected, is the economic stagnation in Eastern Europe and the Soviet Union in the decade of 1980s beforethe radical changes. According to official statistics, the average growth rate of GDP in Hungary was 1.8%between 1981 and 1985 and almost zero in 1988 and 1989. In Poland, the average GDP growth rate wasless than 2% between 1981 and 1989.5 The situation in the Soviet Union was no cal considerations aside, two arguments often come into discussions on the differencesbetween China and Eastern Europe. The first argument is about different levels of economic development:
Eastern Europe and the Soviet Union were at a much higher development stage than China -- China had avery low per capita income with a dominant agriculture sector while the Eastern European and Sovieteconomies were "over-industrialized."6 The second argument is about different reform strategies: Chinahas followed a gradual and piecemeal approach as opposed to the "big bang" strategy in most of after 1989Eastern Europe and the former Soviet Union, like the shock therapy for stabilization in Poland and Russia,
5 Data source for Hungary and Poland is from Table 9.1 of Kornai (1992).
6 For example, Summers (1992) expressed this view when he highly praised China's reformperformance. Sachs (1992) also expressed similar ideas during his interview with the Chinese Journal ofComparative Economic and Social Systems.3
and fast and mass privatization in Czechoslovakia.7We feel that both views are relevant but unsatisfactory, or at least, are incomplete. China's level ofindustrialization was perhaps higher than most people would think. In 1978, China's gross industrialoutput value accounted for 62% of the total output value of society (35% in heavy industry and 27% inlight industry), despite the fact that only 29% of the total labor force was employed in the non-agriculturesector. In terms of GNP, China's industry accounted for about half in 1978, as compared to 60% to 65%in Eastern Europe. Furthermore, in China, reforms have been more successful in the more industrializedregions with a weak central government control (like provinces of Guangdong, Jiangsu, and Zhejiang).
Reforms have not been very successful in both the less industrialized regions (like the Northwest provinces)and the more industrialized regions with a strong central government control (like Shanghai and provincesof Liaoning and Jilin), the latter share similar problems of the earlier Hungarian reform. This fact suggeststhat one cannot explain the success of the reforms by low level of development argument for gradualism also raises more questions than answers. First, the agriculturalreform in China proceeded very fast in the early 1980s. The abolishment of the commune system and thenationwide execution of the household responsibility system (an ownership reform) was implementedalmost at one stroke, thus can be viewed as a big bang. More importantly, Eastern Europe's radicaltransition should not be examined in isolation: it came after deep troubles or failures of many years ofgradual reform. In fact, the Hungarian reform started in 1968 with some initial success, but then ran intodifficulties in the 1980s. Ironically, in several aspects China followed Eastern Europe's gradual reformmeasures. If China's gradualism is a success, why has it worked in China but not in Eastern Europe? Onthe other hand, why was China's success not a temporary one, and will China soon encounter problemssimilar to Hungary's?
7 This view is reflected in Singh (1991), McMillan and Naughton (1992), and Chen, Jefferson andSingh (1992).4
In this paper, we propose a theory to explain the differences between China's reforms and those ofEastern Europe and the Soviet Union. We first make an observation and provide extended evidenceshowing that, unlike the case of Eastern Europe and the Soviet Union, sustained entry and expansion of thenon-state sector in China during the reforms were forceful and fast enough to become an important engineof growth by the end of the 1980s.8 We then theorize an institutional reason which is responsible for thisphenomenal expansion and for the concurrent emergence of the market. We argue that the difference in theinitial institutional conditions concerning the organizational structure of the planning hierarchy playsimportant roles in different transition paths of China and Eastern Europe and the former Soviet Union. Theorganization structures of both Eastern Europe and the Soviet Union were of a unitary form based on thefunctional or specialization principles (the "U-form" economy), and in contrast, the Chinese hierarchy hasbeen of a multi-layer-multi-regional form mainly based on a territorial principle since 1958 (the "deep M-form" economy, or in short, the "M-form" economy). The M-form structure has been further decentralizedalong regional lines during reform with both increased authority and incentives for regional governments,which provided flexibility and opportunities for carrying out regional experiments, for the rise of non-stateenterprises, and for the emergence of markets. Our institutional approach is able not only to incorporateand link together aspects of the arguments concerning the level of development and gradualism, but also toexplain richer phenomena such as the successful use of experiments in China but not the M-form organization in China, interdependence between regional economies is not asstrong as that of the U-form organization in Eastern Europe and the Soviet Union, because each region isrelatively "self-contained." Unlike in Eastern Europe and the Soviet Union, regional governments in China(be it province, county, or township, village) have had considerable responsibility of coordination within theregion. In particular, a large number of state-owned enterprises, including many in heavy industries, were
8 We deliberately avoid the issue of the state sector. Evaluation of the reform in the state-sector hasbeen controversial among China experts and Chinese economists.5
subordinated under the regional governments even before the economic reforms. Hence, each region wasrelatively self-sufficient, the scale of an enterprise was small, and industries were less concentrated. In thisenvironment, regional experiments can be carried out in a less costly way because the disruptive effect tothe rest of the economy is minimal. A successful experiment in one region also has greater relevancy toother regions since adjacent regions are the M-form economy was further decentralized along regional lines in reform and theconstraints on local government were gradually removed, the bottom level regional governments (i.e.,townships and villages in the rural areas, and districts and neighborhoods in the urban areas) gainedsubstantial autonomy in developing their own regions. They establish enterprises outside the state sectorand outside the plan. From their inception, those non-state enterprises (most of them are not privatethough) have been market oriented. Furthermore, competition between regions for getting rich fast putspressure on the local governments to concentrate on growth and their limited access to bank creditsmaintains discipline on their behavior. This explains how the rise of the non-state sector occurred bygradually weakening the existing hierarchical control without destroying the existing structure at course, administrative decentralization induces, at the initial stage, costs of regional conflict,market protection, wasteful duplication, inefficient small scales of production and increased administrativeintervention by local governments. We do not argue against these opinions but we would like to focus on aneglected but important aspect of benefits of a multi-layer-multi-regional form of organization, that is, theflexibility of the system for experiments and hence for institutional changes, and the opportunity providedto facilitate entry and expansion of the non-state sector outside the plan. The unexpected, and perhapsunintentional, growth of the non-state sector is critical for the success of China's economic on Chandler's seminal work (1966), Williamson (1975) first used the terms "U-form" and"M-form" in his study of business firms in the U.S. The U-form referred to the unitary organizational form6
of the firm along functional lines in the second half of 1800s and early 1900s, while the M-form referred tothe multi-divisional form of the firm organized by product, by technology, or by geography, which emergedsince the 1920s. Compared with departments in the U-form firms, divisions in the multi-divisional firmsare more self-contained, their responsibility for coordination and profit inside the division is high. Theregional governments in our multi-layer-multi-regional structure economy share these features. However,our concept is not simply an application or an extension of the Chandler-Williamson's concept from firmsto economies. There are important differences between the two concepts. In a multi-divisional firm,decentralization occurs exactly at the level of general office and the divisions, and each division is oftenorganized by functions. In contrast, in our concept of the M-form economy, decentralization occurs at alllevels of the hierarchy, that is, the M-form is deep. This is critically important: it is exactly because of theautonomy and incentives provided to the bottom levels of the regional governments in China, could the non-state sector grow so remaining part of the paper is organized as follows. Section 2 clarifies the definition ofChina's non-state sector and private sector. Section 3 provides empirical evidence on the sustained entryand expansion of the non-state sector between 1979 and 1991. Section 4 first characterizes institutions ofthe U-form hierarchies of Eastern Europe and the Soviet Union and the M-form hierarchy of China beforethe reform, and then describes several Chinese reform policies that are responsible for furtherdecentralization along regional lines. Section 5 makes a general and preliminary analysis on the costs andbenefits of the M-form organization vis-a-vis the U-form and the implications for transition. Section 6explains specifically how the phenomenal expansion of the non-state sector in China is made possible underits M-form hierarchical organization. The final concluding section discusses implications of the non-statesector for further reforms in China and lessons from the Chinese experience for other economies intransition.7
2. What Is the Non-State Sector in China?92.1. The Non-State SectorBefore defining the non-state sector, we should first define the state sector. In China, by theconstitution, the state-owned enterprises are owned by the "whole people." In practice, every state-ownedenterprise is affiliated with one of the following four levels of government: (1) central; (2) provincial (witha population size of dozens of millions); (3) prefecture (with a population size of several millions); and (4)county (with a population size of several hundreds of thousands). A municipality is treated as one of thelevels of province, prefecture or county, with a majority being at the level of a prefecture. Typically, theresponsible government delegates the supervision of "its" state-owned enterprises to the industrialministries/bureaus. Therefore, even for the state-owned enterprises, they are not homogeneous in terms non-state sector consists of all enterprises not in the state-sector, and it includes the privatesector as a sub-sector. According to the location of its supervising government (if it has one), a non-stateenterprise is designated as either an urban enterprise or a rural enterprise.10 By 1991, there were threecategories of non-state ownership in China's official statistics: "collective ownership," "individualownership," and "other types of ownership." Table 2.1 below provides a detailed picture with both officialand alternative classifications:
9 We only focus on the non-agriculture sector in this paper.
10 An interesting and confusing fact is that many rural enterprises are located in urban areas. They arecalled "rural enterprises" simply because they are supervised by rural community governments (ip or village governments) and the majority of their employees are not registered urban residents.8
Table 2.1 China: Classification of the Non-State SectorOFFICIALCLASSIFICATIONUrban DistrictEnterprisesCollectivesNeighborhoodEnterprisesUrbanCooperativesIndividualUrbanIndividualOthersPrivate;Foreignjointventures;Other jointventuresRuralTownship
Enterprises
VillageEnterprisesRuralCooperativesRuralIndividual(TVEs)ALTERNATIVECLASSIFICATIONCommunityPrivate(A) Collectives (jiti). Urban collectives include (i) enterprises that are affiliated with a districtgovernment under a municipality or a county ("large" collectives, dajiti); (ii) enterprises that are affiliatedwith a neighborhood under a district ("small" collectives, xiaojiti); and (iii) urban cooperatives (chengzhenhezuo). Many urban collectives are subsidiaries of state-owned enterprises which receive some transferredassets from the parent firms and hire their surplus employees or the employees' spouses and children. Theadvantages of subsidiaries being registered as collectives under the supervision of lower level government isless government control and more business flexibility.11Rural collectives include (i) enterprises that are affiliated with a township (xiang or zhen)government; (ii) enterprises that are affiliated with a village (cun) government; and (iii) rural cooperatives(nongcun hezuo). The predecessors of township and village enterprises (TVEs) were commune andbrigade enterprises (CBEs) emerging during the Great Leap Forward in 1958. The ownership form of
11 This is known as "one factory, two systems" (yichang liangzhi) in China, referring to the plannedsystem for the state-owned part, and the market system for the collective part.9
township and village enterprises is truly a Chinese invention that has not been found elsewhere.(B) Individual Business (geti). These are household/individual businesses hiring no more than 7employees. An individual business has been allowed to operate since 1978.(C) Other Types of Ownership (qita leixing). This category includes mainly (i) private enterpriseshiring more than 7 employees (siying); (ii) foreign enterprises and joint ventures with foreigners (sanziqiye); and (iii) other types of joint ventures (e.g., a joint venture between state and private enterprises) andjoint-stock companies. These types of ownership did not emerge until the early 1980s.122.2. The Private SectorDefining the non-state sector in China is easy, but defining the private sector is not. As seenabove, a "private enterprise" is defined in China as a private business establishment hiring more than 7employees. This narrow definition is on purpose, in order to circumvent ideological difficulties. Forexample, an individual/household hiring no more than 7 employees is classified as an "individual business,"not as a "private enterprise," although it is certainly part of the private sector. So are sole foreign businessestablishments. As for joint ventures and joint-stock companies, strictly speaking, only those shares thatare owned by foreigners and domestic private parties can be regarded as in the private sector.13 Some"cooperatives" are more like partnerships hiring many employees. This is especially true in SouthernChina, and in some areas they are called "joint stock cooperatives" (gufen hezuo). In addition, sometownship and village enterprises and urban district and neighborhood enterprises are de facto private
12 If a state-owned enterprise is converted to a joint-stock company or limited liability company("corporatization") or becomes a joint venture, it will be reclassified into the catagory of "others." As aresult, it will not be regarded as "state-owned" anymore, despite the fact that the state may still own themajority interests. This may cause interpretation problems of the non-state sector in the future as more andmore such a conversion occur starting in 1992.
13 About one-half of "others" can be counted as truly private.10
enterprises with vaguely defined ownership under the name of collectives.14Lacking further information and taking approximations, our definition of the private sector inChina in this paper will include individual ownership, cooperative ownership, and other types of ownershipunder the official classification, and will exclude all of the township and village enterprises. We speculatethat this should not give too much bias in either direction for data prior to 1992. The remaining part of thecollectives, that is, enterprises affiliated with an urban district or neighborhood and with a rural townshipor village (TVEs), can be regarded as the community sector.3. Sustained Entry and Expansion of the Non-State Sector in China: Evidence3.1. General FeaturesFrom 1978 to 1991, the share of the non-state sector in national non-agriculture employmentincreased from about 40% to 57%. However, this happened not because of privatization or conversion ofstate enterprises to non-state enterprises. It is mainly due to entry and expansion of new non-stateenterprises. In fact, employment by the state sector increased from 75 million in 1978 to 107 million in1991. Its share declined because employment in the non-state sector grew even faster: from 21 million to44 million in the urban area and from 28 million to 96 million in the rural during the same 's non-state sector is engaged in all kinds of activities: construction, transportation,commerce, service, and in particular, industry. This is perhaps a crucial difference between China's non-state sector and the private sector in Eastern Europe, particularly before 1989.15 During the period from
14 For example, the famous computer company Stone Group is officially a "large collective" underHaidian district in the Beijing municipality, but actually run by a group of private businessmen. InWenzhou municipality of the Zhejiang province, any business establishment with more than three co-owners is classified as a "collective," and is often called a "township" or "village" enterprise.
15 See Kornai (1986) for the private sector development in Hungary before 1989.11
1981 to 1990, the national average annual growth rate of gross industrial output was 12.6%, in which thestate sector grew at 7.7%, collectives at 18.7%, individual business at 92.2% and other types of ownershipat 42.7%. As a result, the share of the non-state industry in the national total has expanded gradually from22% in 1978 to 47% in 1991, and accordingly, the share of the state sector in industrial output shrunk from78% to 53%. To put this into a historical perspective, the share of the state sector in 1991 is already belowthe level in 1957, which was 54% (Table 3.1).16The change of ownership composition of Chinese industry toward the non-state sector did nothappen overnight. In fact, the process started before 1979. Although the true private industry in China didnot appear until the early 1980s, the collectives had grown from 11% out of the national total in 1969 to22% in 1978, or about one percent increase in output share every year (Table 3.1). However, the dramaticshift of weight toward the non-state sector has been apparent since 1979: The non-state sector in industryhas on average experienced an increase in industrial share two percentage points every year for 13 years.17Accompanied by the high growth rate, the non-state sector is also more efficient than the statesector. The annual growth rate of the total factor productivity of the non-state enterprises was much higherthan that of the state enterprises.18 If one ranks all China's provinces according to their shares of the non-
16 In 1957 the first five year plan was finished. At that time, there were still many state-private jointly-owned enterprises (gongsi heying). One year later, during the Great Leap Forward in 1958, the share ofthe state sector jumped to 90%.
17 The Information Center of the State Planning Commission in China has already predicted that by theyear 2000 only about one-quarter of industrial production will be produced by the state-sector in China.
However, see footnote 11 for qualification to this statement.
18 From 1982 to 1987, the annual growth rate of the total factor productivity of the TVEs is 12.5% atthe national level, and 15% in the coastal areas (Xu, 1991). In contrast, from 1978 to 1985, the annualgrowth rate of the total factor productivity of the state-owned enterprises is 1.3% at the national level(Chen, et. al., 1988). Another piece of evidence comes from Xiao (1991). Using the provincial data from1985 to 1987, Xiao shows a significant positive correlation between the total factor productivity of theprovincial economies and the non-state sector share of the industrial output (with an exception ofShanghai).12
state sector in industrial output, the top five, Zhejiang, Jiangsu, Guangdong, Shandong and Fujian, areprecisely those provinces that have much higher growth than the national average.19 An interesting counterexample of the coastal region is Shanghai. Shanghai was one of the most important financial and industrialcenters in the Far East before 1949 and was also the industrial base after 1949. Shanghai has a low shareof the non-state sector in industry as compared to the national average: 22% in 1985 and 32% in 1990.
For the period from 1984 to 1989, Shanghai's industry grew only 7.9%, well below the national average.
Shanghai's share of industrial output dropped from 10% in 1985 to only 6.8% in 1989, below that ofJiangsu, Shandong or additional characteristics about the entry and expansion of the non-state sector in Chinashould be especially emphasized. First, the substantial entry and expansion occurred not because of anintentional design of a reform program from the central government, to the contrary, it came largely fromthe local initiatives. The central government's tolerance is mainly because it solves unemploymentproblems without much financial support from the state. Second, and related to the first, there has been alarge variance in terms of organizational and developmental patterns of non-state-owned enterprises acrossregions. For example, while export and foreign investment have played important roles in some parts ofGuangdong and Fujian, they are not so vital in many other high-growth provinces. On the other hand,township and village enterprises are a dominant force of the non-state sector in Jiangsu and Shandong, butindividual, partnership and private enterprises are much more important in , by 1991, the collectives and joint-ventures are the dominant majority of the non-state sector,and privately-owned enterprises played a minor role on the national scale. The collectives and joint-ventures have larger scale of operation, employ better technology, and absorb more human capital. This isbecause in China, there is still a lack of legal protection of private property rights, let alone commitment to
19 These five provinces are all the coastal provinces. Because of the rapid growth, the share ofindustrial output of these five provinces in the national total rose from 30% in 1985 to 37% in 1990.13
private ownership. Private firms often face discrimination in obtaining credit, labor and material supplies(Nee, 1992). Local government ownerships like a township or a village enterprise can be viewed as aninstitutional response to such an environment, in which they have comparative advantages over both privateand state ownerships. They are "politically correct," protected by at least some level of government, andthey also enjoy the flexibility of business operation that the state-owned enterprises are lacking.203.2. The Non-State Sector in the Rural Areas -- Township, Village and Private EnterprisesWithin the non-state sector, the largest and the most dynamic part is the segment of ruralenterprises, also known as Township, Village and Private Enterprises (TVPs). Between 1978 and 1991,the number of rural enterprises increased from 1.5 million to 19.1 million and employment increased from28.3 million to 96.1 million. Between 1981 and 1990, the total output by rural enterprises grew at anannual rate of 29%, in which the industrial output grew at 28%, much higher than the national average of13%. Exports by township and village enterprises (excluding private enterprises) increased at an averageannual rate of 65.6% from 1986 to 1990 (Table 3.2).About three-quarters of the total output of the rural enterprises came from industry in 1990, lightindustry accounting for 55% and heavy industry for 45%.21 For example, in 1990, rural enterprisesproduced about one third of coal, 40% of canned food and one half of electric fans in China (Table 3.3).
With the rapid growth of rural enterprises, their status in the national economy has changed from asubsidiary sector of agriculture to an important engine of growth. Between 1979 and 1990, as a percent ofthe national total, employment increased from 23% to 39%, total output increased from 7% to 22%, and
20 The fast entry and expansion of the non-state sector has considerable impact on the state sectorthrough increased competition, which forces state-owned enterprises either to ask for more subsidies fromthe government or to change in order to survive. Given the shrinking government budget revenue, reformsof the state-owned sector become more urgent than ever.
21 A Statistical Survey of Chinese Rural Enterprises, 1991.14
industrial output increased from 9% to 25%. Export from township and village enterprises (excludingprivate enterprises) accounted for 24% of the national total in 1990 (Table 3.4). By all measures, theChinese rural enterprises had already expanded to more than half of the non-state sector and to about one-quarter to one-third of the national total by rapid growth of the rural enterprises has changed the industrial structure of the Chinese ruralareas as well. In 1980, the share of agriculture in gross output value in rural areas was 69% and the shareof non-agriculture was 31%, of which industry accounted for only 20%. Ten years later, in 1990 the shareof agriculture output dropped to 46% and the share of non-agriculture output increased to 54%, of whichindustry accounted for 40%.22
3.3. Emergence of the Private SectorThe private sector in China did not appear until the late 1970s and private industry only started inthe early 1980s. There was a tremendous increase in the number of private industrial enterprises in the1980s. In terms of share of industrial output, a significant decline in urban collectives (from 45% to 29%)was accompanied by a surge in individual rural business (from 4% to 11%) and other types of ownership(from 3% to 10%), as shown in Table 3.5. According to our definition, the private sector's share ofindustrial output inside the non-state sector increased from 13% in 1985 to 27% in 1990, doubling in fiveyears. Using a more conservative estimate (only one half of the "others" counted as private), about 10% ofthe total national industrial output was produced by privately owned enterprises in 1990, up from 5% in1985. The expansion of the private sector was remarkably faster in rural areas. Employment by the ruralprivate sector was about 24% and total output about 14% of the rural total in 1984, the correspondingnumbers increased to 49% and 33%, respectively, in 1988 (Table 3.6).
22 Byrd and Lin (1990) contains a detailed study of rural industry in four counties in China: Wuxi ofJiangsu, Nanhai of Guangdong, Shangrao of Jiangxi and Jieshou of Anhui.15
An important part of the private sector in China is "individual business." China restoredindividually or household operated business in 1978 and since then, this segment of the private sector hasregistered rapid growth in both urban and rural areas, largely in industrial and commercial enterprises.
Between 1981 and 1988, the number of individually-run enterprises increased seven-fold, from 1.8 millionto 14.5 million, and employment increased nine-fold, from 2.3 million to 23.0 million (Table 3.7).4. The M-Form and U-Form Hierarchical StructuresThe phenomenal entry and expansion of the non-state sector distinguishes China's reform from theEastern European reforms. Among many reasons which may explain these phenomena are the institutionaldifferences between the (deep) M-form organization in China and the U-form organization in EasternEurope and the Soviet Union, and the subsequent Chinese reform policies of further decentralization alongregional lines which had a major influence on both the transition path and performance.4.1. The U-Form Hierarchy of Eastern Europe and the Soviet UnionIn Eastern Europe and the Soviet Union the economies were organized in the U-form in whichhierarchical information flow and control were organized into a unitary form by functional or specializationprinciple.23 Most enterprises were grouped by industry and under the direct supervision of ministries, andregional governments were primarily subordinates of the center and their roles were limited to collectinginformation from below and implementing plans from above without much autonomy.24In order to fully utilize the scale economy and to avoid conflicting operations, there was littleoverlapping of functions among ministries in a U-form hierarchical economy. Enterprises were highly
23 It is also known as the organization by "branches."
24 In the case of the Soviet Union, ministries of the central government had controlled all enterprises inheavy industry while the regional governments had controlled some light industrial enterprises.16
specialized and their sizes were extremely large. This led to extraordinary industrial concentration.
Because of the strong interdependence between enterprises across different regions, comprehensiveplanning and administrative coordination between ministries at the top level of the government were crucialfor the normal operation of the U-form economy in the absence of the market. To show the complexity, forexample, in the late 1970's there were 62 ministries under the Gosplan in the Soviet Union. There wereabout 48,000 plan "positions" for about 12 million products planned and coordinated by the Gosplan(Nove, 1983).There are several reasons why the Soviet economy was organized in the U-form. First, from thevery beginning, the Soviets had an ideological obsession on the scale economy and gigantic factories.25 TheU-form organization takes advantage fully of the scale economy and specialization. We saw often in theSoviet Union that one or a few gigantic firms produced one product for the whole economy. Particularlywhen the economy was at a lower stage of development and the objective was clear and the decision-making was relatively simple, the U-form organization was effective in mobilizing scarce resources to catchup quickly (Gerschenkron, 1962). Second, when the Soviet Union began to establish a centralized economyin the 1920s, the U-form was the only way of organizing industrial activities within large corporations inthe West, as the multi-divisional firms in capitalist economies had not yet emerged. The claims of Leninand Kautsky about establishing a socialist economy as a gigantic factory also reflected the prevailingknowledge about economic organization at that time. Third, there were political reasons for the U-formorganization, particularly under Stalin, to achieve better control by Moscow over the Soviet Republics andthe Eastern European countries. Because each region of Eastern Europe and the Soviet Republic was madea branch of the grand hierarchy, all regions became strongly interdependent, and ultimately, were dependenton Moscow.
25 Lenin had this famous remark in his book The State and Revolution (1917): "The whole of [socialist]society will become a single office and a single factory." This ideology can be attributed to Marx.17
When the economy becomes more complex, defects in the U-form organization become serious. Inorder to change the organization structure, Nikita Khrushchev in 1957 abolished the ministries all togetherand introduced 105 Regional Economic Councils (Sovnarkhozy), to which all the state enterprises weresubordinated. However, this reform didn't go very far and soon failed. Given the already very concentratedindustrial structure, a change from a unitary form to a multi-regional form required both political changesand economic changes. The power of ministries would be weakened, large enterprises would be broken upor new duplicating enterprises would be established, all of them were very costly. In 1965, blaming of thegrowing "localism" of the Sovnarkhozy and the difficulties of coordinating a regionally operated planningapparatus, the regional coordination system was replaced by the former ministerial system (Gregory andStuart, 1981).4.2. The M-Form Hierarchy of ChinaIn China there are six administrative levels: central, provincial, prefecture, county, township(previously, commune) and village (previously, brigade). In urban areas, there are three levels:
municipality, district and neighborhood. In China's official language, regions at each level are called"blocks" (kuaikuai), as opposed to "branches" (tiaotiao), the bureaucratic supervision along the lines offunction and specialization.26 Instead of mainly following functional or specialization principles like thosein Eastern Europe and the Soviet Union, the Chinese economy is organized into a multi-layer-multi-regionalform mainly according to territorial principle, in which each region at each layer can be regarded as anoperating unit. Each unit is further divided along geographic lines and at the same time the unit controls itsown enterprises along functional and specialization lines. Regions are relatively self-contained; that is, they
26 Strictly speaking, each functional or industrial bureau in a region is subject to "dual leadership"(shuanchong lingdao) of the regional government (by block) and of the upper-level functional or industrialdepartment (by branch). But the former is more important than the latter.18
are self-sufficient in terms of functions and supplies in ly under the control of the central government are 30 province-level regions (blocks) and afew dozen functional and industrial ministries (branches). Before the economic reform which began in1979, industries in China were much less concentrated than those in Eastern Europe and the former SovietUnion and there was a large number of state-owned industrial enterprises not controlled by the centralgovernment. This is true for light industries, as well as for heavy industries. In 1978, the share ofindustrial output of state-owned enterprises controlled by the central government was less than one-half ofthe national total (Wong, 1987). In the automobile industry, almost all enterprises in Eastern Europe andthe Soviet Union were directly controlled by the central government and the number of the enterprises wasrather small. In China, there were 58 enterprises making automobiles before the reform, and most of themwere controlled by the local governments (Wang and Chen, 1991). Consistent with this, the number ofproducts directly under the central plan in China was much smaller, only 791 in 1979 (Zhu, 1985), ascompared to more than twelve million in the former Soviet Union in the late 1970s (Nove, 1980). With amuch reduced work load, the desired number of ministries in the center is much smaller than in the SovietUnion (less than 30 vs. more than 60).The hierarchical structure of each region at each level is a copy of that of the central government.
For example, a county has about ten to twenty townships. The county government controls the enterprisesaffiliated to the county government by functional line and specialization principal (e.g., finance, textile,food processing, electronics, etc.), and it also oversees township governments within its territory.
Similarly, a township controls its own enterprises in addition to the oversight of its commune system in the rural area between 1958 and 1984 provides a good example ofshowing some of the features of the bottom level of the M-form hierarchy. A commune (now township)government was a bottom level government in China (only the level of village is below it). Far from havingspecialization and division of labor, a commune encompassed all kinds of activities of industry, agriculture,19
commerce, education, entertainment and even military ("people's militia"). The counterpart of thecommune in urban areas is the neighborhood committee, which similarly has many of its own should be clear that the difference between China's M-form hierarchy and the Soviet Union andEastern Europe U-form hierarchy is more than the relationship at the top level between the centralgovernment and the provincial government. On the one hand, the CMEA as a whole should not be regardedas a large M-form hierarchy in our sense, since within each CMEA country, the economy is organizedaccording to the functional lines exclusively. On the other hand, the internal structure of a province inChina is different from that of an Eastern European country, even though the size may be similar. Forexample, Hungary with a U-form hierarchy has a different organizational structure from Guangdongprovince of China. As a province, Guangdong is a part of the large hierarchy of China. But Guangdongitself is also organized in an M-form, with multiple-regions consisting of prefectures, counties, townshipsand villages, and all of them are self-contained economic are several reasons for China's economic organization to evolve to the M-form. First,historically, before the Chinese Communist Party fully took power of China in 1949, both the economy andthe military force in regions under Communist control were organized in an M-form. The organizationalheritages and skills accumulated in history have a deep influence on the evolution of organization structureof the Chinese economy. Second, technologically, poor communication and transportation facilities in alarge country makes the M-form organization an easier choice for the Chinese. Third, politically,nationalism was less a problem in China than in the Soviet Union and Mao had many other means (forexample, political movements) to hold the country together. Fourth, militarily, as Mao was worried aboutthe Soviet and American air-raid invasion and the Third World War, industries were dispersed into inlandareas and turned into the supervision of the regional governments. Finally, culturally, there is vast classicalliterature in China on the arts of managing multi-regional organization because for more than two thousand20
years the Chinese empires were basically organized along regional 's M-form hierarchical structure has evolved since 1958. Because of ideological and politicalreasons, China's first five year plan (1953-57) was formulated with the help of the Soviet experts, whichwas a process of copying the Soviet model -- the U-form organization -- into the Chinese economy.
Toward the end of the first five year plan, Mao increasingly dissatisfied with the over-centralization andbureaucratization in the Soviet model. In his famous 1956 speech on the ten major relationships, Maodiscussed the relationship between the central and the local governments and advocated the ideas of"mobilizing two initiatives of both central and local governments" (diaodong zhongyang he difang lianggejijixing) and "walking on two feet" (liangtiaotui zoulu), the latter referring to development of both centraland local industries.27 These ideas later became official government policies and were Mao's initiative, China started to deviate from the Soviet model and moved toward thedirection known as "administrative decentralization" within the hierarchy. Two major waves ofadministrative decentralization occurred in 1958 (the Great Leap Forward) and in 1970 (the CulturalRevolution): the central government's bureaucracy was trimmed; supervision authority of many state-owned enterprises were delegated from the ministries to provinces and cities or even counties; and localgovernments' initiatives for developing their regions were encouraged. The legacy of Mao had great impacton the organizational structure of the Chinese economy. As far as the initial institutional conditions foreconomic reforms are concerned, China's multi-layer-multi-regional hierarchical structure prior to 1979
27 "Our territory is so vast, our population is so large and the conditions are so complex that it is farbetter to have the initiatives come from both the central and the local authorities than from one sourcealone. We must not follow the example of the Soviet Union in concentrating everything in the hands of thecentral authorities, shackling the local authorities and denying them the right to independent action." "Thecentral authorities want to develop industry, and so do the local authorities." "The central authoritiesshould take care to give scope to the initiative of provinces and municipalities, and the latter in their turnshould do the same for the prefectures, counties, districts and townships; in neither case should the lowerlevels be put in a strait-jacket." (Mao, 1977)21
was already substantially different from that of the unitary hierarchical form inherited in Eastern Europeand the Soviet Union before their economic reforms.4.3. Reform Policies of Further Decentralization Along Regional Lines in ChinaHowever, the role of local governments before the economic reform was still limited compared tothat after the economic reform. Before 1979, as the fiscal system remained very centralized, the localgovernment had little financial resources for regional development. Autonomy of the local governmentswas also limited given the constraint of central planning and the use of markets not being officiallysanctioned. Furthermore, the Chinese economy was a closed one without informational and technologicalexchanges with the rest of the subsequent reforms since 1979 opened up the Chinese economy to the outside world. Thescope of planning was gradually reduced and the use of the market was encouraged. More importantly,several reform polices were carried out that have made authorities, information and incentives beingdecentralized to the regional governments. It is only after these complementary reform policies thatinitiatives of the regional governments were mobilized and the market emerged beyond the boundary ofeach region. The reform policies of decentralization were mainly reflected in the following aspects:First, a fiscal revenue sharing system between any two adjacent levels of governments wasimplemented starting from 1980.28 Although schemes vary both across regions and in time, the basic ideais that a lower-level regional government contracts with the upper-level regional government on the totalamount (or share) of taxes/profits revenue (negative means subsidies) to be remitted for the next severalyears, and the lower-level government keeps the er, for example, the fiscal sharing schemes between the central and provincial (local)
28 The nick-name for this fiscal decentralization is "eating in separate kitchens" (fenzao chifan).22
government. There are two categories of revenue incomes in any province: central revenues and localrevenues. Division between the central and local revenues is by source (for example customs duties arecentral revenue and turnover taxes are local revenue) and by affiliation of enterprises (for example, profittaxes from centrally-control enterprises are central revenue and that from provincially-controlledenterprises are local revenue). Only local revenue is subject to revenue sharing, and there have been fourmajor types of sharing schemes (Wong, 1992): (A) To remit a lump sum (possibly with an annualincrement) and retain the rest. (This applied to only two experimental southern provinces of Guangdongand Fujian first); (B) To remit a portion which is fixed for four to five years. (This is for the majority ofprovinces); (C) To remit a portion which is set annually. (This applied to the three cash cows of industrialcities (which have provincial ranks) of Beijing, Shanghai and Tianjin); (D) To receive a fixed amount ofsubsidies. (This applied first to four poor provinces in the Northwest, and later to a total of nineprovinces). Starting from 1988, most provinces shifted to schemes (A) and (D), which have the strongestincentive effects. For example, Shanghai contracted with the central government for remitting a fixed 10.5billion yuan since , the so-called "extra-budgetary" revenues (i.e., the second budget) by the local governmentsand ministries were expanded. Eighty percent of these funds belongs to state-owned enterprises as retainedprofits over which the local governments and ministries have substantial control. Before the reform, theextra-budgetary revenue was relatively small, 9% of GNP in 1978 compared to the budgetary revenue of35% of GNP. In 1991, the extra-budgetary revenue was up to 15% of GNP while the budgetary revenuewas down to only 18% of GNP (Sicular, 1992).Third, the banking system in China was also decentralized with the separation of the central bankand the specialized banks in 1983. Although banks were still owned by the state, each regional branch ofthe specialized banks was required to link their total credit extension to deposits collected within the region(cundai guagou). In case deposits fall short in a specialized bank, it is the regional branch of the central23
bank (not the general office of that specialized bank) which is responsible for reallocating funds within theregion or asking for refinancing loans from the central bank. This regional based banking institution wasalso "deep," as the central bank in China has branches even at the county level. Although the bankingsystem was somewhat re-centralized in terms of personnel appointment starting in the fourth quarter of1988, the influence of the regional government (through regional branches of the central bank andspecialized banks) on credit remained rather , more autonomy was granted and more responsibilities were assigned to the regionalgovernments. These include reduced planning scope of the central government, increased authority of localgovernments for determining prices, for setting up new firms, for making investment with "self raisedfunds," that is, funds drawn from the "extra-budget" or borrowed from banks.29 At the same time, burdensof fiscal expenditure were also decentralized, local government assumed greater responsibility for providingeducation, health, housing, local infrastructure, these reforms, local governments have become almost residual claimants and they haveincentives to maximize local revenues.30 Because the local government's budgets are highly dependent onlocal enterprises, they have incentives to set up more enterprises using their newly gained authority. Morefirms mean more revenue, more revenue means more resources for regional development. With such andecentralization, local governments do not receive a great deal of financial support from the above andconsequently, their responsibilities to the above are also ralization along regional lines in the M-form hierarchy during the reform had great impacton China's industrial structure. First, more state-owned enterprises were delegated to local governments.
In 1985, the state-owned industrial enterprises controlled by the central government accounted for only
29 Although in some cases getting project approved by the upper level government is still needed, whichis known as "project registration" (lixiang).
30 To some extent, the local government holds "local government or regional property rights."24
20% of the total industrial output from enterprises at or above township level, while the provincial and citygovernment controlled 45% and county government 9% (Table 4.1). In 1987, the share of the eight largeststeel firms controlled by local governments was 12.3% as compared to 47.1% for the eight largest steelfirms controlled by the central government (Wang and Chen, 1991). In contrast, almost all firms in thesteel industry in Eastern Europe and the Soviet Union were directly controlled by the central governments.
Second, the Chinese industry has become even less concentrated. For instance, there are more than 100color television assembly lines, and every province has at least one. The number of enterprises makingautomobiles increased from 58 before the reform to 116 in 1987 (Wang and Chen, 1991).Third, the average size of state enterprises in China is much smaller than that in Eastern Europeand the Soviet Union, and is quite close to that in the West. For example, in 1988, employment perenterprise in manufacturing was 806 in the Soviet Union and 460 in Hungary, as compared to 145 in Chinaand 96 in Italy. In wearing apparel, the corresponding figures were 6,600 in Czechoslovakia, 307 inHungary, 80 in China, and 71 in Italy (Table 4.2). In spite of twenty years of reform, the average size ofHungarian enterprises remained substantially larger than that in the West.315. The Costs and Benefits of the U-Form and M-Form Hierarchies And the Implications forTransition: A Preliminary AnalysisThe costs and benefits of different organizations are determined by the essential features of theorganizational structures.32 The important organizational features of the unitary form of hierarchies of
31 Many economists criticized these reform policies on the basis of their adverse macroeconomicconsequences, for example, declining fiscal revenue, pro-cyclical effect of the fiscal sharing schemes(contract is not indexed to inflation), and loss of control over fiscal instruments and credit. All of thesetend to undermine the macroeconomic stability of the economy (Lou, 1991).
32 In order to make our points clearer and sharper, we need to make some abstractions which may makethe descriptions not identical to the reality. But the essential features of the reality is preserved in ourabstraction.25
Eastern Europe and the Soviet Union (the U-Form) are: (i) organization mainly by functional orspecialization principles; (ii) regional governments' roles are limited and supplementary; (iii)interdependence between regions is strong and coordination at the top is critical; and (iv) the size ofenterprises is generally large and industries are very concentrated. In contrast, the organizational featuresof the multi-layer-multi-regional form of hierarchy in China are: (i) organization mainly by territorialprinciple in additional to by functional or specialization principles; (ii) each region is relatively self-contained and interdependence between regions is relatively weak; (iii) coordination at all levels isimportant but at the top it is not particularly critical; (iv) the size of enterprises generally is small andindustries are less concentrated; and (v) the above features extend to many levels down to the very characterization helps to clarify the relationship and differences between our concepts of U-form and (deep) M-form economies and the U-form and M-form firms in the literature. It looks as if that,because divisions in a multi-divisional firm are also organized by product, the organization of the Sovieteconomy is similar to a multi-divisional form rather than unitary form. However, that similarity issuperficial. From an organizational point of view, relationships between different ministries and the role ofthe center in Eastern Europe and the Soviet Union resemble the relationships between different functionaldepartments in the U-form firms: interdependence between departments is strong, coordination role of thecenter is critical, etc. On the other hand, China's multi-regional form shares several essential properties ofmulti-division firms: each operating unit (division in a firm and region in an economy) is self-contained,much of the coordination is delegated to the operating unit, performance evaluation of each unit is based oncomparisons of performance between units. One of the differences between M-form economy and M-formfirm is property (v) above, that is, the M-form economy in China is a multi-layer one, or it is on the above theoretical abstraction, we provide a general and preliminary analysis of thecosts and benefits of the M-form and the U-form hierarchies and of their implications for transition to amarket economy. The U-form and M-form organizations affect static and dynamic efficiencies as well as26
evolutionary processes of the system.33Economy of Scale, Specialization, and Industrial ConcentrationThe U-form economy was designed to explore scale economy through technology engineering andthrough specialization and division of labor.34 The U-form organization is effective in mobilizing scarceresources and concentrating on a few high priority objectives. Enterprises in the U-form economyconsistently have the following three features: a large scale of operation, a narrow scope of products, and ahigh degree of vertical integration. This leads to two significant features of the U-form economy: a highdegree of industrial concentration and a high level of regional ed to the U-form hierarchy, the M-form hierarchy is less efficient in utilizing scaleeconomies. The automobile industry in China provides an extreme example: there are more than a hundredsmall-scale state-owned auto makers in China, each producing on average about ten thousand automobilesannually. It is typical that regional governments in China control both heavy and light industries, andtherefore regions are less specialized in products and industries are less concentrated. This leads tocriticism of China's "local industrialization" for inefficient scale and wasteful duplications, and forassociated regional protectionism and segmented markets, in particular in the presence of distorted pricesand taxes (Wong, 1992).On the beneficial side, duplication may reduce vulnerability and increase reliability of supplies
33 Chandler (1966) and Williamson (1975, 1985) first analyzed the unitary form and multi-divisionalform of large organizations in the U.S. The problems with the traditional Soviet-type planning system arealso well described (for example, Kornai, 1992, and Ericson, 1991). In addition, many experts on Chinahave studied its problems from administrative decentralization, such as wasteful duplications, notexploiting scale economies, local protectionism, and market fragmentation (for example, Wong, 1987, andWu and Reynolds, 1988).
34 In all centrally planned economies the curricula of universities were designed by the center to train thelabor force for utilizing specialization and division of labor. The design of the fields of concentration hasbeen narrowly focused and students were more specialized than their counterparts in market economies.27
under uncertainty. It may also induce competition and facilitate technology diffusion into inland areas.
Furthermore, less specialization may also be more beneficial: less specialization may reduce coordinationcosts (Becker and Murphy, 1992), and less specialization may also make workers more efficient in learningand in operation, as shown by the Japanese experience (Aoki, 1986).CoordinationIn the M-form economy of China, coordination is distributed at all levels of the hierarchy: regionalgovernments have substantial responsibility for coordination in addition to the important (though notcritical) coordinating role of the central government.35 There are two reasons which favor a moredecentralized coordination vis-a-vis a more centralized one: First, to the extent that information is initiallydispersed, local governments have better information than the central government simply because they arecloser to sites. Hence the local information is better used by local governments than by the centralgovernment for regional development. Second, decentralized coordination has lower requirements forcapability in communication and information processing. The burden of communication and informationprocessing is reduced since fewer messages need to be transmitted and fewer tasks need to be coordinated.
Therefore, the M-form hierarchy has advantages when there is a high degree of complexity in an economyand the communication and information processing technologies are r, decentralized coordination may also result in inefficiency when a market is incomplete(Weitzman, 1974, Bolton and Farrell, 1990, and Milgrom and Roberts, 1992). In the case of China,interdependence between economic activities in different regions is not strong, and a more decentralized
35 In a multi-divisional firm, day-to-day coordination is delegated to divisions, which enables the generaloffice to concentrate on long-term and strategic decisions (Chandler, 1966, and Williamson, 1985).28
coordination is likely preferred to a more centralized one as in the U-form, other things being equal.36 Inthe U-form organization, industries are highly concentrated, the regions are highly specialized, andoperating units of ministries and enterprises alike are strongly interdependent. Hence, a rigorouscoordination at the center is crucial for maintaining the normal operation of the economy, and adecentralized coordination at the regional level may not be ses to External ShocksWith little or no duplication and with strong interdependence between different units in the U-formeconomy, once a shock hits one unit, which may be the only one in the economy in producing the particulartype of products, the trouble in that unit may spread to the whole economy. This implies that the U-formeconomy is more fragile to external shocks. In contrast, with many duplications and a weakinterdependence between units of the M-form hierarchy, the adverse effects of an external shock to one orseveral units on the whole organization will likely spread in a slower and weaker way. That is, the effectsof shocks in an M-form hierarchy can be effects of region-specific shocks and industry-specific shocks to the U-form and M-formeconomies are also different. In the U-form economy, regional shocks affect not only the local economybut also affect the whole economy through strong regional interdependence. The adverse effects of thecollapse of CMEA is a good example. In the M-form economy, a region-specific shock may not affect theeconomy as a whole because industries are spread out in many regions. The sustainability of the Chineseeconomy during the Cultural Revolution illustrates this point. During that period, some regional economiesin China collapsed (due to factional conflicts) but the national economy did not: national income dropped
36 The logic here is similar to Weitzman's thesis of price versus quantity (Weitzman, 1974). The moredecentralized mode of control (price in that case) is better when inputs complementarity is weak so themarginal benefit curve is flatter.29
in only two years (-7.2% in 1967 and -6.5% in 1968), and recovered quickly the other hand, since different regions have similar industrial compositions, an industry-specificshock may affect all regions but in a similar way. This may reduce the aggregate adverse effect for severalreasons: each region is better capable of dealing with the shock locally since the magnitude of the shock issmaller; regions may better adjust to new environment by learning from each other since all regions facesimilar shocks; and the incentive may become less a problem because the shock is transformed into asystematic one in the M-form organization rather than an idiosyncratic one as in the U-form organization(see below).IncentivesIn a U-form hierarchy, incentives of subordinates are designed for implementing commands fromthe above since coordination at the center has the highest priority. Agents are subject to frequent andarbitrary control by their superiors, and thus they try to avoid any changes or risks (Ericson, 1991). In anM-form organization, coordination at the center is not so critical, thus providing semi-autonomy togetherwith higher powered incentives to local governments may be optimal. Indeed, in China, local governmentshave not been subject to arbitrary control from above for tasks within their autonomy for more than twentyyears. After further decentralization in the reform, local governments have more incentive to build up theirregional empires and have less interest in promotion to a higher e the regions are self-contained with delegated authority and because different regionsengage in similar composition of activities, aggregate indicators like growth in revenue or output reflectmore on the true performance of the government than noises. Therefore, tournament or yardstickcompetition between regions is a powerful tool for providing incentives by filtering out common orsystematic uncertainties (Holmstrom, 1982). In China regional governments often take a great pride inbeing ranked in first place in a competition among neighboring regions. The public and the media also30
place great importance on such a ranking. This type of incentive would be less effective and more costly toprovide to ministries in the U-form hierarchies because idiosyncratic uncertainty is more ment Through DecentralizationIn any economy, incentives cannot be really created unless the government is able to make acredible commitment for not expropriating promised incomes and not subsidizing loss makers. Absence ofsuch a commitment was a legacy of centralized economies that led to the "ratchet effect" ("excess" profitswere constantly siphoned away, Berliner, 1957) and "the soft budget constraint" (loss makers werecontinually bailed out, Kornai, 1980). This lack of credible commitment is a fundamental problem incentralized economies because the state is too powerful to tie its hands. In contrast, credible commitmentmay be achieved under ipont and Maskin (1991) argue that dispersed banks and decentralized informationstructures can harden the budget constraint. This is because when a bank is constrained by the fundsavailable, additional financing must come from another bank. In such a case, inefficient ex postrenegotiation (say, due to asymmetric information between the new and old banks) reduces the returns andthus the incentives of the new bank from refinancing.37 This in part explains why the budget constraint isharder for township and village enterprises in China, since most of them borrow from small rural China's decentralization, many upper level government departments and bureaus wereremoved or merged, and the number of bureaucrats was cut down. According to Milgrom and Roberts(1990), this reduces information channels between the superior and the subordinates, which in turn reduces
37 Alternatively, Qian and Xu (1993) suggest that even if banks are large, as long as the projects notbeing financed exclusively by one bank, then achieving agreements among many banks is more difficult atthe time of renegotiation, which makes the budget constraint harder.31
influence costs. Thus a better commitment may be achieved as less information reaches the central government in the former Soviet Union retained strong discretionary power during itsreforms. In contrast, China's reform policy of decentralization of authority to local governments makes itdifficult for the central government to use its discretion.38 In his study of the history of economicdevelopment, Weingast (1993) emphasizes the role of decentralized political institutions in achievingcredible commitment to thriving markets by the state. The crucial aspect of what he called "market-preserving federalism" is that the central government's authority to make economic policy must be limitedand this authority must be placed in the hands of the local governments. This is viewed as the key tosolving the "fundamental political dilemma of an economic system:" a government strong enough to protectproperty rights is also strong enough to confiscate the wealth of its citizens. One of the key differencesbetween China's and Russia's reforms, as seen by Weingast, is that China proceeded in this direction butRussia did mental Approach, Learning, and Institutional ChangesIn Eastern Europe and the Soviet Union, some experiments had been introduced in their reformsbefore 1989. However, the experiments were often unsuccessful; even when they were successful in thelocal area, they were rarely promoted nationwide. Economists tend to believe that regional experiment isnot the right approach to reform a planned economy. However, one major feature of the Chinese reform isits success in using local experiments and in adopting the "bottom-up" approach (Chen, Jefferson andSingh, 1992, and McMillan and Naughton, 1992). Then a question arises: why is China so special inusing experimental approaches?
38 During the 1990 retrenchment, the central government tried to revoke fiscal revenue sharing schemesand to re-centralize investment decisions, but encountered strong opposition from the governors ofprovinces led by the Guangdong Governor and gave it up.32
In a U-form organization, with a high degree of interdependence between operating units, allowingone or a few regions to do experiments may be very costly or perhaps not feasible. This is becauseexperiments generate shocks and may disturb normal operations of the economy regardless of the successor failure of the experiments evaluated locally. This makes the scope of regional experiments more limitedand chances of success smaller. Even when an experiment was a success in a particular industry or region,its relevancy to other industries and other regions is less significant because of heterogeneity acrossoperating units. Given these features of the U-form hierarchy, economic reforms will more likely be carriedout in an "up-down" fashion, in which decisions for changes have to be more centralized to minimizetransition costs. In this sense, the U-form organization makes the institution more rigid and more difficultto change through local the M-form organization, however, the regional interdependence is relatively weak, so even afailure in the experiment will not considerably disturb the whole economy. In this case, the regionalexperimental strategy of reform in an M-form organization is less costly and more feasible. Under the M-form structure, large scale regional experiments can be carried out, many regions have a chance to developa large variety of "mutants," and the central government may be able to compare and select among variousalternatives.39 Furthermore, because adjacent regions are similar in terms of economic structure, asuccessful experiment in one region can be relatively easily promoted to other regions. Hence, under theM-form organization, reforms may proceed more efficiently with the "bottom-up" approach,40 whichprovides a less costly way of learning to establish and to use market institutions in a unprecedented
39 An important component of China's reform is the establishment of special economic zones with theexplicit purpose for experimentation.
40 However, the bottom-up approach has its own limitations, for example, in the reforms of the taxsystem and the financial system.33
environment. This makes the M-form organization more flexible in the institutional evolutionary process.416. The M-Form Hierarchy and the Non-State Sector in China6.1. Direct Effects of the M-form Hierarchy on the Non-State SectorThe M-form organization is directly responsible for fast entry and expansion of the non-state sectorunder the condition that the existing hierarchy is not destroyed in one stroke. The most relevant aspects ofthe M-form organization are those associated with the two bottom levels of government, that is, townshipand village governments in the rural area, and district and neighborhood governments in the urban area. Inwhat follows, local governments refer to the two bottom levels of ives and Authority of Setting Up Non-State EnterprisesThe major responsibility of a local government in the M-form is regional development and welfare.
Compared to their counterparts in the U-form economy, regional governments in China pay less attention tobargaining with the higher authorities because they have less to gain from bargaining within the hierarchy.
The local government has to raise revenue on its own without much help from above, and so it has strongincentives to set up and to support local enterprises for revenue generating and employment purposes.42
Some scholars even view a township or village as a "corporation," and the government of the township asthe board of directors and the management team of the corporation (Oi, 1992).
41 Experimentation under the decentralized market system is important for the growth of the West, aseconomic historian Rosenberg and Birdzell (1986) explain: "This diffusion of authority was interwovenwith the widespread use of experiment to answer questions of technology, marketing, and organization forwhich answers could be found in no other way; and with the emergence of great diversity in the West'smodes of organizing economic activity."
42 The rapid growth of the commune-brigade enterprises in Jiangsu province in the mid-1970s hadalready shown the potential of the M-form structure in the development of non-state enterprises.34
A field research found that a significant portion of the net profit of township and village enterpriseswas used for the administrative budget of township and village governments (Rural Policy ResearchDivision of the Central Committee Secretariat, 1986). In another sampling survey, researchers found that77.5 percent of the village administrative budget came from the village enterprises and that most villagegovernment officials responded that one of the major motivations for setting up village enterprises was toexpand their administrative budget (Li, 1987).A Harder Budget Constraint for Non-State EnterprisesOne pervasive problem with state-owned enterprises is soft budget constraints (Kornai, 1980).
This problem is particularly serious for enterprises affiliated with central and provincial governments.
However, at bottom levels of the hierarchy, financial resources available to local branches of the statebanks and rural credit cooperatives and to local governments are very limited, and non-state enterprises donot have easy access to subsidies and credits as do state-owned enterprises (but still better than privateenterprises). This limited power of community governments disables them from bailing out loss-makingcommunity enterprises, thus enabling them to commit to terminating troubled enterprises (Dewatripont andMaskin, 1990). Hence, the budget constraints for non-state enterprises are much harder than the state-owned enterprises. With hard (or harder) budget constraints, community governments are more consciousabout risks and profitability and, in the final analysis, the efficiency of their number of township-village enterprises that went bankrupt during the 1989-91 retrenchmentcould be used as evidence for the harder budget constraints in the non-state sector. In 1989, about threemillion township-village enterprises went bankrupt, or were taken over by other township and villageenterprises nationwide, while in the same year almost all loss-making state-owned enterprises were bailed35
out by the state.43 In 1990, the loss-making township and village enterprises accounted for 7.5% of alltownship and village enterprises and the figure dropped to 4.6% in 1991. In contrast, the loss-making stateenterprises accounted for 31% of all the state enterprises in 1990.44Horizontal Relationship Between Regions and Emergence of MarketsAn important feature, which distinguishes the M-form hierarchy from the U-form hierarchy, is thehorizontal, and potentially market-oriented, relationship between regions and between regionalgovernments, despite the fact relationship between a local government and its superior or its subordinate isstill vertical. Thus horizontal relationships between regions have developed, first, to create a condition formarket-oriented transactions and trade among enterprises across the regions and outside the planning scope,and second, to generate competition between regions for getting rich first and fast, and third, to facilitatelearning by one region through imitating another region for successful reform policies or developmentstrategies. This is how the market mechanism in China emerged at such a fast pace within the existinghierarchical contrast, in the U-form hierarchy, transactions between two enterprises must advance throughtheir common superior. The high degree of specialization requires rigorous administrative coordination andthus development of the horizontal relationship inside a U-form hierarchy may become damaging. It is thendifficult for the market mechanism to emerge and evolve within the existing hierarchical system.45Regional competition will not be efficient unless factors can move freely. During the reformperiod, constraints on capital and labor movement have been gradually relaxed, especially in the southern
43 People's Daily, Overseas Edition, March 23, 1990.
44 Zhongguo Xiangzhen Qiye, No.8, 1991.
45 Kornai (1992) is right that the horizontal market coordination is incompatible to the verticalbureaucratic system (of the U-form organization).36
coastal areas. In fast growing areas like Guangdong and Jiangsu, many non-state enterprises hire morethan half of their labor from inland provinces like Sichuan and Hunan.46 Capital poured into these areas aswell, as shown by the substantial increase in bank deposits in the last few years.47Development of Entrepreneurship and Use of Local KnowledgeWith the weak bargaining position in the hierarchy, low-ranking government bureaucrats'temptation for promotion within the hierarchy have been greatly reduced. Rather, many bureaucrats turnedto entrepreneurs, by either quitting their jobs to join a business company or running the government like acorporation. Instead of implementing commands from the above, their major job is to use their autonomouspower in making profits. Entrepreneurship is developed among many local government bureaucrats orParty cadres, a hard-to-believe phenomenon in the U-form hierarchical economy or in the hierarchicalgovernment in the market economy.48Government bureaucrats' knowledge and information about local economies and governmentpolicies, their connections with the local community, and their past experience in coordination, are allvaluable assets. In China, the existing organization is not destroyed at one stroke and governmentbureaucrats are transformed into entrepreneurs in the reform. Hence, the valuable organizational capitaland human capital accumulated and embodied in the M-form hierarchy are better utilized in developing
46 It is estimated that there are about 70 million "floating migrants" every year in recent years in Chinalooking for temporary jobs (People's Daily, Overseas Edition, p.8, March 10, 1993).
47 For example, specialized banks in Zhongshan municipality of Guangdong province borrowed about2.1 billion yuan through inter-bank loans from other regions (Qian and Stiglitz, 1993). In 1992, total bankdeposits in Hainan province (now a special economic zone) was 20 billion yuan, increased by 142.6% overthe previous year and most of the increase were deposits from other provinces (People's Daily, OverseasEdition, p.2, March 3, 1993).
48 It is not uncommon to see a person has several titles on the name card: Party secretary, Chairman ofthe Board of Directors and CEO of a township or village corporation.37
non-state enterprises (Qian and Stiglitz, 1993). This is particularly important for China because of thescarcity in its human Roles of the Central and Higher Regional GovernmentsPartly due to the unpopular political movements in the Culture Revolution, the central governmentin China has committed to economic development as the "central task" since the beginning of economicreform. The government officially encouraged people to get rich, thereby allowing some people and someregions to become rich earlier or quicker than others. The reform policies of decentralization, which can beregarded as utilizing the features of an M-form organization, strongly encouraged local governments andentrepreneurs to experiment with various alternatives and hence opened up the way for the "bottom-up" other aspects, the roles of the central government in the Chinese reform are limited. The fastgrowth of the non-state sector is not in the plan of the government, but rather almost a spontaneous processunder a relaxed political and economic environment. The central government acknowledged openly that thefast growth of the non-state sector was an unexpected surprise.49 China's case demonstrates that withcommitment to economic development and commitment to decentralization, which may not be doneconsciously, reforms can go very far even with the limited roles of the central government, given the M-form structure and incentives to lower-level government in expanding non-state ed to the central government's role in Eastern Europe and the former Soviet Union, China'scentral government is relatively passive in guiding reforms. It has not provided any coherent plan for thereform. It gives a green light for local experimentation, and it approves and promotes successful reform
49 Deng Xiaoping admitted in 1988 that the amazing growth of the township and village enterprises wascompletely unexpected and was the greatest achievement of the reform (Zhongguo xiangzhen qiye, 1989).38
measures discovered in regional experiments.50 At the same time, it also imposes limits on reforms orinstitutional changes, for instance, it continues to restrict activities of state-owned enterprises and it isagainst mass privatization. The observed gradualism in China is, to a large extent, a reflection of thesebinding limits. However, the central government is pragmatic and it accommodates its policies to the newsituation. The attitude of the central government toward township and village enterprises is a goodexample: it discriminated against township and village enterprises in the early 1980s, then turned tosupport them several years later after discovering their provincial governments are authorized to experiment with different reform measures in theirprovinces within the limits set by the central government. This helps to explain why there are largevariations in the reforms from province to province. In many cases, a higher level of regional governmentprotected their lower level governments and the non-state enterprises in time political atmosphere at thecenter turned against them.6.2. Interactions Between the M-Form Organization and Other Reform PoliciesAlthough we primarily emphasize the importance of the M-form hierarchy and decentralizationpolicies for the entry and expansion of the non-state sector in China, we also regard many other reformmeasures, such as the open-door policy, the dual price system and the success of agricultural reforms, asimportant. We argue, however, that the achievements of these measures are better understood within ouranalytical framework of the M-form Open-Door PolicyThanks to the open-door policy, foreign technology and investments come to China, and non-state
50 This strategy is known in China as the one of "groping for stones to cross the river" (mozhe shitouguohe).39
enterprises have a chance to access international markets and resources. For the enterprises which useinput supply from abroad and sell their products in the international market, the existing planning systemholds little constraint on them and they are completely market oriented. More generally, the open-doorpolicy affects all non-state enterprises. Imports of ideas, concepts, technologies, and especially,international market competition, helped to create a market environment that gradually eroded the oldplanning es between the open-door policy and the features of the M-form organization are close, andits influence for expansion of the non-state sector is significant. A crucial component of the open-doorpolicy is the establishment of special economic zones, which are experimental regions for not just attractingforeign investments, but also learning to establish and to use market institutions. In fact, all of thosespecial zones are located outside the old industrial bases and in remote areas where the central governmentcontrol is weak. This ensures a maximum autonomy of the special zones and an isolation of potentialadverse effects of experiments from the rest of the economy. A dominant majority of enterprises in thespecial economic zones are in the non-state sector. It is these special zones that pull up the neighboringnon-state enterprises as seen most strikingly in the Pearl River Delta of Dual Price SystemThe dual price system is by no means a brand new practice. It was in fact originated before 1979.
China has had two prices for grain (the official price and negotiated price) since the 1950s. During theadministrative decentralization in 1958 and 1970, a large number of small non-state enterprises emergedunder local governments' support. Because those enterprises were outside the planning scope, the marketprice on top of the planned price has to be tolerated for these enterprises' survival. In the CulturalRevolution, central planning system was crippled, and input allocations to many state-owned enterpriseswere not guaranteed by the plan. Thus, horizontal cooperation (hengxiang xiezuo) between regions and40
between enterprises, including semi-legal black markets and barter trading, started to develop within thestate sector. The dual price system of the 1980s is merely an official legalization and an increase of itsscope of the existing practice.51The dual price system has been controversial among economists. Critics emphasize its effects ofcorruption, inefficient bargaining (that is, rent-seeking), and supply diversion from the state to the non-statesector, etc. (e.g., Wu and Zhao, 1987, and Murphy, Shleifer, and Vishny, 1992). Advocates argue thatfacing a market price at the margin, the managers in the state sector will make the right decisions becausethe planned quotas becomes lump-sum taxes/subsidies in effect (e.g., Byrd, 1987, and McMillan andNaughton, 1992). We focus on a different effect of the dual price system. If for some reason the pricecannot be liberalized at one stroke, introducing legalized markets for all goods (an important distinctionbetween Chinese reforms and Eastern Europe reforms before 1989) has a critical benefit for facilitatingentry and expansion of the non-state sector, although it is at the margin and is in an imperfect way. This isbecause a necessary condition of fast growth of the non-state sector is the existence of markets forintermediate goods which include capital goods and materials. Although the state sector faces two pricesfor one product, the non-state sector faces only one price, the market price. In a more or less competitiveenvironment with market price signals, the non-state enterprises are likely to be more efficient than the statesector, which is essential for fast expansion of the non-state Success of Agriculture ReformsThe development of the non-state sector has benefitted from agriculture reforms in at least threeaspects: (i) capital accumulation; (ii) release of labor force; and (iii) creation of demands. However,surplus labor, financial savings and potential of markets by themselves cannot be transformed into growth
51 Although there were similar phenomena in the Soviet Union (Berliner, 1957), the influence there wasfar less important than that in China.41
automatically. Institutions are required to facilitate trade, and entrepreneurs are needed to organizeproduction and distribution. It is the M-form organization that provides the flexibility within the system forefficient utilization of those favorable conditions. For example, many entrepreneurs in the non-state sectorwere in fact Party cadres or former commune leaders, and their organizational experience and connectionsin the local government have been turned into assets for the non-state success of the agricultural reform itself is helped by the M-form structure. The householdresponsibility system was based on experiments initiated from regional governments (villages, township,county and province) before it was promoted nationwide by the central government. Strong motivation andinitiatives by local governments, tolerance of the central government, and rapid promotion of this system,are all made possible by the M-form organization structure. In addition, with a more decentralized system,industrial supplies to agriculture like agriculture machinery and spare parts, chemical fertilizers,transportation service, are more reliable and less vulnerable to external shocks, and individual householdsare likely to deal with competitive suppliers, not a monopoly. These seem to be different from the situationin the former Soviet Union.7. Concluding RemarksWe have provided a comparative analysis of transition from institutional perspectives, and haveaddressed issues of how initial institutional environments differ between China and Eastern Europe and theformer Soviet Union, how reform and transition strategies in China depend on institutional conditions; andhow institutional changes of decentralization affect China's transition path and outcomes. In particular, thedecentralized M-form organization has provided room for the fast entry and expansion of the non-statesector which made the economic transition relatively smooth compared to those in Eastern Europe and theformer Soviet Union. In this final section, we briefly discuss implications of the non-state sector for furtherreforms in China and lessons from the Chinese experience for other economies in transition.42
Denationalization of the State Sector in ChinaThe recent Eastern European experiences have shown that massive and fast privatization of thestate sector is rather costly. Given the initial condition of the M-form organization, it may be easier andless costly for China to follow the evolutionary approach of developing the non-state sector rather than therevolutionary approach of massive and fast privatization. Eventually, the state sector will be forced toshare a minor role in the national economy.52This has important implications for the possibility of denationalization, instead of privatization, ofstate-owned enterprises in China in the future. Denationalization is a transformation process whichincludes successful non-state enterprises taking over or merging with state enterprises; state enterprises areconverted into joint ventures with either domestic or foreign non-state enterprises; state enterprises arereorganized into joint stock companies, etc. In either case, the transformation may include the sale ofsmall-sized state enterprises or sale of parts of large- and medium-sized state enterprises.53 In fact, recentlytakeovers and mergers by the non-state enterprises have already emerged in China and reorganization tojoint stock companies has also become a fashion. With the crowding out effects of takeover, mergers andtransformation of ownership, the economy will eventually rely more on the non-state sector. This isperhaps an alternative way to privatization and a less painful path of transition for the extent that the majority of the non-state sector has community or local governmentownership rather than private ownership at the present time, China can be better described as"decentralized market socialism" according to its ownership structure (Qian and Xu, 1993). It isdecentralized because non-state properties are not owned by the central government; it remains socialism
52 Lau (1992) studied the experience of Taiwan and South Korea where the reduction of the publicenterprise sector has been achieved mainly through the growth of the private sector, rather thanprivatization of the state enterprises.
53 The denationalization process also likely incorporates spontaneous privatization.43
because properties are owned by organized communities like townships or villages (von Mises, 1981).54
What is less clear at this point is whether this type of decentralized socialist ownership is a mere transitionphenomenon, or whether it is sustainable for a long time. In any event, decentralized market socialism isclearly a unique outcome of China's gradual transition s for Other Economies in TransitionWe believe that the lessons which other transition economies can learn from China rely on thecorrect understanding of China's reforms in the first place. Our analyses have demonstrated that thesuccess of China's particular gradual reform strategies depends on its initial institutional conditions (as wellas other micro- and macro-economic environment which are not discussed here), that is, the transition is apath dependent evolutionary process. For this reason, China's experience can not, and should not, besimply copied to other economies in transition. One of the important implications of our analyses is thatthe difference in the initial institutional conditions concerning the organizational structure of the planninghierarchy should be taken into account when making policy suggestions for other countries based onChina's reform central idea underlying our theory is that, in addition to ownership, organization structure ofthe economy matters. We have discovered several important linkages between the reform process and theorganization structure of centralized economies, which have policy implications, though tentative, for othereconomies in transition. First, decentralization and deconcentration of the state sector are desirable in theirown right, and for facilitating entry and growth of private business (Aghion, Burgess, and Xu, 1993).
There are several reasons: (i) Although privatization, understood as a process of simply transferringownership from the state to citizens, might be achieved relatively quickly, privatization as a mechanism to
54 Some economists further argue that even in the state-sector, many of the Chinese state-ownedenterprises have become de facto local governments' or regional properties (see Granick, 1990).44
achieve efficient organizational structure and competitiveness is bound to be a long historical process.
Typically, privatization process per se does not automatically change industrial structure of the economy(the Czech Republic is an example). If the U-form structure is not changed, the fundamental problemsrelated to the high degree of concentration may still remain after privatization. (ii) If for some reasonprivatization will be delayed, then there is a need for explicit policies to maintain and restructure theexisting state-owned enterprises. The policies of decentralization and deconcentration of state enterprisesare beneficial in generating competition and improving performance (perhaps with an exception of thenatural monopoly industries). And (iii) decentralization and deconcentration of the state sector willfacilitate and speed up entry and growth of new private businesses, which is a vital part of privatizationboth in long run and in short run. The growth of the private sector in Eastern Europe and the former SovietUnion has so far remained limited to trade, services, and construction, while other sectors such asmanufacturing industries have not yet been much affected. The monopoly and monopsony power of theconcentrated state enterprises or newly-privatized firms are one of the major barriers to entry and growth.
Decentralization and deconcentration will reduce these barriers. In addition, decentralization of financialinstitutions also helps private firms to access credit, which is again critical for the fast growth of the , a competent and limited central government combined with many vigorous and competitiveregional governments is the right balance of power for the state in transition. This amounts to reducing andrestricting discretionary power of the central government and strengthening the local governments' authorityin regional reforms and development at the same time. The scope of the central government's authorityshould be restricted, and the central government should be competent in executing only those reformprograms that regional governments couldn't or are unwilling to do, for instance, reforms that are related tomaintaining macroeconomic stability and preventing regional protectionism. The balance of power betweenthe central and regional governments has several benefits: (i) Decentralization helps to create competition45
among regions. (ii) With less discretionary power by the central government, regional transition anddevelopment will be less affected by the fluctuations of the central government policies. This will reduceuncertainties from the political opportunistic behavior or power struggles between different factions of thecentral government. And (iii) a better commitment can be achieved with the limited discretion of the centralgovernment, so the problems of the ratchet effect and the soft budget constraints can be , given the unprecedented and complicated nature of the transition from centralized to marketeconomies, an experimental approach may be a less costly way of learning to establish and to use marketinstitutions in transition. Economic theory does not provide sufficient guidance for the transition. Othercountries' experience may be relevant, but must be adapted to the own country's situation. By thedecentralized nature of market economy and by the very nature of the transition, a large amount of bottominitiated institutional experimentation is needed to acquire knowledge in transition. Although the U-formstructure is not suitable for large scale experiments as we analyzed in the paper, it is still possible toestablish some special areas for the purpose of experimentation. To avoid interfering with the normaloperation of the economy, these regions should be located outside the old industrial bases and far awayfrom the central control, as was done in China. Alternatively, after decentralization and deconcentration ofthe state sector, the economy will be more suitable for local experiments.46
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