Protection of Property Rights as a Key to Economic Success in China

(Photo: Flickr user PaulSchliebs)
(Photo: Flickr user PaulSchliebs)

By Xingyuan Feng, Christer Ljungwall, and Yeliang Xia

This article originally appeared in the 2013 International Property Rights Index report, a project of the Property Rights Alliance.

In 2010, China became the world’s second largest economy in terms of GDP and joined the list of middle-income economies with a per-capita GDP of USD 5,432 and 6,100 in 2011 and 2012. However, a number of political, economic and social problems have created a bottleneck in maintaining sustainable economic growth. As has been seen in many other middle-income economies, this can result in a “middle-income trap”. To escape this “trap”, China must work to improve the efficiency of production factors to maintain high economic growth over an extended period of time. This is a necessary step for any country that ultimately wishes to move into the high-income bracket.

Looking back the short history of China’s reform and opening policy since 1978, one can find that the resurgence and development of the private sector has been the key to China’s economic success. Since then, the number of non-state enterprises has increased considerably. In 1978, there were only 140,000 self-employed individuals, but by 2011 there were 9.677 million of private enterprises and 37.565 million individually-owned businesses. Between 1992 and 2011, the number of private enterprises and individually-owned businesses maintained an average annual growth rate of 28.15% and 4.54%, respectively. In 2011, the number of employees in private enterprises reached 103.536 million and the total amount of registered capital of those enterprises totaled RMB 11.7 trillion. The number of employees working in individually-owned businesses reached over 57.764 million, and their total registered capital reached RMB 900.6 billion. These are only two types of non-state enterprises and do not include a range of others including limited liability companies, shareholding companies, cooperatives, shareholding cooperatives and collective enterprises. In contrast, there were only 261,944 state-owned or –controlled companies in 2011.

It is estimated that the contribution of the non-state economy (including the farming sector) to China’s GDP was between 66% -74.9% in 2011. There were 235.4 million employees in non-state enterprises, accounting for 30.8% of all employment in urban and rural areas. In contrast, SOEs accounted for only 8.8% of total employment in China. In terms of technological innovation, non-state enterprises have also taken a dominant position in secondary sectors. In 2011, non-state industrial enterprises with an annual turnover from main business activities of RMB 20 million or more have registered 131,986 patents, accounting for 65% of all patents in China. Of these, the number of patents created by private enterprises was 41,366, accounting for 26.1% of all patents, 2.5 times the number of patents registered by SOEs.

The resurgence of the private sector coincided with the gradual re-emergence and selective introduction of private property rights. Reforms began with the household responsibility system in agriculture during late 1970s, which gave farmers land use rights, but not private ownership of land. While collective ownership of land remained in effect, the conferral of land use rights to farmers greatly increased production. This kind of reform has been labeled a “Pareto improvement” in the sense that there were no losers in this reform. In fact, the origins of the household responsibility system came from 18 farm households in Xiaogang Village, a small, poor village in Anhui Province, which adopted the system illegally in December 1978. It was initlaly tolerated by local government officials, then later officially accepted and extended nationwide by the central government.

The spontaneous formation of individually-owned businesses (getihu) and private enterprises (siying qiye) in China represented the country’s next step towards private property rights. Entrepreneurs in non-state enterprises were initially suppressed, but then gradually tolerated and ultimately recognized by the government. In the early 1980s, the rural collectively owned cottage industries, also known as collectively-owned “township and village enterprises” (TVEs) mushroomed, and both rural and urban markets grew significantly. Meanwhile, individually-owned businesses emerged organically and were tolerated as they could provide supplementary production support or services that complemented state-owned enterprises and TVEs. In 1982, the constitution was amended to protect the legal status of individually-owned businesses. At the same time, many private entrepreneurs began forming larger private businesses, most of which were ‘red hat’ companies, formally collective owned, but in practice, completely private. It was only in the late-1980s that the government began to tolerate and gradually allow the existence of private enterprises. In 1988, constitutional amendments gave legal status to private enterprises, with the caveat that it should be a complement to the publicly-owned economy. In 1992, the Communist Party proposed that economies under various ownership systems coexist with public ownership in the long-term and develop together while public ownership maintained a dominant position. Since then, China’s private sector has developed rapidly. In 2004, the constitution was amended further to provides protection of citizens’ “lawful property rights.”

Another source of private sector development is privatization has taken place in China. In the early 1980s, collective ownership through TVEs gained momentum and began to compete with state-ownership. The advantage of collective ownership over state ownership was that personal liability was more visible. By the end of the 1990s, TVEs accounted for half of the country’s industrial output, yet they continued to face soft budget constraints similar to state-owned enterprises. At the very beginning, state-owned enterprises controlled resources, but later the dual-track pricing system, which lasted until the early 1990s, allowed some resources to be allocated directly to market entities like TVEs, though at higher prices. This was undoubtedly the consequence of the Pareto improvement concept. At its inception, the dual-track pricing system emerged as an ad hoc method of carrying out transactions between the SOEs and TVEs, spurred by the potential for profit in the market. The central government attempted several times to stop these transactions, but it was unable to effectively eliminate the dual-track system. In the end, the central government recognized such a system.

The actual economic development shows that there was an efficiency gap between enterprises with different ownership models. Private ownership outperformed all others and eventually led to two waves of privatization. The first wave took place more or less between 1992 and 1995, during which the reform of state-owned enterprises was characterized by a “transformation of operational mechanisms” while collective enterprises were more transitional, involving full or partial privatization.

The second wave began after 1996, when state-owned enterprise reform was characterized by a modernization of corporate structures. A policy of “managing large enterprises well and being flexible toward small enterprises” allowed many collective enterprises to privatize.

Since 2006, renationalization sped up with a government policy of creating mega SOEs through the merging of existing SOEs that could be global players. With this, SOEs strengthened their positions while government imposed monopolies that controlled the upper streams of industrial chains. They also dictated the ‘market prices’ of basic resources such as petroleum while private companies and consumers were forced to accept them. SOEs also began to acquire private enterprises or enter competitive sectors almost without any competition. In China, SOEs can be established by government order without the need for legislative approval. State-owned petroleum companies also launched campaigns to expand in the retailing sector by acquiring or forcing privately owned gas stations out of business. The monopoly of SOEs is even protected in the 2007 Anti-Monopoly Law, which states that government imposed monopolies in sectors that are essential to the national economy or ‘security of the state’ are exempted from the law.

Does China really need SOEs to safeguard the national economy or the “state security”? The answer is no. On the whole, SOEs remained profitable between 2001 and 2009, but according to a report by the Unirule Institute of Economics, more and more made losses in 2010. The reason is that SOEs paid very little or even nothing for land and raw materials, paid less interest on loans, less tax, and received massive government subsidies. When all of these are put together, the total is greater than the profit on the book. This is enough to prove that we cannot rely on SOEs, which are clear loss makers, to safeguard our economy and our future.

At the same time, government has relied too much on increases in fiscal spending to maintain high economic growth. The fiscal stimulus package of 2008, which totaled RMB 4 trillion, marked a speeding up in fiscal spending. The central government encouraged local governments to establish many local financing vehicle companies to raise debt and finance local spending in 2009. As a result, the total balance of direct and indirect debt held local governments today is at least RMB 24.7 trillion, or 47.56% of GDP. Total government debt reached RMB 46.48 trillion in the end of 2012, making up 85.65% of GDP.

Renationalization and excessive fiscal spending not only led to the crowding out of private investment and private sector development, it also delayed the adjustment of ownership and industrial structures in the Chinese economy. A slowing in external demand for Chinese goods and services as well as increases in labor costs, manufacturers in coastal areas are facing a crisis. Similar to other countries, this economic slowdown is part of a long-term trend after years of high-speed growth. High levels of debt financing makes it almost impossible for the government to launch a new wave of large-scale economic stimulus programs as it would affect fiscal stability. In May 2013, the National Development and Reform Commission (NDRC), formerly the Planning Commission, submitted a new urbanization plan to the State Council that would cost RMB 40 trillion. This plan is said to have been sacked by the new Premier Li Keqiang over worry of China’s debt situation. The National Audit Office released a new report on government debt in 36 local jurisdictions. According to the report, the ratio of government debt to local GDP at the end of 2012 was over 100%, reaching as high as 188.95% of the 15 audited provincial capital cities. The default rate exceeded 10% in two provincial capital cities, reaching 16.36%. 20% of repayments by local financing vehicle companies in the 36 jurisdictions were financed by new borrowings, which suggests high financial risk. Since most of the borrowings are bank loans, the banking sector has accumulated a high number of non-performing loans. Non-performing loans are mainly hidden in new loans following loan restructuring. Fiscal risks that spill over to into financial risks create a precarious situation that could lead to a fatal collapse of the financial system.

Furthermore, Chinese urbanization is pressing forward at the expense farmers’ property rights. Land allocation is being carried out on a massive scale with farmers being compensated the very minimum possible. Future urbanization should take farmers’ property rights into account and be pushed forward in full cooperation with the private sector.

In summary, the only way out of an all-out crisis is to boost private sector development and better protect the property rights of farmers and private entrepreneurs. Policies should include the introduction of an independent judiciary that guarantees citizens the ability to protect their property rights against government discretion, local democracy to increase government responsibility and fiscal transparency, privatization of SOEs and state-owned banks, free market entry of non-state enterprises in all economic sectors and the financial sector, new public management which allows more private participation in public infrastructure, and land reform which at the very least allows land transfers at fair market prices and enforces land allocation based on due process and proper compensation.

Xingyuan Feng is Vice Director of Unirule Institute of Economics and Professor of Chinese Academy of Social Sciences in Beijing, China. Christer Ljungwall is Associate Professor at Department of International Economics and Management, Copenhagen Business School. Yeliang Xia is a Professor at the School of Economics of Peking University, Beijing, China.