Lecture 2. The gradual approach to reform and the flexibility of China’s

administrative organization.

1. Introduction.

• Reforms started in the countryside in 1978 with decollectivization and the introduction of the household responsibility system. No real reforms were enacted in cities.

• After the success of decollectivization (agricultural output increased by nearly 60% between 1978 and 1984, township village enterprises were a big success), in 1984 reforms started in cities: dual-track price liberalization and increased autonomy to state-owned enterprises.

• Privatization and enterprise restructuring only in the nineties and very gradual. Banking reform only started to be handled seriously in the last few years and is still ongoing.

1. Introduction.

• This illustrated Chinese gradualism in the transition.

• While in Eastern Europe, there was strong emphasis on creating irreversibility and moving fast on all fronts (big bang approach), in China there was emphasis on flexibility and cautious experimentation.

1. Introduction.

• Much of experimentation was local.• Special economic zones were set up in 1980 in

Shenzhen and a few other places and were isolated from the rest of the economy.

• Decollectivization had started in Szechuan province earlier and had positive results.

• Other examples. • The Chinese form of administration helped as central

planning was organized on a territorial basis.• We analyze 1) logic of gradualism in reform process, 2)

flexibility of Chinese form of government administration.

- Assume infinite horizon with discount rate d- Assume two reforms, R1 and R2. Each reform i yields a positive aggregate NPV outcome Oi

Gi with probability pi and a negative aggregate NPV outcome Li with probability (1- pi). => Aggregate uncertainty- Assume that each reform has a reversal cost xi and define x = x1 +x2

- Default payoff is 0. - Assume that after one period of implementation

of partial reform, the NPV payoff is < - xi so that after partial reform there are only two options : go back or go forward. After one period, O1+d ,, <0d

=>Complementarities.

- Compare 2 strategies : Big bang (try two reforms at once) and gradualism (try reform 1 first and possibly try reform 2 one period after.

- Expected payoff under big bang:

)(,max)()1()( 2121 OOERREBBE

After reform 1 has been implemented and its outcome O1 (G1 or L1) observed, define the expected value of reform continuation E(RC):

1111

21211

)()(

),max)()1()(

LRCEbutGRCEAssume

OOEROEORCE

Expected payoff under gradualism:

)(){1()()()1()(

,

)()1()()(

)1()()()1()(

1111

1111

11111

LRCEpBBEREGRE

Therefore

LRCEpGRCEpBBE

writecanwethatNote

pGRCEpREGRE

> 0

Delayed big bang

Option value of early reversal

>0 or <0

• When d -> 1, gradualism dominates big bang if and only if option of early reversal has value.

• Option value of early reversals increases expected payoff because lower cost of experimentation!

• Gradualism thus makes it easier to start the reform process.

• Experimentation has been key element of Chinese reform strategies. Helped to start the reform process as soon as 1978. More ambitious reforms were then politically not possible.

Complementarities and reform momentum.

Gradualism not optimal without complementarities when reformsare statistically independent. E(R1,R2)=E(R1)+E(R2)

If no complementarities, optimum is no reform, full reform or partial reform.If for example at most reform 1 will be implemented.

With complementarities, reform 2adopted if E(RC/O1)>-x1, i.e. if

0)( 2 RE

0)}(,max{)]()[1( 211211 REOREO

- Keep positive outcome - save on reversal costs

Complementarities: swallow “bitter pill” to keep “sweet pill”.=> Sustain momentum via adequate sequencing.

China: decollectivization followed by price and enterprise reform. Family farming from 1% in 1979 to 45% in 1981 and 90% in 1984 and agricultural output went up by 56% (Lin, 1992). This created support for urban reforms (Naughton, 1995, Qian, 1999).

This also gives idea about reform sequencing: better to start with reforms with a higher probability of a positive outcome so as tocreate momentum.

Goes against standard political economy of stabilization where it is better to start with difficult reforms.

• Now that we understand the option value of early reversal and the value of experimentation under aggregate uncertainty, we can understand a feature of Chinese administration that further increased this flexibility.

• Central planning system in China was organized by provinces whereas in the Soviet Union, it was organized by sectors (functional ministries).

• The Chinese system, also present in former Yugoslavia and in USSR under Khrushchev (1959-1964) was criticized for duplication and lack of economies of scale but this turned out to be an advantage in reform.

• There is a strong analogy between the organization of central planning in China and the M-form organization and the USSR and the U-form organization. (Chandler, 1962, Williamson, 1975).

M-form U-form• Assume 2 regions A and B and 2 reforms 1 and 2.• Without reform, status quo NPV payoff in each region is

½.• Only one blueprint of reform available per period. It is

good with probability p, in any region at any time, and bad with probability (1-p). Has NPV of 0 if bad (worse than status quo).

• Good blueprint can however also fail due to bad coordination in implementation. Coordination of “attribute shocks”.

• Example: Coordination of enterprise restructuring and creation of social safety net. Attributes of laid off workers: age, seniority, skills, family composition, current wage, … Attributes of social safety net: rules of eligibility, rules of benefits, type, administration, technical support, …

M-form U-form• Assume extreme complementarities in coordination of

reform. We compare not only reform strategies but also coordination capacities under M form and U form.

• Information between any two managers from different units on attribute matching transmitted correctly with probability l 7 {0,1}. Noise is independent across tasks and time.

• NPV Payoffs for region A (B defined symmetrically) when blueprint is good: with change in both reforms, G/2 if matched and 0 otherwise.

• pG assumed >1.• Reform blueprints come for free but setup cost C per

manager who coordinates.

A U-form organization

Top manager

decides reformcoordinationsetup costs

Manager 1 Manager 2

Task 1A Task 1B Task 2A Task 2B

informationflows

A M-form Organisation

Top manager

decides reform

Manager A Manager B

Task 1A Task 1B Task 2A Task 2B

Coordinationsetup costs

Coordinationsetup costs

)1(1)1( 22 p

pGppG mm

Compare first M form and U form with big bang reform.Expected payoff if reform in M form is:

On the cost side, 2 managers are involved in coordination:

)1(1

2)1(2 22 p

CcpCc mm

)]1()1([1)]1()1([

)]}1()1([1)]{1(1[

])1(1[

])1(1[2)1(

2

)1(])1(2

)1(2[

22222

2

222

222

2

2

222

2222224

2

pp

CcppCc

pp

pG

GGwhere

pG

Gp

uu

u

uuu

Under the U form:

One sees that the M-form benefits from advantages in coordination but disadvantage in costs.

2222 , umum cc

Relevant parameters are l and C. When l -> 1, U2 dominates M2 and when C -> 0, M2 dominates .

Trade-off between better coordination in M formbut duplication of setup costs.

Compare now big bang and gradual approach withinM form. Reform tried in one region yielding payoff of(1-d)(G+1)/2 in the first period if the blueprint is good. In thesecond period, the reform is extended to the other regionyielding a per period payoff of (1-d)G. If the program is bad, A will get 0 and the non experimenting region will get (1-d)/2. A new experiment will then be tried the next period. The expected payoff under gradualism is:

)1(1

)1(])1([

)]1(1[2

)1()1(

]2

1)[1(]

22

1

2[

11

11

p

pCcppCCc

p

Gp

pGG

p

mm

mm

)1(12

1)1()1(

)()( 221121

p

pGpC

ccMM mmmm

C(1-p)d is the option value of waiting to implement the reformin the second region. One economizes on setup cost in oneregion in case the blueprint is bad. Close to option value of early reversal seen above.(pG-1)(1-d)/2 is expected cost of delay in implementing reformsin both regions under gradualism.If the former dominates, gradualism is better and vice-versa.Gradualism better if p low, C high, G not too high and d low (learning not too fast).

• Note that the U form does not have the flexibility of the M form. Complementarities and difficulties of coordination make gradualism dominated. Moreover, no option value of waiting since set up costs bourn at the center.

• When l is close to 1, then U2 >max[M1, M2]. Indeed, coordination disadvantage are minimal and advantages in setup costs.

• When l is small and C is large, M1 will dominate because of option value of waiting and good coordination.

• Parallel experimentation: fast learning despite larger costs.

The Chinese experience

• Experimental and gradual approach was a major feature of Chinese strategy.

• Household responsibility system tried in Anhui province in Fengyang county. Households contracted with local government to deliver fixed quotas under household farming.

• Special economic zones. Started in 1980 with 4 zones: Shenzhen, Zhuhai, Shantou, Xiamen. M-form structure made it possible for local governments to coordinate activities across all industries as the zones were insulated from the rest of the economy. Many of the successful practices of special economic zones were adopted nationwide.

The Chinese experience

• Privatization of SOEs also started with local experiments in the early nineties in Guangdong, Szechuan, Shandong provinces. County governments were in charge of coordination of complementary policies (changes in corporate governance, ownership structure, debt consolidation,…)

• Layoffs in SOEs also based on experimental approach in managing layoff and redeployment of labor force, social welfare management.

Chinese experience

• Useful to contrast differences with Russia. Under U form, MTS stations for tractors, different ministries responsible for input delivery, storage, transport,…At least 8 different ministries responsible for farming. Local coordination structures were created (RAPO) but conflicted with U-form line of authority.

• Reforms in agriculture also had big coordination failures. Coordination of land sales, upward, downward linkages, transport and infrastructure,…