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The Role of Local Government and Economic Developmentin Decentralization in China

Gangming YuanProfessor, Institute of Economics,

Chinese Academy of Social Sciences

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The evolution of decentralization in China

• Fiscal decentralization (1980-1993) • Recentralization (1994-2002)• Investment decentralization (2003-now)

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Fiscal decentralization (1980-1993)

• Economic reform in China since 1978 has been characterized by decentralization

• The decision-making power of the central government shifted and dispersed to local governments.

• Local governments have vigorously expanded their regional economies in response to this decentralization.

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Criticism of decentralization

• Fiscal decentralization gave excessive stimulation to local governments, resulting in misallocation of resources

• Local investments repetitive and excessive.• Local governments’ administrative protection,

market segmentation• Unconstrained expansion of local economies• Resulted in investment overheating and

macroeconomic fluctuation

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Criticism from two sides

• Planned economy view: Decentralization weakened the central government’s competence for centralizing fiscal resources and control of the macroeconomy

• Market economy view: The decentralization was administrative, not market competitive, deviating from the direction of market reform.

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Recentralization (1994-2002)

• In 1994, fiscal decentralization was cancelled.

• Central government share of revenue increased, local government share reduced

• Central government share increased greatly from 22% in 1993 to 56%

• Local decision power taken back by the central government

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The increased share of central revennuesince 1994

0

10

20

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40

50

60

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

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2008

%

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The decision-making power concentrated in the central government

• In 1998, the decision-making power of local branches of state-owned banks for loans was returned back to the banks headquarters.

• Decision-making powers for the key investments in the locals were concentrated in the central government.

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The worst macroeconomic performance in recentralization

• The expanding enthusiasm of local investments disappeared

• During 1998-2002, all indexes, including growth rate, investment, consumption, income, price, employment, worsen:– The rate of GDP increase was 8.2%, 2 percentage

points lower than the past period 1978-1997.– The increase rate of investment below 10%. – The price index drop to negative.– The rate of unemployment rises to more than 4% from

lower than 3%.

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Local investments expansionduring the conflict (2003-now)

• Since 2003, local investments have been vigorously reviving.

• Local investments boom in steel, cement, aluminium, electricity, coal, etc.

• Scale and speed of local investments exceed central investment

• Macro-management department opposes strongly local investments expanding

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Macroeconomic performance

-20-10

010203040506070

%

GDP price investment

fiscal decentralization recentralizationinvestment

decentralization

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The criticism from macroeconomic management department

• Local investments are expanding excessively, causing economic overheating and bottleneck tension

• Local investments expanding at a low level, causing industrial structure degradation.

• Local investments expanding blindly, causing a surplus of production capacity

• Local investments have been supported and protected by local governments, violating rules

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Arguments for local investments

• Not causing economic overheating• Not expanding only at low levels• Not blind• Not violating rules• Governance improved• Self-restrained

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Local investments not causing economic overheating

• Macroeconomic performance has been good• China's economy has been growing at more

than 10% for 5 years continuously • Bottleneck restrictions such as energy,

transportation, steel, cement, etc. have eased• No inflation• Indicators such as residents income,

consumption, employment have been the best since 1997.

• Efficient management of local governments, has undoubtedly played an important role.

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Local investments not expanding only at low levels

• Local investments have increased production capacity, for example, in steel: industrial, advanced, and high-quality technology

• High-standard product technology, conserving energy, using better material, environmental protection

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Local governments and local investments not blind

• Local governments support local investments, gauging market dynamics, and swiftly seizing development opportunities.

• Pay more attention to the long-term investment project and strategic meaning.

• Expect to get steady, continuously, high-efficiency development, occupying the forefront in categories such as scale, technology, quality, benefit, etc..

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Local investments not causing production surpluses

• The total amount of steel production countrywide break yearly targets set by the management department, from 150 million tons to 450 million tons.

• Electric, coal, cement, aluminium etc. similar.• The output of products increased in a large

amount has covered the shortage. Local investments have made the contribution.

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Amount of steel production

0

50

100

150

200

250

300

350

400

450

500

Nov-02

Jan-03M

ar-03M

ay-03Jul-03Sep-03N

ov-03Jan-04M

ar-04M

ay-04Jul-04Sep-04N

ov-04Jan-05M

ar-05M

ay-05Jul-05Sep-05N

ov-05Jan-06M

ar-06M

ay-06Jul-06Sep-06N

ov-06million tons

Limited line

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• Local investment enterprises and local governments pay attention to market trends and the overall situation of industries more than the department of central government.

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Opinion differences on local investments in hot industries

• Central department: producing or aggravating production surplus and vicious competition.

• Local governments: efficient exceed the inefficient in competition, favorable to development of the industries.

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Local enterprises regulated by central department, from limited to accepted

• Local enterprises expanding, growing into leading enterprises

• Central department warning and limiting at first, accepting finally

• TV: Changhong (长虹）

Car: Cherry（奇瑞）, Jili（吉利）

Mobile phone: Bird（波导）

Steel：Sha steel（沙钢）, Jian Long（建龙）, Laigang（莱钢）, Hualing（华凌）

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Local investments not violating rules

• In the interest of local development and environment

• Local governments supervise and control illegal and low quality investment strictly, initiatives exceed the capability of the central government.

• Local governments do not provide the protection for investments with low efficiency and high pollution.

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Investment in rules compliance

• Local governments ask local investments to comply with the rules

• A tragic case: Central government punished severely Tieben Steel Plant (铁本）for violating rules in 2004.

• Local governments have understood, do not grossly violate the rules.

• The costs of violating the rules for large-scale investments are enormous.

• Local investor consciousness for following the norm is very strong

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Rationality and efficiency of local government’s decision

• Local governments support local investments warmly, is rational.

• Wishing eagerly to improve public service ability through local industries' development.

• As sharp as entrepreneurs, courageous and resolute, swift, efficient

• Rationality and efficiency of local government’s decision in supporting investments are far higher than central departments

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Local governance improved

• Local governments obtain abundantly more information than the central government .

• Local investments approved by local governments have obvious stimulation and market mechanism constraints.

• Local investors assume sole responsibility for returns and losses of investments.

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Local governments self- restrained

• Local governments have enthusiasm in supporting local investment expansion, also have self- restrained response to economic fluctuations to evade risk

• Reduced investment, which is the effect of the central government’s regulation for preventing overheating, but more a function of self-restrained behavior of local investments.

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Steel investment growth

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200

Nov-02

Jan-03

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Sep-03

Nov-03

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May-06

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Nov-06

%

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Dilemma of decentralization

Decentralization strongly stimulates the vigor of local economies

but may bring macroeconomic overheating and fluctuation

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The conflict intensifies and eases

• In 1994, the problem was resolved by cancelling decentralization and recentralization.

• In 2004, the conflict between decentralization and recentralization have occurred and intensified.

• Since 2005, the conflict easing, investment decentralization has been maintained

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Tieben Steel Plant in Jiangsu province was closed in 2004

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Shagang(沙钢）in Jiangsu province, the largest nonstate-owned steel plant, is expanding

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The tragedy of recentralization not replayed

• Local governments and local investments self- restrained behavior, relieving the conflict

• Local governments and enterprises are vigorous, while also self -restrained.

• The tragedy that excessive local expansion resulted a returning of concentrated powers has not been replayed