Economic Reforms and Development in China : Volume 1 [1 ed.] 9789814332484, 9789814332163

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Selected Works of Cheng Siwei:

Economic Reforms and

Development

in China Volume 1

Cheng Siwei

i

Selected Works of Cheng Siwei This book, in three volumes, presents the thoughts and reflections of the highly regarded Chinese scholar and statesman, Cheng Siwei. The author outlines his theories for bringing economic reform to China in the context of a global economy. Using the principles of complexity science and finance, the author also elaborates on the characteristics and laws of fictitious economy in China and from this perspective, studies such issues as venture capital, financial crises, capital and monetary markets, inflation and deflation, housing system reform, the social security system and enterprise management in contemporary China. The book has been highly regarded by top-ranked Chinese politicians and distinguished scholars and is essential reading for anyone wishing to understand the economic complexities of the development of China.

Published by Enrich Professional Publishing (S) Private Limited 16L, Enterprise Road, Singapore 627660 Website: www.enrichprofessional.com A Member of Enrich Culture Group Limited Hong Kong Head Office: 1/F., Lemmi Center, 50 Hoi Yuen Road, Kwun Tong, Kowloon, Hong Kong, China Beijing Office: Rm 1108A, Culture Plaza, No. 59 Zhongguancun St., Haidian District, Beijing, China

English edition © 2011 by Enrich Professional Publishing (S) Private Limited Chinese original edition © 2001 China Renmin University Press Originally published in 2001 by Oxford University Press and The Hong Kong Polytechnic University All rights reserved. This book, or parts thereof, may not be reproduced in any form or by any means, electronic or mechanical, including photocopying, recording or any information storage and retrieval system now known or to be invented, without prior written permission from the Publisher. ISBN (Hardback) ISBN (ebook)

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This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Enrich Professional Publishing is an independent globally minded publisher focusing on the economic and financial developments that have revolutionized new China. We aim to serve the needs of advanced degree students, researchers, and business professionals who are looking for authoritative, accurate and engaging information on China. Printed in Hong Kong

Contents Foreword to the 2001 Edition . . . . . . . . . . . . . . . . . . . . . . . . . . . vii Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xi

Acknowledgements to the 2001 Edition . . . . . . . . . . . . . . . . . . . . . . xv

Chapter 1 The New Economy and the Development of China in the

Twenty-First Century . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

Chapter 2 Venture Capital Business and its Emergence in China . . . . . . . . . . . . . . 33 

Chapter 3 Fictitious Economy and the East Asian Financial Crisis . . . . . . . . . . . . . 67                    

Chapter 4 An Analysis of the Complexities of Enterprise Management and

its Implications for China . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109

Chapter 5 The Theory and Practice of Managing Enterprises by Government . . . . . . 149

Chapter 6 Establishing an Adequate, Equal, and Effective Social Security System

for China . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183

Chapter 7 A Systematic Analysis of the Housing Reform in China’s Urban Areas . . . . 219

Chapter 8 An Analysis of China’s Rural Consumer Markets . . . . . . . . . . . . . . . . 263

Contents

Chapter 9 Devoting Major Efforts to Developing China’s Multinationals . . . . . . . . . 297

Chapter 10 Strategic Directions and Policy Implementation for Reforming China’s Institutional Units . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375 Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 385

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Foreword to the 2001 Edition This is a monograph dedicated to theoretical and practical issues surrounding China’s economic reforms. It grew out of the creative research of a distinguished Chinese scholar, Professor Cheng Siwei, who is also Vice Chairman of the Standing Committee of the National People’s Congress of the PRC. China began its reform program about 20 years ago, and since then its economy has grown fast and people’s living standards have improved significantly. Indeed, China’s market economy has enjoyed unprecedented prosperity. As a long-term strategy of development, however, China’s reforms and opening-up is a necessarily complex and arduous task that demands careful thought and study. The objective of such a study is to come up with a theoretical framework that can integrate international experiences and Chinese characteristics, and to find a form of development that can cater to China’s realities. To this end, Professor Cheng has been working hard and the result is his impressive research output, which has provided valuable insights into China’s economic development and structural reform. We are delighted to see that much of his knowledge, wisdom, vision, and spirit have been woven into this fantastic book, and we firmly believe that its publication will be of great significance. What strikes us most is Professor Cheng’s pioneering research in venture capital. Indeed, the rise and development of China’s venture capital industry is much indebted to his unremitting efforts. Today, Professor Cheng is already a big name and has even been called ‘the father of China’s venture capital industry’. As early as 1981, when he went to the United States for further studies, he began to be interested in the development of venture capital and its role in promoting high-tech industrialization. He immediately sensed the future prospects of the industry and proactively proposed to introduce it to China. When he returned to China in 1984, he began to practice his ideas and to study actively the issues surrounding the development of venture capital in China. Later, he was invited to participate in a research program on venture capital in the United States. To date, Professor Cheng has published widely and delivered many important speeches, elaborating on the role of venture capital in China. In 1997, he organized and presided over an international symposium on

Foreword to the 2001 Edition

venture capital operations, which laid the theoretical foundation for the practice in China. In 1998, at the Ninth National Congress of the Chinese People’s Political Consultative Conference, be and his Central Committee of China Democratic National Construction Association raised a ‘proposal to speed up the development of venture capital operations in China’. As the ‘Number One Proposal’, it received wide attention from the participants, which was then echoed throughout the country. In the proposal he made it clear that China should create a legal environment favorable to the development of venture capital, provide preferential policies, and reform the personnel system to cater for the new needs. In recent years, he has been committed to the legislation of venture capital and worked tirelessly for its development. Today, venture capital is already a hot topic in China and plays an increasingly significant role in the market economy and development of the high-tech industry. Professor Cheng is a man of great learning. His research covers many economic disciplines. In this book we can also sense his strong interest in the emerging complexity science, the ‘science of the twenty-first century’ in the eyes of many scientists. It tries to use system theory and scientific means to study complex issues surrounding social development from a broad perspective. Because of its depth and breadth of research, such an approach is more scientific and practical than any other existing form of research study and can therefore create a better social effect. Professor Cheng has also taken up the fictitious economy as a research subject. Based on a systematic analysis, he has proposed to strengthen macro control of the fictitious economy and bring into full play China’s economic advantages, vigorously promote the growth of the high-tech industry, and ensure the healthy development of the real economy. In this book, in-depth research and penetrating analysis can be found on many other practical issues currently evolving in China’s economic reforms. This has much to do with his role as the Director of the Management Science Department of National Natural Science Foundation. It was a result of his proposal that a contingent research fund was set up in the latter half of 1997 to support research programs in management science with practical significance. Since then, 16 projects have been initiated, and many of them are practice-oriented studies. Stepping into the twenty-first century, China’s economic development is facing the challenge of economic globalization and the knowledge economy. With imminent accession into the World Trade Organization (WTO), China will be facing more opportunities and greater challenges and turning over a new page in its history. The development of China at this time calls for an appropriate guiding theory, and in the same way, China’s reforms in the new age demand continuous innovation of economic theories. An increasing number

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of insightful people are expected to study the practical issues in the economic field and to contribute their talents and wisdom to China’s economic reform through down-to-earth work. Without doubt, the publication of this book will lend impetus to such a move, and I firmly believe that the readers will feel the same gratitude and respect for Professor Cheng’s contribution. The Hong Kong Polytechnic University and I feel proud of our opportunity to help Professor Cheng in the publication of this masterpiece. Professor Cheng is closely associated with our university: he is an honorary professor as well as an honorary graduate of the university. At present, he is working with us on several research programs in venture capital operations. In 2000, he made a personal visit to our university and gave an extremely successful open lecture. During his stay at our university to receive his honorary DBA (Doctor of Business Administration) degree, he took the opportunity to visit the Hong Kong Secondary School, his alma mater . At his meeting with the faculty and students, he talked about the three turning points in his career and his motto in life. He said, ‘We need to be upright in conduct, conscientious in work, and industrious in research’. When he became Vice Chairman of the Standing Committee of the National People’s Congress of the PRC, he placed even higher demands on himself: ‘more study and less talk, more learning and less socializing, more consultation and less assertion, more earnest work and less public appearance’. His speech moved and excited everyone at the meeting. To conclude, Professor Cheng is a scholar of great learning, and at the same time, he is an outstanding statesman and leader of a democratic party. He has succeeded in combining two roles in his career, and is leading a most fulfilling life. On the eve of publication, I write down these words as congratulations. Let me wish great success to Professor Cheng’s book, and great achievements for China’s economic reforms and development. Poon Chung-kwong, PhD, DSc, JP President The Hong Kong Polytechnic University 2001

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Preface Before you is a book written by a Chinese scholar who is the Chairman of International Finance Forum, the Chairman of the Association for Soft Science of China, the Director of the Research Center on Fictitious Economy and Data Science of the Chinese Academy of Sciences, the Dean of Institute of Management at the Graduate University of the Chinese Academy of Sciences and the Director General (1996 – 2004) of the Management Sciences Department at the National Natural Science Foundation of China; a statesman who was a Vice Chairman of the Standing Committee of the 9th and 10th National People’s Congress; and a democratic party leader who was the Chairman of the 6th, 7th and 8th Central Committee of the China National Democratic Construction Association. The book grew out of my research on China’s economic reform and development. Looking back, there have been three turning points in my career. The first was my decision to go back alone to mainland of China from Hong Kong in 1951, which laid the foundation for my dedication to the motherland. The second was my study of business administration in the United States in 1981, which broadened my research fields. The third was joining the China National Democratic Construction Association in 1995, which marked the beginning of my political career. For decades I have followed the principle of ‘being upright in behavior, conscientious in work, and industrious in research’, and have dedicated myself to the complete reunification of the motherland with Hong Kong and Taiwan and revitalization of the nation. Serving the motherland is the ultimate objective of any academic study or political career, and academic study is surely the foundation of political career. To this end, I have been working with my colleagues in management sciences to deploy a complexity science approach to the study of issues on China’s economic reform and development, to expound the laws of development and characteristics of the fictitious economy, and to promote the venture capital business in China. I have strived to be specific, timely, and practical in all studies and to ensure that all of my proposals are feasible in technique, reasonable in economy, permissible by law, operational in implementation, realizable in schedule, and acceptable in politics. This is an effective way to minimize interference and obstacles in implementation. In my research approach, I have integrated quantitative analysis with qualitative studies, innovative ideas with solid data. Complexity science holds complexity and complex systems as its object of study. It is a new phase of the development of system science, and is often

Preface

referred to as the science of the twenty-first century. By drawing on the achievements of physical and biological complexity studies, as well as on mathematics, economics, and behavior science, I have applied and developed such approaches and tools as quantification of qualitative variables, group decision-making, evolutionary computation, and mathematical logic to discuss a number of complex and pressing issues in China. These issues include enterprise management, housing system reform, the improvement of the social security system, the reform of institutional units, the development of the rural consumer market, fostering Chinese multinationals, revitalizing township enterprises, developing western China, urbanization, the challenges of the knowledge economy and economic globalization, formulating antimonopoly policy and energy policy, the methodology of economic planning, the transformation of bonded areas to free-trade zones, etc. The fictitious economy is a model of economic activity corresponding to the real economy in the economic system. It refers to the economic activities relative to the circulation of fictitious capital mainly on the financial platform and all relationships thus generated. At present, the total volume of world’s fictitious economy is growing rapidly and has exceeded that of real economy. With the principles of complexity science and financial engineering, I have been attempting to elaborate on the characteristics and laws of the development of the fictitious economy, and from this perspective to study such problems as chaos and self-organization in capital and monetary markets, financial crises, inflation and deflation, reform of commercial banks, rural finance, futures and financial derivatives, exchange rate of Renminbi, real estate finance, etc. In recent years, I have studied project screening, the development of business plans and venture enterprise management, and the strategy, legislation, and policy of Chinese venture capital development. Regarding the development of non-governmental venture capital, our proposal is for the government ‘to encourage rather than to control, and to guide rather than to interfere’. This book in 3 volumes is a collection of 30 papers. 15 of them are based on further analysis of the findings of hundreds of researchers under my leadership regarding the three fields mentioned above. Another 15 papers are based on my personal research and thinking. Some papers have been previously published in the Contingency Research Series on China’s Economic Reforms and Development sponsored by the National Natural Science Foundation of China and a number of journals, such as the Journal of Management Sciences and Economics Affairs , while some are first published in this book. Despite the fact that these papers cannot fully represent my current ideas, and some predictions may not be necessarily correct, they remain unchanged in this book so that the reader can

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follow the evolution and development of my academic concepts. In line with the notion that ‘when we present our views vehemently we cannot expect everyone to be satisfied and when we perform our duties we should always seek a clear conscience’, I have not only publicized my ideas in books and papers, but also provided suggestions and advice for the top leaders of the Communist Party of China. In addition, I practice what I preach in my work with the Standing Committee of the National People’s Congress and the Central Committee of China National Democratic Construction Association. As a scholar, the purpose of my academic study is to provide support rather than to replace the government in decision-making. By discussing theoretical issues, evaluating international experiences, improving overall frameworks, and analyzing the difficulties of implementation, we can promote scientific and democratic decisions. As a political figure, I need to apply my research findings in my legislative and supervisory work at the National People’s Congress. I firmly implement the scientific view in development, push forward the reform and opening up and observe the policy of ‘ruling the country by law’, promoting the development and stability of the country, and safeguarding the fundamental interests of the majority. As a leader of a Democratic Party, I combine my research with participation in state affairs and democratic supervision, and play an active role in China’s political life in line with the policy of ‘bearing the cardinal principles in mind, taking the overall situation into account, and making my own contributions’. Despite my tight schedule and being 74 years old, I am still enthusiastic about study. I spend at least one hour each day on reading, write at least one paper every month, and plan to publish at least one book a year. This is where I have found real joy and excitement. China is a populous country with a long history, and the majority of the population is made up of farmers. In such a large developing country, it is impractical and unrealistic to copy Western experiences. The revitalization of the Chinese nation will not be possible in this new century until we find our own way of development by integrating theory with practice. As Lin Zexu, a national hero in the Qing Dynasty, wrote, ‘How can we shirk our responsibility to the motherland for our own interests?’ My only wish is to continue working with my colleagues in management sciences for the prosperity of the country, the progress of society, and the comfort of the people. Cheng Siwei August 2009

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Acknowledgements to the 2001 Edition I am grateful to Professor Poon Chung-kwong, President of the Hong Kong Polytechnic University and Mr. Alex Tzang, Deputy President of the Hong Kong Polytechnic University for their support in publishing this book. I am also grateful to Professor Chen Gongmeng at the Hong Kong Polytechnic University for his time and effort in helping me to review the manuscripts. I would like to thank Professor Feng Zhiyan, my assistant at the National Natural Science Foundation of China, for her help in organizing the contingency research projects. Cheng Siwei, 2001

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1

Chapter

The New Economy and the Development of China in the TwentyFirst Century

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ECONOMIC REFORMS AND DEVELOPMENT IN CHINA VOL. 1

The phrase ‘new economy’ was first used in 1996, and is now widely accepted throughout the world. Confusion still exists, however, over its definition. Based on my studies, I argue that it should cover three elements: knowledge economy, the new form of social economy; fictitious economy, the new model of economic activities; and web economy, the new means of economic operation. The knowledge economy is based on knowledge, and relies directly on the production, distribution, and use of knowledge. The fictitious economy comprises economic activities of fictitious capital (including securities, futures, options, etc.) in financial markets, or simply activities of generating money through money. Its development has experienced four stages: capitalization of idle money, socialization of moneyed capital, marketization of securities, and internationalization of financial markets. At present, the fictitious economy is stepping into the fifth stage, the integration of international finance. Its system is characterized by complexity, metastability, high-risk, parasitism, and periodicity. In the knowledge-based society, fictitious economy will play an increasingly important role. The web economy is also referred to as the Internet economy. It involves such economic activities as production, circulation, and exchange through the Internet. Based on information technology (IT), it is characterized by high transparency, high innovation, high integration, increasing returns, and rapid application. The impact of the web economy on economic development can be felt in four ways. First of all, it can help reduce costs and promote competition. Second, it can increase aggregate demand and aggregate supply, and propel sustainable growth of economy. Third, it only produces a short-term impact on inflation. Fourth, most of its benefits will finally be transferred to consumers. The new economy has posed a severe challenge to the development of China in the twenty-first century. This is reflected in a number of ways. First, elimination of the economic gap between China and developed economies will be increasingly difficult. Second, inequality will be inevitable in the process of economic globalization. Third, the knowledge advantage of developed countries will turn into economic advantage. Fourth, the competition for knowledge workers will intensify. Fifth, enterprise management in China will face a severe challenge. Finally, social values will change drastically. To meet the above challenges, China needs to embrace a number of new measures. First, we must achieve a balance between efficiency and equality. Second, we must improve our productivity, realize a strategic transfer of labor force, and step up urbanization. Third, we must develop the high-tech industry, rely on venture capital for industrialization, and explore the development of the knowledge economy in developed regions. Fourth, we must encourage a large

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number of innovators, set up an incentive system encouraging learning and innovation, and improve vocational and continuing education. Fifth, we must absorb Western culture selectively and inherit Chinese culture critically. The new economy is in embryo and we need to keep a close eye on its development and changes. We need to study carefully and understand its features and laws of development. In the meantime, we should also pay due attention to its impact on our national economy and social development. We must develop a vision, bring into full play our competitive edges, seize opportunities, meet challenges bravely, and formulate a well-thought out plan. We must also work hard to build China into a prosperous, democratic, and highly civilized socialist country by the mid-twenty-first century.

THREE ASPECTS OF THE NEW ECONOMY The world economy has witnessed a number of major changes at the start of this century. The US economy has maintained its growth for 10 years since March 1991 when it went pulled out of a sluggish phase. Between 1994 and 2000, the annual growth rate was kept at 4 per cent, while the unemployment rate and inflation rate were 4 per cent and 2 per cent respectively. In 1992, the federal government deficit was US$ 290.4 billion, but in 2000 the surplus hit a new record of close to US$ 237 billion. In this context, Business Week published a series of papers elaborating the concept of the ‘new economy’. On 17 November 1997 another article appeared in the journal, reaffirming the existence of new economy in the United States. Former President Clinton disclosed the 2001 Report on 28 January 2000, and formally discussed the features and nature of new economy. On 5 April 2000, he called a meeting on the new economy in the White House, with such important participants as Alan Greenspan, Chairman of the Federal Reserve, and Bill Gates. These are the roots of the new economy. In fact, some futurists have already forecast that human society would experience a new economic form. The representatives of this thinking are Toffler, author of the Third Wave, and Naisbitt, author of Megatrends. They pointed out that human society would take a new economic form after thousands of years of agricultural society and hundreds of years of industrial society. However, scholars have divergent views on what will be the exact new form. Clinton and Greenspan, for example, call it the new economy; the OECD (Organization for Economic Cooperation and Development) calls it the knowledge economy; the US Congress and Chamber of Commerce refer it as the digital economy; and still others use such terms as information economy, web economy, or Internet economy. In China, some scholars call it the intellectual economy and spiritual

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economy. Some even refer it as the attention economy, eyeball economy, direct economy, or confidence economy. An economist from an investment bank argues that it is a ‘naked economy’ because of the high transparency of the web economy. The confusion in terminology has in fact reflected the confusion of three concepts: form of socio-economy, model of economic activities, and means of economic operation. I argue that a sound definition of the new economy should include all three aspects. In other words, the knowledge economy is the new form of socio-economy; the fictitious economy is the new model of economic activities; and the web economy is the new means of economic operation. The concept of the knowledge economy was first proposed by the OECD in 1996 in a book entitled The Knowledge-based Economy. It pointed out that knowledge economy is a knowledge-based economy and relies directly on the production, distribution, and use of knowledge. A 1996 estimate by the OECD shows that 50 per cent of GDP in major economies is based on knowledge, with research and development (R & D) taking up 2.3 per cent of GDP, education 12 per cent of government expenditure, and vocational training 2.5 per cent of GDP. As a socio-economic form, knowledge-based society corresponds to labor-based agricultural society and capital-based industrial society. The fictitious economy is a new concept derived from the idea of fictitious capital proposed by Marx in his famous work Das Kapital . It refers to economic activities of fictitious capital (including securities, futures, and options) through financial markets. Opposite to it is the substantial economy, or economic activities of capital through the market, such as commodity production, circulation, and exchange. The fictitious economy and the substantial economy are two basic forms of socioeconomic activity. Two confusing concepts are ‘virtual economy’ (i.e. economic activities with IT as their tools and network as their base), and ‘visual economy’ (i.e. computer-simulated visual economic activities). The web economy refers to the Internet economy, or such economic activities through the Internet as production, distribution, and exchange. Based on IT, its economic operation is featured by high transparency, high innovation, high integration, increasing returns, and rapid diffusion. Some might argue that the new economy is still far from a reality and that any study is redundant. I feel that any new phenomenon has a social background, and when it first emerges, its importance to the future development of society is often ignored. A high sensitivity to newly emerging things is a necessary, quality for modern people. We recommend (1) A careful study of the meaning, features, and importance of new economy on the future development

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of society. (2) An objective analysis of the challenges of the new economy on the basis of China’s realities, and proposals of possible countermeasures. (3) Advocacy of academic democracy, seeking common ground while reserving differences, and acquiring truth through a combination of theory and practice. In the following text, I will attempt to discuss the contents, features, and challenges of the new economy, and hope that more people will recognize the importance of the issue.

KNOWLEDGE ECONOMY IS THE NEW SOCIOECONOMIC FORM The knowledge economy has been a hot topic in China, and over 1,800 papers and reports have been published on the subject. In December 1997, the Chinese Academy of Social Science disclosed a report, Greeting the Era of Knowledge Economy and Creating a National System of Innovation, which immediately aroused the attention of the top leaders. However, the academic community did not reach any consensus on the definition, features, and laws of development of the knowledge economy. The major disparity is reflected in the understanding of its main contents, features, and practical importance for China. From an economic perspective, the knowledge economy has four features:

1. Knowledge-based Industries Have a Dominant Position in Industrial Structure In the history of the development of socioeconomic forms, human beings have undergone three periods. The first period was that of agricultural economy, which lasted thousands of years. With labor as its basis and land as its factors of production, the agricultural economy featured individual or collective closed production and tyrannical management. Its development was isolated or restricted to small regions. The second period was that of the industrial economy, which from the seventeenth century until the present. It was based on capital and used machines as basic tools of production. It had specialized divisions and collective production, and followed hierarchical management. Its development was cross-regional and sometimes even transnational. The third period is the emerging knowledge economy. It is based on knowledge, and its first productivity is science and technology. It is process-oriented and flexible, and follows contingency management. Its development expands from a single country to the whole world. The cure of an insect disease illustrates this. In the agricultural economy, the farmers tried to kill the insects through manual work. It was labor-based in essence. In the industrial economy, insects were killed

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through pesticides. The development and production of pesticides demanded

enormous capital and was thus, in essence, capital-based. In the knowledge economy, insects will be killed through genes, and therefore the knowledge economy is knowledge-based in principle.

2. Knowledge Plays a Key Role in Economic Growth According to neo-classic economics, the basic formula for economic growth is: Y=A+αK+βL where Y is the growth rate of total output, K is the growth rate of capital

input, L is the growth rate of labor input, a is the elasticity of capital input/ output, β is the elasticity of labor input/output, a+β=l, and A is the growth rate generated by overall productivity.

This in fact divides economic growth into three parts: the growth of

capital input, the growth of labor input, and the growth generated by overall productivity. The growth generated by overall productivity is related to technology and management, or is based on knowledge.

In a developed economy, the proportion of A reaches as high as 60 per cent

in economic growth. This is obtained when α=β=0.5. According to the formula, the proportion of overall productivity is around 20–30 per cent in China. Some people argue that we need to do the calculation based on α=0.8, β=0.2, as labor efficiency is extremely low in China. The result is 30–40 per cent, and even so, there is still a large gap between China and developed economies.

The growth rate of overall productivity is closely related to such ‘soft’ factors

as technology, education, and management. A case study of the US aerospace industry in the 1980s reveals that technology accounts for 38.1 per cent, efficiency

of capital utilization 25.4 per cent, efficiency of capital distribution 9.5 per cent, economy of scale 11.7 per cent, and quality of labor force 14.3 per cent of the growth rate of overall productivity. Technology takes the lead, followed

by management (47.6 per cent in total), which includes efficiency of capital

utilization, efficiency of capital distribution, and economy of scale. The third important factor is education (14.3 per cent), or quality of labor force and training.

According to World Bank statistics, per capita income was almost the same in

South Korea and Ghana in the 1950s. In the early 1990s, however, the per capita income of South Korea was six times higher than that of Ghana. The difference can be partially attributed to the great success of South Korea in acquiring and applying knowledge.

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The New Economy and the Development of China in the Twenty-First Century

3. Knowledge Has a Critical Impact on Productivity Productivity is composed of laborers, means of labor, and subjects of labor, of which laborers are the most active element. In a knowledge economy, knowledge has a critical impact on all three elements.

As concerns laborers, quality is closely related to their level of knowledge. In

developed countries, the demand on laborers’ knowledge is increasingly high, and almost all laborers in high-tech enterprises are university graduates.

As concerns means of labor, the demand for precision and reliability is

increasingly high and the role of software is increasingly large. In China’s

chemical production, for example, workers in the 1950s had to do the rounds to examine thermometer and pressure gauges and controlled production based on past experience. In the 1970s, instruments were used and workers stayed in the control room to make raw records. This required laborers to be well educated.

After the 1980s, large-scale chemical plants began to adopt the DCS (Distributed

Control System), and all parameters and status of a specific process could be displayed on a computer. At this stage, laborers needed not only knowledge of process, but also knowledge of computer hardware and software. From this example we can see that the progress in instruments of labor has increased the demand on the quality of laborers.

As concerns subjects of labor, utilization of low-end, renewable resources is

made possible with the development of science and technology. For example, the sea is rich in various resources, but their content is relatively low. In the past, exploration was very difficult, but now people have begun to extract

potassium, magnesium, bromine, and iodine and some have even tried to recover gold and manganese nodule. The Roman Club argued in the Limits of

Growth that human beings would face the exhaustion of natural resources. A crisis might occur when all resources were used up. This is too pessimistic a

view, as the prospect of utilizing renewable resources will be unlimited with the development of science and technology. The first resources used by humans were animal and plant resources, and people relied on wood for fire. Later,

people turned to coal and oil. As oil reserves are smaller than coal reserves, many countries are developing a new generation of coal chemical technology

and clean coal combustion technology. It can be predicted that human beings

will turn back to animal and plant resources when coal is exhausted. The

United States and Russia are experimenting with the production of alcohol with cellulose and semi-cellulose. If the experiment is successful, energy will be sustainable, as cellulose and semi- cellulose are inexhaustible in plants.

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4. Items Related to Knowledge Have a High Proportion in the Total Cost The production cost of normal products includes variable costs and fixed costs, and can be broken down into labor cost, capital cost, and material cost. Labor cost covers wages and benefits, capital cost involves depreciation and interests, and material cost includes raw materials and energy. With the development of the knowledge economy, intellectual property is increasingly important. Knowledge-related cost, such as patent fees, license fee for technical knowhows, and charges for technical services, will have an increasing share in the total cost. The present proportion is kept at around 20–40 per cent, and in technology transfer of some high-tech products the price of software is much higher than that of hardware. In microelectronics in particular, raw materials are cheap while the price for precision processing technology is extremely high. Compared with goods export, knowledge export can create more job opportunities and generate more revenues. The higher the technical content of exports, the bigger the margin. This is simple because the marginal cost for knowledge reuse is very low. According to the World Bank, during between 1976 and 1996 the proportion of high-tech products increased from 11 per cent to 22 per cent of the total export while the proportion of primary products dropped from 45 per cent to 25 per cent. In addition, the knowledge related service trade is growing fast. The volume of international service trade increased from US$ 405 billion in 1982 to US$ 1 trillion in 1992, 150 per cent in ten years. In the same period, the world’s trade of goods went up by only 100 per cent. In the future knowledge society, the knowledge economy will become the key socioeconomic form. However, agricultural and industrial economies will still coexist, and invariably they will rely more on knowledge.

FICTITIOUS ECONOMY WILL BECOME THE NEW MODEL OF ECONOMIC ACTIVITIES 1. Fictitious Capital and Fictitious Economy The concept of fictitious capital was first used by Karl Marx in his famous work Das Kapital . He had two main arguments. First, he argued that fictitious capital was developed on the basis of credit capital (interest-bearing capital) and credit system of banks, including stocks, bonds, and mortgages on real estate. Second, he argued that fictitious capital did not have any value by itself, but could generate profit (i.e. surplus value) through circulation. The arguments of Marx are vitally important. Stocks are a good example. They are paper money

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The New Economy and the Development of China in the Twenty-First Century

and do not have any specific value in themselves. However, they can be easily turned into wealth or real money through the securities market. In addition, the wealth formed by stocks will fluctuate along with the market. A good example is Priceline.com, which hit a record high in April 1994 after its listing, up to US$ 162 per share, but then began to drop from September 2000 on as the prospect for its performance weakened. Within three weeks, it went down by 79 per cent, to US$ 5.25 per share. Jay Walker, the co-founder and vice president of the company, suffered a huge loss of US$ 875 million within three weeks, when the value of his shares shrank from US$ 1.1 billion to US$ 242 million. The fictitious economy refers to economic activities of fictitious capital through circulation on the basis of a financial system. Marx has an in-depth discussion on the transformation of capital forms. He argued that the first form of capital was money that was turned into labor, facilities, and raw materials through purchasing activities, and later into products through production. The products were turned into commodities through circulation, and finally commodities were turned into money through exchange. This cycle represented the whole process of the transformation of capital forms in the real economy. In the fictitious economy, capital does not go through the same cycle, but instead relies on the financial markets for its economic activities. We can say that the products of the fictitious economy are financial instruments such as securities, bonds, futures, options, and derivatives; its plants are financial institutions; and its exchanges are financial markets.

2. The Development of Fictitious Economy The development of the fictitious economy has undergone five stages. The first stage is the capitalization of idle capital, that is, turning idle capital to interestbearing capital. For example, A wants to manufacture a product, but he does not have sufficient capital to procure raw materials and facilities. B has idle money in hand, and is willing to lend the money to A. When A produces and sells his product, he begins to pay back the principal and interest according to the agreement with B. In this process, B does not participate in the production, but turns his idle money into interest-bearing capital. The second stage is the socialization of moneyed capital. The loan behaviors between individuals can only be built on mutual trust and the quantity involved is very limited. With the development of social productivity, the demand for capital increases rapidly. This gives rise to banks and securities. The role of banks is to concentrate disposable cash and to lend it to people who need the money. In this case, the idle capital is turned into interest-bearing capital. In this process, idle capital is concentrated and effectively used, and the relationship

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ECONOMIC REFORMS AND DEVELOPMENT IN CHINA VOL. 1

between the lenders and borrowers is legally protected. Individuals deposit their money in banks or lend their disposable money to banks. Banks lend the money to people who need capital, and make a profit through their operations. Finally, banks pay interest to depositors. To reduce financing costs, some businesses turn to social financing rather than bank loans. For example, they issue bonds or stocks in exchange for disposable cash. The third stage is the marketization of securities. When people buy nonnegotiable stocks and bonds, they have to wait patiently until the businesses distribute dividends or pay back at the time of maturity. In this case, the bonds and stocks have poor liquidity and cannot be cashed easily. Therefore, the marketization of securities can meet the demand of cashing and financial markets are formed in which fictitious capital is exchanged. The first products in the financial markets are securities and bonds, and later futures. With the marketization of securities, capital is concentrated in an even larger scale and scope and flows in the right direction. The fourth stage is the internationalization of financial markets. At the end of the nineteenth century, the United States issued multinational bonds to build railway. The transnational flow of virtual capital during the 1920s and 1930s was impressively big in size, but the process of internationalizing financial markets came to a halt as a result of the American Depression in the 1930s and the Second World War. This was not reversed until the Bretton Woods agreement was implemented and the US dollar became an international currency after the war. From then on, the internationalization of financial markets began to speed up. The last stage is the integration of international finance. Financial markets throughout the world are increasingly tied to the fast development of IT and financial engineering, such that events in one country will influence the whole world. The East Asian financial crisis in 1997 is a good example. The breakdown of Thailand’s financial markets has produced a huge impact on the rest of Asia and the world. In terms of total size, the fictitious economy has far exceeded substantial economy. Since the 1980s, the average annual growth rate of the world’s economy has maintained at 3 per cent, international trade at 5 per cent, and international capital flow at 25 per cent. In 1997, the total volume of the fictitious economy reached as high as US$ 140 trillion, of which the market value of stocks and bonds was US$ 60 trillion and the trading volume of financial derivatives was US$ 80 trillion. However, the world’s total GNP was only US$ 28.2 trillion in the same year. In other words, the size of the fictitious economy was five times as much as that of substantial economy. Today, the daily

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The New Economy and the Development of China in the Twenty-First Century

flow of the world’s fictitious capital is over US$ 1.5 trillion, almost 50 times as much as that of international trade. This means that only 2 per cent of the daily flow is involved in international trade, while 98 per cent is in financial markets (i.e. economic activities that generate money with money). It is predicted that the size of fictitious economy will further be increased with the development of e-commerce and e-money.

3. Features of Fictitious Economy The first feature of the fictitious economy is complexity. The fictitious economy is a complex system, comprising natural persons and legal persons (investors, investment beneficiaries, and financial intermediaries) who operate in financial markets in line with the rules of the game. Each individual has the autonomy to make decisions on the basis of his understanding of the environment and its prospects. Nevertheless, his decisions will always be influenced by the decisions of others. On the one hand, this non-linear function gives rise to chaos in the system, and on the other hand, the self-organizing effect leads to a certain order and metastability. The fictitious economy is closely related to human behavior, and therefore characteristics of human behavior must be taken into account in fictitious economic activities. Some people, for example, have argued that the financial turmoil in East Asia is not a crisis of solvency but a crisis of liquidity. Any country that pays back old debts through new debts will survive as long as it can borrow money. However, when the economy of the country is considered unviable, a creditor will refuse further loans, and his decision might influence the second and third creditors. This is a chain reaction and can result in a debt crisis. It is the same in the market economy. A business can make its own decisions on what to produce and how much to produce. However, its decisions will invariably be affected by other businesses and the external environment. In seemingly chaotic behavior, there is a selforganizing effect that guides the macro-economy to move in a certain direction. The second feature of the fictitious economy is metastability. The fictitious economy is a metastable system with a dissipative structure. Its stability relies on capital exchange with the outside. It is intrinsically unstable because the capital itself is fictitious. This is best reflected in the securities market. A makes money from B, and B makes money from A. Sometimes they make money and sometimes they lose money. Only the government can always make money through the stamp tax. The survival and development of the securities market rely on the continuous entry of new investors and new capital, i.e. on exchange

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ECONOMIC REFORMS AND DEVELOPMENT IN CHINA VOL. 1

with the outside. If no one buys and sells in the market, the securities market will disappear and the government will not have any stamp tax income. The third feature of the fictitious economy is high-risk. Due to the instability of the system and the limitation of human perceptions, the risks are often high and unpredictable. In general, a rational investor will not make an investment when the risk is asymmetrical to returns. However, when both risks and potential returns are high, people will still make an investment. The lottery is an example. Its risks and returns are obviously asymmetrical, because its issuing costs and profits are all covered by the sales revenues. Nevertheless, there are still people who are willing to gamble. The fourth feature of the fictitious economy is parasitism. The fictitious economy is generated in and dependent upon the system of the substantial economy. The risks of the substantial economy system, such as inventory and bankruptcy, will be transferred to the fictitious economy system and will lead to its instability. The risks of fictitious economy, such as fluctuations of stock indexes, downturns of real estate price, increases in dead bank loans, and devaluations of currency will also have a huge impact on the substantial economy system. Today finance has become the core of the economy and the substantial economy can no longer operate in isolation from the fictitious economy. Therefore if we view the substantial economy system as the hardware of the economic system, then the fictitious economy system is the software of the economic system. But although the size of the fictitious economy has far exceeded the size of the substantial economy because of the ‘multiplier effect’, the fictitious economy cannot operate freely in isolation. The United States received a bitter lesson in this regard. Since 1998, the web economy has been growing fast, and dot.com companies have been emerging like bamboo shoots in spring. Many people in Silicon Valley have become millionaires overnight. The following joke is quite revealing: A beggar is walking on Wall Street, with a board on his chest saying he is a beggar. But no one gives him money. A professor comes by and tells him why this does not work. The professor says what he needs is to add ‘.com’ after the word ‘beggar ’. The beggar takes his advice and immediately people give him money. Another professor comes and tells the beggar that he can have an even better life if he adds ‘e-’ in front of the word ‘beggar’ so that his sign will read ‘e-beggar.com’. After the change, venture capitalists approach the beggar and ask him at which price he is willing to sell his dot.com company. The joke reflects the fever of dot.coms in the United States. When MARKETWATCH, a subsidiary of CBS, went public, the price soared to over US$ 100 per share. Yahoo had a loss of US$ 2 million, and EXCITE had lost US$ 4 million when

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The New Economy and the Development of China in the Twenty-First Century

they listed. The turnover of Amazon.com in 1998 was US$ 293 million but its

losses were US$ 61 million. People buy these stocks and expect these companies to make huge profits in the future. In April 2000, internet fever began to fade.

The highest index of NASDAQ was over 5,000 points, and the lowest was

only around 1,600 points. These examples show that the fictitious economy is

dependent on the substantial economy and is unlikely to swell in isolation from the latter.

The last feature of the fictitious economy is periodicity. The evolution of

the fictitious economic system is featured by periodicity. However, this is not a simple repetition but a spiraling process. The fictitious economy is involved in a cycle of swelling, bubble forming, bubble bursting, deflation, and breakdown.

Bubbles always exist in the securities market, and they are generated by the confidence of investors. When investor confidence swells, share prices

accordingly increase and bubbles expand; when investor confidence falls, bubbles begin to shrink and finally break down. I happened to be in the United

States during ‘Black Monday’ in 1987. Share prices went down sharply, and a sense of doom seemed to descend on the country. People jumped from tall buildings and committed suicide in other ways. Some even shot their agents.

At that time, the Dow Jones Index was below 3,000 points, but now it is 11,000

points at the time of writing. Therefore, the development of the fictitious economy progresses in waves.

In the knowledge-based society, the fictitious economy will be more

prominent. There are at least three reasons for this. First of all, the proportion

of consumption expenditure will decrease while the proportion of investments

will increase in tandem with people’s wealth. This will promote the expansion of capital markets and the innovation of finance, and provide more investment

tools for investors. With the multiplier effect, the size of the fictitious economy will further expand. Second of all, with the increase of the value of knowledge,

people will emphasize intellectual value when they make investments in capital markets. As a result, enterprises with higher intellectual value will have a higher PE (Price per Earnings). Third of all, the proportion of expenditure on basic needs will diminish while the proportion of expenditure on spiritual needs

will increase, and consequently the growth rate of the primary and secondary industries (mainly in substantial economy) will be much slower than that of the tertiary industry (mainly in fictitious economy).

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WEB ECONOMY IS THE NEW MEANS OF ECONOMIC OPERATION 1. The History of the Web Economy The web economy is also referred to as the Internet economy. It involves such

economic activities as production, circulation, and exchange through the

Internet. The United States began to build its Internet as early as 1982, but its use was limited mainly to academic institutions. Only in the 1990s did the Internet develop fast throughout the world. In 1995, Internet use began to be

popular in the information industry and dot.com companies emerged like bamboo shoots in spring. The wide use of the Internet for commerce speeded up the transition of the IT industry from the period of personal computers to the period of the Internet. This year was also called the ‘Year of the Internet’.

In the same year, Netscape, the developer of Internet search engines, went

public. Almost overnight the company, which had an investment of US$ 17 million and had been in the red for 16 months, became a star with a market value

of over US$ 2 billion. This was one of the miracles of the Internet age. In October

of the same year, Security First Network Bank was set up in the United States and was the first bank in the world with no actual buildings. It only has home pages and websites. The public listing of the general portal American Online

and the search engine Yahoo led to another wave of investment. The share price of Yahoo soared to US$ 450 within a year. The soaring share price of dot.com companies attracted an increasing number of investors. In 1999, the average share price of dot.com companies went up by 230 per cent after their IPOs.

In May 1997, the online bookstore Amazon.com was listed, and the model or

e-commerce was immediately accepted. Many people believed in the prospect of virtual markets. By November 1998, the share price of Amazon had risen by 2,300

per cent and rose a further 300 per cent three months later to a market value of US$ 40 billion. In 1998 and 1999, the Department of Commerce disclosed two specific reports affirming the role of e-commerce and IT in social and economic development. Beginning in 1999, government procurement totaling US$ 200

billion each year was completed through e-commerce. This initiative helped

e-commerce in the United States to speed up. A number of experts hold that the

development of computers and networks is pushing the United States to enter into an age of web economy. As the focus of the web economy, e-commerce

is flourishing and the development of IT will invariably be dominated by e-commerce in the twenty-first century.

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The New Economy and the Development of China in the Twenty-First Century

2. Main Features of the Web Economy The first feature of the web economy is that it is based on IT. The web economy turns all factors of production into information and allows them to flow through the network. In other words, it uses information flow to replace the flow of personnel, materials, energy, capital, and knowledge, and performs virtual production, circulation, and exchange through the network. It guides the combination and operation of all real factors of production. For this reason, we can conclude that the web economy is first of all based on IT. IT is the technology of processing and transmitting information, including hardware production, software development, service support, telecommunication facilities production, and telecommunications service. They are the basis of productivity in the information industry and a critical force propelling the development of web economy. The information industry provides IT products and services for society. Since computers can increase the efficiency of socialization and the Internet can reduce the cost of socialization, the diffusion of IT can help the national economy achieve low-cost socialization. Statistics show that 40 per cent of economic development and growth is attributed to the contributions of the information industry. In many developed countries, the output of the information industry has accounted for 45–65 per cent of growth. In the United States, 40.4 per cent of the output of the manufacturing sector comes from the added value of information products. In the late 1990s, the annual growth rate of the world’s economy was kept around 3 per cent, less than one half of the growth rate of IT and related industries. In developed economies, the information industry has become the largest industry in the national economy. In 1998, the contribution ratio of IT and the information industry to the world’s economic growth was 14.7 per cent, and the actual contribution ratio was over 25 per cent if we take into account the price decrease of products and services. With fast social, economic, and technological development, the amount of information that needs processing is increasing exponentially and the demand for processing efficiency, speed of information transmission, and quality of information products is mounting. For this reason, countries all over the world attach great importance to the development of IT and the information industry. In the United States, Japan, and the European Union, expenditure on IT has been increasing at an annual rate of 12 per cent, much higher than that of total investment. In terms of actual value, IT investment in the United States after 1992 has been increasing at a double-digit speed, and reached as high as 20 per cent between 1997 and 1999. In a report entitled ‘The Emerging

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Digital Economy’ disclosed by the Department of Commerce in April 1998, it was pointed out that between 1993 and 1998 the share of the IT industry in the economy had increased from 6.4 per cent to a projected 8.2 per cent and that with such a rapid growth, its share in nominal GDP had been almost double its share in the economy. The second feature of the web economy is high transparency. The Internet provides abundant opportunities for producers and consumers in the economic systems of countries all over the world. This has greatly increased the transparency of the web economy. A consumer, regardless of place and time, can obtain all the information available about the products he wishes to buy as long as he can get access to the Internet. The information includes specifications, variety, appearance, price, delivery, payment, and quality assurance. He can also select the best product and most reliable source of supply by comparing the information provided by different producers. The transparency of the web economy has substantially reduced the negative impact of information asymmetry on economic operation. For this reason, economists from investment bank Warburg Dillon Read suggest the term ‘naked economy’ to refer to web economy. The third feature of the web economy is innovation. As a new means of economic operation, the web economy is developing rapidly. New demands are emerging with the development of science and technology and the improvement of quality of life. This in turn promotes the innovation of business models and product customization. The Internet can provide new information systems, new niche markets, new communications means, and new distribution channels. By early 2000, 77 innovative models of web economy had been created under 12 categories: B2B, online finance, online sales, online auction, network software services, network hardware services, suppliers of digital products, technological innovation, content services, portals, online communities, and bystanders. It can be predicated that the innovations of the web economy will accelerate with the development of high-performance computers, wide-band networks, and mobile telecommunications. The fourth feature of the web economy is high integration. The web economy is an intensive economy, which integrates the whole process of economic activities through information to achieve overall optimization. For example, it integrates the selection, orders, and payment of products through B2B and B2C e-commerce, allowing international trade, domestic trade, and household purchasing to be completed online. The sales of global e-commerce were less than US$ 1.2 billion in 1994 and US$ 2.6 billion in 1997, but soared to US$ 50 billion in 1998. A report by the United Nations shows that the trading volume of global e-commerce reached US$ 377 billion in 2000 and can be expected to reach

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The New Economy and the Development of China in the Twenty-First Century

US$ 1 trillion by 2010. In the next 10 years, about one-third of international trade will be completed online. In the manufacturing sector, the global manufacturing network dominated by large multinationals is developing rapidly. The digital drawing designed according to standardized technology can be transmitted through networks to the most proper node in regard to technology, facilities, and economics for production, and assembled at the most proper place to directly deliver to customers. In this way, resource optimization can be achieved on a global basis and at the same time quality is improved, cost is reduced, delivery time is shortened, investment in facilities and human resources is reduced, and management efficiency is improved. In circulation, third-party logistics companies independent from suppliers and purchasers integrate the information on warehousing and transportation facilities, and optimize resource allocation and transportation in line with the needs of customers. This can substantially reduce logistics costs. In Japan, such companies have accounted for 80 per cent of the logistics market and in the United States 57 per cent. The Internet is also conducive to supply chain management and optimization of the whole process from procurement of raw materials to sale of products. The fifth feature of the web economy is increasing returns. The main product of the web economy is information, and its reuse will not increase the cost of production nor reduce the use value. When the marginal cost approaches zero, the effect of increasing returns is prominent. From the perspective of the producer, the greater the number of users, the lower the unit cost. From the perspective of the consumer, the wider the use of the purchased products and services, the larger the benefits. This is the ‘network effect’ of the web economy. The effect of increasing returns can create a competitive advantage for the first movers and force latecomers to innovate in business models and products. This can lead to monopoly, but the Internet will decrease the market entry barrier and increase overall competition and efficiency. The final feature of the web economy is rapid diffusion. The rapid diffusion of the web economy is closely related to the fast development of the Internet. The Internet has been growing at an unprecedented speed since its birth and is becoming an irresistible force. Incomplete statistics show that the number of Internet users was less than 90,000 in 1992, but soared to 40 million in 1996, 170 million in 1999. and 414 million in 2000. It is estimated that in four years the number of Internet users will increase by 1 million each month, and the total number will reach 1 billion in 2005. No single technological innovation in human history can be compared to the Internet.

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The driving force for the fast growth of the Internet is the rapid improvement of the performance-price ratio of computers, software, and telecommunications products. According to the Law of Moore, computer capabilities double every 18 months, while the prices halve. This encourages individuals and businesses to use the Internet. Another driving force is the role of the Internet in improving efficiency and reducing costs.

3. The Impact of Web Economy on Economic Development The first impact of the web economy on economic development is the reduction of costs and the increase of competition. Based on the theory of competition, information asymmetry is an important factor contributing to market inefficiency. The high transparency of web economies can bring into full play pricing mechanisms, improve the efficiency of economic operations, and create an ideal environment of near-complete competition (i.e. an environment with rich information, zero transaction costs, and no market entry barriers). Through the improvement of information exchange between sellers and buyers, market efficiency is increase and optimal distribution of resources is guaranteed. In general, the web economy can improve efficiency and reduce the cost of production in the following three ways: One: the web economy can reduce purchasing costs and easily identify the supplier with the lowest price. In the past, when a producer wanted to purchase raw materials, he could only get three quotations but now he is able to get an unlimited number of quotations on the Internet. Information asymmetry is reduced, the best quotation is obtained, and the purchasing cost is lowered. The total trade volume through EDI (Electronic Data Interchange) has reached US$ 150 billion, and the related businesses have cut their purchasing costs by 5–10 per cent. General Electric even managed to lower its purchasing costs by 30 per cent. Online trade with suppliers can lower the total cost of a car by 14 per cent. In the top five industries in the US, B2B can reduce the overall price level by 4 per cent simply by cost saving in purchasing. Two: the web economy can improve inventory management and reduce inventory to almost zero. As information flows fast between producers and consumers, investment in inventory facilities can be saved and inventory costs can be lowered. In the 1980s, for example, the ratio between inventory and sales was 17 per cent in the United Kingdom and the United States, but now it is only 8 per cent. According to an estimate by Ernst & Young, e-commerce can reduce inventory totaling US$ 250–350 billion. IBM, for example, has saved costs of US$ 50 million through the Advanced Planning System (APS) to provide direct contact between sellers and buyers.

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The New Economy and the Development of China in the Twenty-First Century

Three: the web economy can improve the supply chain management and shorten the production and product cycle. Through the use of the online network, the annual turnover of inventory in a number of North American general assembly plants has been increased from around 10 to 130. Some argue that the Internet and IT have increased the efficiency of the US economy by at least 10 per cent. The second impact of the web economy on economic development is the increase of aggregate demand and supply and contribution to sustainable economic growth. In line with traditional economics, the reduction of production costs will encourage producers to produce more at a given price and increase the aggregate supply. In economic terms, the supply curve moves rightwards. If equity investors expect a rapid growth of the output and margin of a business, they will rush to purchase its shares. As a result, the share price will be pushed up and paper wealth will be increased. High share prices and the resulting low capital costs can promote investment and increase the aggregate demand or move tile demand curve rightwards. A new equilibrium is achieved at a high output and a low price level, which in turn stimulates economic growth. According to a study by Goldman Sachs, B2B can permanently increase 5 per cent of the output of the top five industries that account for one fourth of American GDP. Half of the target will be realized in 10 years, which means an annual increase of GDP by 0.25 per cent. The percentage can further be increased to 0.5 per cent if use of the Internet can be extended to other industries. Statistics from a data company show that the Internet created a value of US$ 300 billion for the US economy and 1.2 million job opportunities in 1999. The value created by the Internet in 17 years is as much as that of the automobile industry in 100 years. The third impact of the web economy on economic development is that it only has a short-term impact on inflation. Some argue that the web economy can promote economic growth simply because it can reduce inflation. The US Department of Commerce points out that the obvious reason behind the surge of the IT industry in nominal economic shares is the improvement of the performance of the IT industry, the reduction of the price of computers and semiconductors, and the resulting decrease of price levels in the IT industry. This can cover the price increase of other economic elements, and ensures the decrease of overall inflation. Between 1996 and 1997, the price reduction in the IT industry lowered the inflation rate by 1 per cent. Without the contribution of the IT sector, the 2 per cent of inflation rate in 1997 would have been 3.l per cent. A chief economist at Lehman Brothers maintains that the Internet has

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intensified global price competition and, coupled with a set of sound monetary and fiscal policies, has effectively controlled the inflation in the credit market. E-commerce has a deflationary nature. However, some economists do not agree to this view and argue that the reduction in price does not fully represent the reduction of inflation. Only when price is reduced to a new and low equilibrium can inflation decrease. As inflation is a monetary phenomenon, the Internet is not able to reduce its level permanently. If the central bank does not change the inflation target, the inflation rate will remain the same in the short term. When the Internet reduces the price and lowers the inflation below the target, the central bank will lower interest rates to stimulate economic growth. As a result, inflation will remain the same. The price of online products might decrease, but the price of other products and services will increase. The third impact of the web economy on economic development is that most of the benefits generated by the web economy will finally be transferred to consumers. The final beneficiary of any technological advance will be consumers. Examples are railways, electric power, telephones, and computers. The Internet enables an increasing number of consumers to communicate, shop, make reservations, buy shares, and trade real estate on line. In addition, it makes it easy for both buyers and sellers to compare prices and reduces transaction costs by saving the cost of intermediaries between businesses and consumers. British Telecom announced that online shopping can reduce the transaction cost by 90 per cent on average and can lower the price of related products and services by 11 per cent. For example, the price of online books and CDs is 10 per cent lower than in traditional stores (including tax and delivery cost), and price competition also drives traditional retailers to lower their prices. A study by Lehman Brothers reveals that the cost of each transaction is US$ 1.27 if bank clerks are used, US$ 0.27 if an ATM is used, and US$ 0.01 if the Internet is used. The web economy needs the support of fictitious economic activities as its raw materials and its value cannot be measured against traditional criteria for the substantial economy. The measurement should be based on the needs and confidence of individuals. One kind of information might be worthless for one person, but precious to another. In the securities market, the impact of people’s expectations is most obvious. The ups and downs of web stocks in the US market is a good example. From 1995 onwards, people became excited about the great success of Netscape, Amazon.com, and America Online, and began to believe in the miracle that one-year’s investment in the web industry is comparable to a 100-

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The New Economy and the Development of China in the Twenty-First Century

year investment in traditional industries. This pushed up the web shares in NASDAQ such that the NASDAQ Index reached 4,000 points just before the Christmas 1999. On 10 March 2000, it hit a record high of 5,048 points. In 1999, 486 new companies were listed in the United States, of which 242 were dot.com companies. However, of these dot.com companies, 224 did not have a record of profit. The great difference between share price and performance deprived investors of confidence, resulting in a sharp downturn of dot.com shares in 2000. The NASDAQ Index showed a 39.3 per cent decline in a single year, with losses of US$ 3 trillion. One hundred and fifty dot.com companies closed down. Beginning in 2001, the NASDAQ Index continued to decline sharply, and on 12 March it went below 2,000 points, with a low of 1,600 points. According to the statistics of Webmergers.com, over 493 dot.com companies closed down after January 2001 and 55 per cent of them announced their bankruptcy in the first five months of 2001. At the time of writing, the decline of the fictitious economy is slowing down the economic development of the United States.

CHALLENGES OF THE NEW ECONOMY FOR THE DEVELOPMENT OF CHINA IN THE TWENTY-FIRST CENTURY The new economy will pose great challenges to the development of China in the twenty-first century. This will be reflected in the following six ways:

1. The Economic Gap Between China and Developed Countries Will be Increasingly Difficult to Bridge China’s economy has realized substantial growth since the reform and opening up. Table 1.1 shows that the annual growth rate of China in 20 years between 1979 and 1997 is three times the world’s average, four times the average of developed countries, and two times the average of developing countries. Based on the above picture, some people optimistically predict that China’s economic aggregate will catch up with or even overtake the United States in 50 years. I am not as optimistic as that, because the emerging new economy has increased China’s difficulty in eliminating its economic gap with the developed countries. First of all, the per capita GDP in China is only one-tenth that of semideveloped countries. This gap is increasingly difficult to bridge when the new economy promotes the sustainable growth of the world’s economy (in spite of the temporary recession). Only when developed countries experience a continuous recession while China experiences continuous growth can China have a chance to catch up with them in a shorter period.

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Table 1.1.

US

Japan

Canada

EU

Germany

Britain

France

Italy

Annual Growth Rate of Related Countries and Regions between 1979 and 1997 (per cent) 2.5

3.1

2.5

2.2

2.2

2.1

2.0

2.1

China

Taiwan

Hong Kong

South Korea

Singapore

Thailand

Indonesia

Malaysia India

9.8

Brazil

2.7

7.3

Mexico

3.1

7.7

Asia

7.3

6.6

7.9

Latin America

2.9

7.2

Africa

2.1

7.2

Developing Countries

5.0

World

3.3

6.3

5.2

Developed Countries

2.5

Second, China still has a dual economy structure, with an agricultural economy and an industrial economy existing side by side. Industrialization has not been completed, science and technology lag far behind, technological innovation is weak, high-tech industrialization lacks momentum, the level of education is generally low, and the knowledge economy plays a minor role in economic development. These gaps are even more difficult to eliminate than the gap in GDP. Third, there is a vast gap between China and developed countries in core technologies and infrastructure of the knowledge economy. Knowledge-based industries account for 10 per cent of China’s GDP, and second mover advantage is unlikely to be created due to the effect of increasing returns of knowledge. Second mover advantage means that a country can jump over a distance covered by the first mover, and this is possible in the age of industrial economy. In the knowledge economy, however, the second mover advantage can hardly be realized, as development is closely related to knowledge (i.e. the effect of increasing returns). Finally, economic growth cannot be measured by quantity alone. Quality is at least as important. It is true that China has witnessed its highest economic growth rate in recent years, but it still has a lot of problems in terms of quality. The major problems include an irrational industrial structure, unbalanced regional economic development, weak international competitiveness, corruption that prevents the enforcement of law, scarce and poorly distributed water and oil, and difficulty of transferring rural surplus labor. All these factors will inhibit the continuous, fast, and stable development of China’s economy.

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2. Inequality is Inevitable During the Process of Economic Globalization Economic globalization is an irreversible trend. Some scholars argue that its process started as early as the birth of capitalism. It has gone through four stages: globalization of raw materials procurement, globalization of product trade, globalization of technology trade, and globalization of capital flow. The present stage is economic globalization. No single country can develop its economy in isolation from the rest of the world. China is absolutely right in its decision to join the World Trade Organization (WTO). In general, the advantages are greater than the disadvantages. With the acceleration of economic globalization, the earlier we join the WTO, the smaller the cost will be. However, we must also be aware that inequality does exist and that economic development differs enormously from country to country. According to data from the World Bank, the total population of the world was 5.9 billion in 1998, GNP was US$ 28.9 trillion, and per capita GNP was US$ 4,890. The 24 high-income countries and regions had a total population of 885 million, but had US$ 22.6 trillion of GNP and US$ 25,510 of per capita GNP. In other words, they had a share of 80 per cent in the world’s GNP but their population was less than 15 per cent in the total. Such an obvious gap in wealth makes economic globalization become a double-edged sword. The disadvantages for China will be reflected in the following three aspects: First of all, the rules of the game are formulated by developed countries and they will become non-tariff barriers. Tariff barriers will disappear after China’s accession to the WTO, but all kinds of non-tariff barriers will remain. These nontariff barriers are the rules of the game formulated by developed countries with their technological advantages. Examples are ISO9000 (quality accreditation) and ISO14000 (environmental protection accreditation). These standards have already been accepted by developed countries and are now being imposed on developing countries. This is in fact a technology tariff. We can find similar inequality in environmental issues. The United States has emitted a large proportion of the world’s carbon dioxide. The per capita emission is much smaller in China than in the United States. However, the total emission is still enormous given China’s large population. China proposes a standard based on per capita emissions, and the United States insists on a standard based on unit GNP. This is unfair because US GNP is eight times that of China. From the perspective of human rights, each individual should have the right to emit the same amount of carbon dioxide. Second, inequality exists in the pricing of intellectual property. It should

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be decided between the seller and the buyer while due attention should be given to the number of users around the world. Software disks are made of polycarbonate, and their unit cost of raw materials is less than one yuan, but these disks are sometimes sold at a cost of tens or even hundreds of US dollars. Here arises the issue of reasonable pricing. Software is a knowledge product with a fixed development cost. The copy cost is very low, and consequently the margin for profit soars with increased sales. Pirated software cannot be eliminated simply because the margin is extremely high. If the price of original software was reasonable and after-sale service was good, no one would buy the pirated edition. Any crackdown on illegal software must be combined with reasonable pricing. Third, developed countries have a large surplus of capital, and fictitious capital will flood into developing countries for higher profits. Multinationals will bring with them the culture of their home country and will gradually impact upon the politics and economics of the host country. Such an impact might be even larger in medium and small developing countries, and a few multinationals have become independent kingdoms in these countries. We greet the entry of multinationals that bring in capital, technology, and management expertise, but at the same time we must take measures to prevent their negative impact on our culture, economics, and social development.

3. The Knowledge Advantage of Developed Countries Will Turn Into Economic Advantage The key to the transformation of knowledge into technology is innovation. Unfortunately, the existing technological structure in China fails to provide the momentum for innovation. Commercialization of scientific discoveries is the major way for science and technology to serve economics. To date no effective measures have been developed in this regard. Under the planned economy system, we have been used to the linear science-push model (i.e. identifying a market after successful research), rather than the market-pull model (i.e. identifying a market before doing research). As we know, the market-pull model has played an important role in the fast development of Japan and South Korea. In China, things are quite different. For many years, we have been under the influence of the former Soviet Union and have set up many research institutions along the science-push model. As a result, a number of research projects are not market-oriented and the push effect of science and technology on economics is relatively weak. In contrast, developed countries have an environment for transforming scientific discoveries into productivity and therefore can turn their knowledge advantage into technological advantage at a faster speed.

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4. The Competition For Knowledge Workers Will Intensify Many management experts have come to the same conclusion that the most valuable asset in the twenty-first century will be knowledge workers. These workers have expertise and skills, and their objectives are clear. They can manage themselves and emphasize continuous learning and innovation, work quality, and freedom of employment. Peter Drucker, one of the most distinguished management gurus in the world, has predicted that the country that can improve the productivity of its knowledge workers in the next 50 years in the most systematic and effective way will assume leadership of the world’s economy. In a sense, knowledge workers represent the advanced productivity in the knowledge economy and will sooner or later become the major players in economic development. Many governments and businesses in Western countries have realized that human resources are the biggest source of competitiveness and the most valuable assets of an organization. For this reason, they have developed a number of measures to attract overseas talent. Even the most conservative countries in Europe have opened their doors to the necessary technical staff. A number of multinationals have set up knowledge-based businesses or research institutions in developing countries and their purpose is very obvious: to make the best use of the cheap but talented human resources in these countries.

5. Enterprise Management in China Will Face Grave Challenges In the knowledge economy, profit maximization should not be the only objective of a business. It will not grow until it takes into account its own benefits and that of its customers and community. Hammer et al. argued in Reengineering the Corporation in 1993 that the management of the corporation faced a severe challenge at the end of the twentieth century. It was Adam Smith who first advocated the division of labor and it reached its peak when Henry Ford broke down car manufacturing into 8,872 jobs in the beginning of the twentieth century. However, too much division only leads to increased organizational layers, distortion of information, lack of co-ordination between departments, and weakening of the employees’ creativity and overall perspective. In modern businesses, and in high-tech businesses in particular, such a division of labor is inappropriate. Modern businesses need to reengineer then business processes and reduce layers of management, allowing each individual to take management responsibility. If an organization wishes to survive and develop in an everchanging and increasingly complex environment, it must develop the ability to quickly obtain correct information from the outside and the ability to adjust its

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internal structure to changes in the environment. The knowledge economy needs informal organizations without fixed boundaries, flat organizations with fewer layers, network organizations that facilitate effective communication among members, and semi-autonomous organizations that encourage internal innovation. Businesses also need to be innovative in developing competitive strategy. As the law of competition is one of the basic laws of the market economy, modern management in the West attaches great importance to the role of competition. Modern businesses study competitive strategy carefully, strive for competitive edges, increase market shares, create strong brands, beat the competition relentlessly, take monopoly positions, keep down the price of raw materials, retain customers, etc. Each business tried to fight to a bitter end in order to survive in the market. In recent years, however, people have begun to realize that mere competition has its weaknesses. A business needs to build a strategic partnership with its suppliers, customers, and even its competitors. Competitors need to seek a common ground, integrate their respective advantages, develop and expand the market, and share benefits. The mindset of enterprise management needs to change, and particular importance should be given to cultural management. Management has three levels: experience management, scientific management, and cultural management. With the arrival of the knowledge economy, enterprise management should be upgraded to the level of cultural management and bring into full play the individual initiative. Many enterprises in China still remain at the level of experience management, and some are implementing scientific management with regulations and quantitative methods. In future we need to advocate cultural management. The core of cultural management is to respect individuals and mobilize their initiatives, allowing employees to develop shared values and culture towards quality and social responsibility. Compared with the Fortune 500, the top 500 industrial companies in China are relatively weak. In the year of 1998, the average of our total assets and sales revenues is only 0.88 per cent and 1.74 per cent of the world’s average. The average return on assets, per capita profit, and per capita income are 24.6 per cent, 12.3 per cent, and 9.15 per cent respectively. In terms of R & D, our percentage is less than 1.38 per cent, and the world’s average is 5–10 per cent. Most of the Fortune 500 are multinationals with international competitiveness, and their investment, production, and sales are global. They are not only leaders in the domestic market but also major players in international markets. In comparison, the top 500 industrial companies in China are only leaders in the domestic market, and it is a long shot for them to develop international competitiveness.

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6. Social Values Will Change Along with the social and technological development comes the rapid expansion of knowledge wealth. Research shows that the knowledge acquired in the past 30 years is equivalent to the total of the past 2,000 years, and that the next few years will continue to witness exponential growth in quantity and breakthrough in quality. By 2050, the total knowledge acquired by human beings will be 100 times as much as at the time of writing. With the development of the new economy, a knowledge society is forming at the same time. In such a society, people will learn knowledge not only for life but also for better development. Learning will be a spiritual need, and all individuals will want to learn for self-improvement. Education will be a consensus of social groups, and a basic social requirement for everyone. It will be the legal right and obligation of every citizen. A knowledge society is also a learning society, as the sense of learning is popularized and learning behaviors are socialized. The arrival of a learning society will greatly change our social values. ‘Never too old to learn’, ‘life is learning’, and ‘society is a school’ are concepts that will become the basic values and norms of behavior. Compulsory education will be replaced by life education. Learning will no longer be a narrow, passive, and short-term utility but an active and conscious behavior and life objective. People will emphasize not only the learning of new knowledge, but also the application of new knowledge to social reform.

COUNTERMEASURES FOR CHINA To meet the challenge of the new century, China should take the following countermeasures:

1. To Create a Balance Between Efficiency and Equality A pressing problem for any country in its development is how to balance between economic efficiency and social equality. Marx and Engels were right when they proposed the concept of absolute poverty of the proletariat. Lenin continued to argue that ‘imperialism is the last stage of capitalism-dying and rotten’. In the last several decades, capitalist countries have tried hard to learn from past experience and to reform their societies. One of their most important measures is to give due attention to social equality while striving for economic efficiency. Finland, Sweden, and Denmark, for example, have implemented a high welfare policy under the guidelines of social welfarism. The United Kingdom, Germany, and the United States have set up a social security system.

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These measures have softened social conflicts and played an important role in preventing social upheaval. In addition, the universal increase of people’s income has led to the expansion of the middle class and has consequently increased social stability. The present problem lies in the inequality of distribution in the world’s economy, because the achievements of developed countries have been realized through their economic advantages to developing countries. As far as we understand it, the core of the concept of the socialist market economy proposed by Deng Xiaoping is to make the best use of the advantages and features of the market economy and to allow them to become the basic means of resource allocation and improvement of economic efficiency. In the meantime, we should also adhere to our socialist system, ensure social equality and fairness, and prevent a wide gap between rich and poor. Equality should not be achieved at the cost of economic efficiency. We had a bitter experience in the past when we advocated the ‘big pot’ and the ‘iron bowl’. The objective of a socialist market economy is to balance between efficiency and equality. For example, after the adequate development in eastern China, we should immediately begin development in western China. We should not allow regional differences to increase without control, as the principle of socialism is to ensure social equality. Western development will play a critical role in setting up a uniform market for the socialist market economy, narrowing the regional gap, maintaining social stability, and strengthening national unity. We should also encourage competition, improve the rewards for talent, and allow some people to get rich first through honest work. We should provide low-income earners with poor education and abilities with the basic means of life. To this end, we should establish a social security system to protect the weak in social competition. This is a prerequisite to social equality. We should also protect the ecological environment while we try to make the most of resource advantages. In maximizing profit, a business should also emphasize social effects. The conflict between equality and efficiency will exist forever, and our government should pay due attention to the problem.

2. To Increase Productivity, Realize the Strategic Transfer of Labor, and Step Up Urbanization There is a large gap between China and developed economies with regard to per capita GDP, and one of the major factors is the low productivity of labor. According to an evaluation of international competitiveness by the IMD (International Institute for Management Development), China was ranked 29 out of 47 countries in terms of international competitiveness (Hong Kong was

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ranked 7), 36 in management (Hong Kong was ranked 5), and 46 in GDP per worker, with an average of US$ 5,837 (Hong Kong was ranked 20, with US$ 46,848). This shows clearly that, without improving the productivity of labor, it is impossible to increase a country’s economic strength. China has a population of over 900 million farmers, with little per capita arable land. With the progress of agricultural production, enormous labor is made idle and, as a result, the productivity of labor can hardly be increased. Research shows that the impact of China’s accession to the WTO will be greater on agriculture than on the automobile industry. For example, labor costs in China are RMB 44 for every 100 kilograms of wheat, RMB 10 in the United States, and RMB 4 in Canada. A country cannot be competitive if it cannot improve productivity of labor. While doing this, we need also to realize a strategic transfer of surplus labor. The improvement of productivity and employment is a dilemma. It is essential to improve efficiency and eliminate redundancy, but reemployment is important for laid-off workers. In fact, the transfer of rural labor is already taking place. Only women and the old stay at home, while the strong go to work in township enterprises or do odd jobs in cities. They do not return home until the busy season. It is important to step up urbanization, as it can help realize the transfer of rural labor and create new needs and promote consumption. Urbanization can take place on three levels: small cities (towns), central cities, and supercities. We should develop small, medium, and large cities at the same time in line with the regional characteristics, and attract more farmers to work and do business in cities. In the meantime, we should also reform and improve the existing land administration and residence registration system to facilitate the transfer of the rural population. When the urban population increases, consumer needs and job opportunities will increase. In a similar way, when the rural population decreases, the productivity of labor and farmers’ income will increase and the rural market will prosper. The rural economy is basically a self-sufficient economy. Purchasing potential is great, but the consumer market is difficult to develop. In the 1980s, farmers’ income increased significantly as a result of the household contract responsibility system. The early 1990s witnessed another big increase because of the price hike of farm produce. However, the overall income of farmers is still low and, compared with urban residents, their purchasing power is weak. According to a sample survey, two-thirds of farmers do not have purchasing power. In general, farmers have a strong sense of self-security and tend to put all their money in banks. Thrifty as they are, the only money they spend is on house building and marriages.

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The constructing of small cities and towns provides a momentum for the transfer of rural labor and a new opportunity for the development of township enterprises. City planning should be improved, and businesses should be guided to concentrate in small cities and industrial parks. In this way, the development of township enterprises and the construction of small cities will complement each other and create more job opportunities and market needs. I agree that the twenty-first century is the century of urbanization. Central cities have played a critical role in economic development throughout the world. In 1998, China had 37 large cities with an urban population of over one million and their GDP accounted for 24.4 per cent of the total. These cities are hubs of regional development; regional centers of politics, economics, and culture; poles of growth; bases of technological innovation, capital concentration, information diffusion, and training of high-quality laborers; sources of technology, capital, information, and facilities for neighboring areas; and ports of optimal logistics management. The residents of central cities are real consumers who can create demands and promote the needs of surrounding rural areas. Therefore, their role in economic development should never be ignored. The American futurist McKinley Conway predicts that the number of cities with a population over one million will increase from 228 in 1996 to 550 in 2015, and the number of metropolises with a population over five million will increase from 16 to 26 in the same period. In 20 to 30 years, there will be 10 supercities, including Shanghai and Wuhan.

3. To Develop High-tech Industry, Rely on Venture Capital for Industrialization, and Explore the Development of Knowledge Economy in Developed Regions In the context of economic globalization, the development of the high-tech industry is an important means of improving a country’s competitiveness. High technology means a height of technology and a favorable position in the competition. For example, China has a large output of computers but our chips are purchased from Intel and our software is purchased from Microsoft. In a sense, we are making money for Intel and Microsoft and their margin is much higher than ours. Our Video CD player business is the largest in the world, but it enjoys hardly any profit, as it still relies on imports for key technologies. In general, it takes three to seven years for a technological innovation to succeed, and the risk of failure is extremely high. Entrepreneurs have technology, but they do not have capital, nor do they have assets for mortgages. For this reason, banks are reluctant to provide them with long-term loans. Start-ups, in particular, have a large demand for capital and venture capital

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is obviously an effective financing tool. It can not only provide capital for entrepreneurs, but also help them develop the market and strengthen enterprise management and supervision through selection of leadership and financial control. Using venture capital to realize technological innovations and high-tech industrialization and to explore the development of the knowledge economy in developed regions will help China become a ‘brain nation’ that can ‘produce’ knowledge and possess key technologies with intellectual property, rather than a ‘body nation’ that can only apply knowledge and import technologies.

4. To Create a Large Number of Innovators, Set Up an Incentive System Encouraging Learning and Innovation, and Improve Vocational and Continuous Education We should step up the development of education and provide different training to meet different needs. Our primary objective is to create innovative people through educational reforms. We need to increase our input in developing young and middle-aged scientific workers, and give them trust and power. In the meantime, we need to continue to rely on the old generation and allow them to raise their successors. We should encourage people to study abroad, and take steps to attract them back. An effective incentive system needs to be set up to motivate learning and innovation, and a favorable environment needs to be created to help talented people stand out. Vocational training and continuous education should be strengthened to improve the laborers’ culture and quality of life. This is a requirement of the knowledge economy. Therefore, one of our important strategic objectives in the twenty-first century should be to improve the cultural standards of the whole nation and to create a working class with knowledge.

5. To Absorb Western Culture Selectively and Inherit Chinese Culture Critically Culture is a key element to social progress. Some people argue that Western countries wish to export their culture and realize cultural globalization through economic globalization, and their ultimate objective is to export their political systems and to realize political globalization. We must be aware that the younger generation in China is quite influenced by Western culture. To resist Western cultural penetration, we need to carry forward and develop our own advanced culture. Such an advanced culture should first of all be a patriotic culture, an open culture, and an innovative culture. It should maintain the tradition of Chinese culture, and at the same time interact with and learn from other cultures. It

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will progress with the scientific, social, and economic development, and absorb Western culture selectively and inherit Chinese culture critically. To conclude, the new economy is still an infant that needs our particular care. We need to keep a close eye on its development and changes. We need to study it carefully and understand its features and laws of development. In the meantime, we should also pay due attention to its impact on our national economy and social development. We must develop a vision, bring into full play our competitive edges, seize opportunities, meet the challenge bravely, and formulate a well-thought outplan. We must also work hard to build China into a prosperous, democratic, and highly civilized socialist country in the mid twenty-first century. Completed on 12 June, 2001

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2

Chapter

Venture Capital Business and its Emergence in China

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Venture capital is a high-risk, portfolio, long-term, equity and professional investment. It plays a critical role in promoting the industrialization and commercialization of research fruits, stimulating the development of hightech industries and providing us with an effective investment tool. Realizing technological innovations and high-tech industrialization through venture capital will facilitate China’s strive to become a ‘brain country’ in the age of knowledge economy which is able to ‘produce’ knowledge and own intellectual rights, rather than a ‘body country’ which can only use knowledge and import technology. The United States is not only the first country to develop venture capital, but also the largest nation in terms of size. Its major experience can be summarized as: 1. Limited partnership is the basic organizational form of venture capital companies; 2. An effective incentive system is the key to the success of venture capital; 3. Venture capital should support start-ups and development of high-tech venture enterprises; 4. IPO and sell-out are the major exits of venture capital; 5. The government should create a favorable policy and legal environment for venture capital development. After more than a decade of exploration and preparation, venture capital industry in China began to move forward rapidly since 1998, and has gradually shown its importance in the transformation of scientific fruits and industrialization of high-technologies. Up to now the aggregated venture capital investments in China have amounted to US$ 600 million. However, the size of venture capital investments is yet to be expanded, and relevant laws and regulations are yet to be stipulated or revised. In addition, further understanding is necessary over venture capital characteristics, its focal areas and difficulties; venture capital investments need to be standardized; cases of great success are few; and private participation is inadequate. I have studied the venture capital investments in China from three aspects: macro system (systems and mechanisms), micro system (including organizational form of venture capital companies and operating mechanism), and practices. The target of venture capital development in China is to establish a comprehensive venture capital system within 10 years, with the annual venture capital investments up to RMB 10 billion. To this end, we suggest a three-step

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development strategy. The first step is to establish venture capital consulting and management companies which evaluate and recommend venture capital projects for investors at home and abroad, manage the projects for the investors and if conditions permit, establish venture capital investments according to the Company Law. The second step is to establish venture capital funds and formulate relevant regulations and management rules to attract capital both in and outside China. The third step is to establish a comprehensive venture capital system which will support venture capital industry and provide it with an exit. The government must develop measures to support venture capital industry through legislation, including investments, grants, guarantees, interest rate subsidies, tax reductions and regulations over M&As and IPOs of venture enterprises. Furthermore, rules and regulations shall be promulgated upon venture capital intermediaries and the second board shall be constructed. To realize the above strategic target and tasks, consistent efforts must be exerted to create several fundamental conditions: a group of entrepreneurs with innovative products, a number of outstanding venture capitalists, sufficient capital support, exits and favorable policy and regulatory environment. System innovation in venture capital in China shall facilitate the creation of venture capital professionals, support innovators to become entrepreneurs and attract investors to make venture capital investments. Limited liability company could be the major organizational form for venture capital companies at the present stage, but shall gradually be transformed to limited partnership. Project managers must have bigger power, and a flat and semi-autonomy learning organization must be created. Investments on venture enterprises shall be made in a ‘soft commitment’ method by which the investment shall be in line with the percentage of equity shares and can be transferred among shareholders who directly invest in the venture enterprises. An incentive system, including salaries, welfare, bonus, equity shares and stock options, must be established in venture capital companies. The basic responsibility of the venture capitalists is to select good projects, characterized by distinct business models, mature technical bases, promising market prospects, solid economic benefits, feasible satisfaction of capital requirements and reasonable pricing of technologies. To develop venture capital in China, we must draw on international experiences and come up with a way with Chinese characteristics. We believe that venture capital will certainly become the big engine propelling the wheel of innovations toward prosperity as long as we observe the spirits of ‘try audaciously, observe carefully, and avoid pointless debates’ advocated by Deng Xiaoping.

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CHARACTERISTICS OF VENTURE CAPITAL AND ITS ROLES IN THE ECONOMIC DEVELOPMENT OF CHINA Venture capital is a commercial investment in high-tech and innovative areas with high risks for potential high returns. The essence is to invest in highrisk and high-return portfolio of projects, in which owners’ equity rights of successful projects are divested through IPOs or sell-outs to compensate for the loss of unsuccessful projects and provide high returns for the investors There are 5 characteristics of venture capital investments: 1. It is a highly risky investment. Venture capital investments are made to support innovative technologies and products with high risks in technologies, economic returns and market prospects and the success rate is as low as 30 per cent. According to the experience of the venture capitalists in the US, only one third of the venture capital projects are quite successful with another one-third in even and still another one-third ending up in total loss. However, as the investment returns for successful projects are extremely high, some investors cannot resist the temptation. 2. It is a portfolio investment. To diversify risks, venture capital investments usually consist of a group of investment projects. This is to use high investment returns after divestments of successful projects through IPOs or sell-outs to compensate for losses of unsuccessful projects and achieve certain returns. 3. It is a long-term investment. Returns are usually achieved through divestments from 3 to 7 years after the initial investments are made. And additional investment to those promising projects is likely inevitable in this period. 4. It is an equity investment. Venture capital is an equity investment rather than a loan and emphasizes the future development prospects and valueadded assets rather than present profits or losses of its investment targets. It achieves high returns through future divestments. Venture enterprises supported by venture capital tend to have negative cash flows in their growth stages when they expand in size and develop the market. The general investors usually ignore such enterprises with operating losses, but venture capitalists take consideration of the owners’ equity, believing that investing is worthwhile so long as the enterprises keep growing in value. 5. It is a professional investment. In addition to providing capital for entrepreneurs, managers also bring with them expertise, experiences and an extensive social network. They participate actively in the management of the venture firms founded by the entrepreneurs, such as to help them reform organizational structures, direct business development, strengthen financial management, and headhunt key leaders. Venture capital mainly plays

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three roles in China’s economic development. The first is to promote the industrialization and commercialization of research fruits. A scientific fruit usually passes 4 stages from the initial design to the final industrialization: research, development, demonstration and diffusion. Venture capital usually supports the development (industrialization) and demonstration (commercialization) stages. Capital needed for research is one tenth of the development stage, so is the percentage between development and demonstration. High risks, slow returns and huge demands characterize the development and demonstration stages, during which the government is unable to provide sufficient capital, banks are reluctant to give loans and general investors are unwilling to invest. It is roughly estimated that each year there are about 30,000 scientific fruits in China, among which only 20 per cent are transformed into products and less than 5 per cent are commercialized. The low percentage of transformation can be largely attributed to a serious shortage of investments during development and demonstration stages. An investigation reveals that within the transformed high-tech fruits, 56 per cent of the transformation capital is self-financed, 26.8 per cent is financed by the national scientific plans and only 2.3 per cent by venture capital. Therefore, venture capital industry in China must be developed to effectively promote the transformation of scientific fruits. The second is to promote the development of high-tech industries. In the increasing globalization of economy, high-tech industrial development is the main solution to enhance national competitiveness. Whoever masters high technology occupies the high peak of technology and manipulates the competition. As it takes 3 to 7 years from a technological innovation to final success, banks are reluctant to provide long-term loans for entrepreneurs with high-risk projects. Start-ups have a large demand for capital and venture capital is an effective financing tool. It cannot provide capital for entrepreneurs and help them develop the market, but also strengthen management and supervision of enterprises through selection of leadership and financial management. The third is to provide an effective investment tool. Venture capital is a very professional and sophisticated investment tool. By meticulous selection, risk diversification, strengthening of management and timely divestment, it not only supports entrepreneurs to start their firms, but also help investors to speculate on high returns. This is a win-win situation for both parties. It is reported that the average rate of return on venture capital investments in the US between 1965 and 1985 was 19 per cent, twice that of stock investments and 5 times that of long-term bond investments. In China, the capital market is not well developed, and the bank savings exceed RMB 10 trillion, of which two thirds are personal

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savings and one third institutional savings. As banks operate on liabilities, they bear heavy interest payment burdens when the consumer market is dim. As a long-term investment tool, venture capital can effectively diffuse some deposits, thus alleviating the burdens of banks. In the 21st century, China will be facing great challenges of the knowledge economy. In the new economy, knowledge-based industries will play a dominant role in the economic structure, the comprehensive factors relevant to knowledge will contribute significantly to the economic growth, knowledge elements will have key impact on productivity, and knowledge cost will be an important item in the cost structure. Whoever owns the knowledge can develop a competitive edge and win the fierce competition. Utilizing venture capital to realize technological innovations and industrialization of high technologies will help China become a ‘brain nation’ to ‘produce’ knowledge and own intellectual rights instead of degrading to a ‘body nation’ that can only apply knowledge and import technologies.

MAJOR EXPEREINCE FROM THE US IN VENTURE CAPITAL DEVELOPMENT The United States is not only the first country to develop venture capital, but also the largest nation in terms of size. Comprehensive analysis and study of its experience will contribute to the venture capital development in China. As a special form of investment, the source of venture capital can be traced back to 1920s and 1930s when some rich families and individual investors in the US provided some startup capital for enterprises such as Eastern Airlines, Xerox and other projects which turned out to be very successful. It is generally held, however, that modern venture capital industry began in 1946 when the first venture capital investment company – American Research and Development Corporation – was founded. Venture capital has gone through huge ups and downs in the 20th century: formation in the 50s, growth in the 60s, recession in the 70s, revitalization in the 80s, and temporary setbacks in the early 90s. Beginning from the mid-1990s, venture capital began to be felt strongly and became a propeller for the US high-tech industrial development. In the 1980s, the United States managed to improve its economic efficiency and benefits through economic structural adjustments, organizational streamlines and deregulation. However, this was completed at the cost of 44 million jobs. Under this context, venture capital was used as a means to support technological developments, and to create new market and new ventures. In the end, 77 million new jobs were created and the US economy witnessed sustainable growth in the 1990s.

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An investigation by OECD revealed that from 1984 to 1991, the number of new companies founded in the US was 4 times that of France and 8 times that of Denmark. From 1982 to 1996, 85 per cent of the new jobs in the US were created by small enterprises. The developed venture capital market not only provides the Americans with more job opportunities, but also provides thousands of young people with chances to exploit their own capabilities. Through venture capital, the dreams of many innovators have come true, huge social benefits have been created, sustainable economic development has been maintained, investors have realized huge returns, and venture capitalists have made great fortunes. In recent years, a number of high-tech enterprises sprung noticeably out from Silicon Valley into the world arena. These ‘babies’ nurtured by venture capital rapidly grew to become a strong force enhancing the economic competitiveness. It is estimated that 1,000 new venture are created each year in Silicon Valley and several years later these films will either succeed, or merely survive or fail and the percentage is roughly one third for each type. It is also reported that in early 2000 when venture capital was most rigorous, there were 7,000 venture firms in Silicon Valley where every day 30 people became millionaires, 500 new venture firms opened their doors and the same number closed down. Since 1992, venture capital investments in the US have been growing rapidly with increasing returns. During the two decades from 1975 to 1994, the average rate of return on venture capital was only 13.1 per cent, but it hit 48 per cent, 40 per cent and 36 per cent in 1995, 1996 and 1997 respectively. There are two statistical parameters to estimate the size of venture capital investments in the US: commitments to venture capital funds and amount raised by venture backed companies (i.e. actual input made in backed enterprises from venture capital funds). Table 2.1 sums up the data from 1996–2000 in the US. Table 2.1.

Statistical Data of the Size of Venture Capital Investments in the US between 1996–2000

Number of VC funds

Committed investments (US$ billion)

Actualinvestments (US$ billion)

Number of projects financed Average size of investment (US$ million/project)

1996

1997

1998

1999

2000

/

/

/

34.538

69.082

/

/

/

202

249

9.046

11.416

15.039

38.186

68.756

3.50

4.00

5.00

7.00

11.00

1676

1841

2046

3317

4107

Note: The data are taken with slight changes from the PricewaterhouseCoopers Money Tree Survey in Partnership with Venture One.

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As is shown in Table 2.1, venture capital investments in the US grew rapidly between 1996 and 2000. The actual investments, the number of projects financed and the average size of investment in 2000 were 7.6, 2.5 and 3.1 times that of 1996, especially during the three years from 1998 to 2000 when the actual venture capital investments in the US nearly doubled each year. On the quarterly basis, however, venture capital investments in the US have been going down: US$ 5.081 billion in the first quarter in 1999, 8.323 billion in the second, 8.969 billion in the third, 15.813 billion in the fourth quarter, 19.354 billion in the first quarter of 2000, 18.927 billion in the second, 16.764 billion in the third, 13.71 billion in the fourth quarter and 10.11 billion in the first quarter of 2001. Therefore, on yearly basis, 2000 was the peak while on quarterly basis, venture capital investments reached highest in the first quarter of 2000 and began to slip thereafter. This coincides with the American economic development trend. Until recently some are still optimistic, holding that venture capital investments will maintain great momentum in the US as they are shifting from IT and Internet technology to biotechnology industry. I believe, however, the size in 2001 may well be below that in 2000. Facts have proven and will continue to prove that ‘progress in waves and uprise in spirals’ is the general rule governing all fictitious economy including venture capital. The geographic distribution of venture capital investments in the US is also expanding. In the total venture capital investments in 2000, California (mainly around Silicon Valley) accounts for 45.6 per cent, New England (clustered around Highway 128) 10 per cent, New York 8.8 per cent, Southeast area (mainly in Carolina) 6.7 per cent, and areas neighboring Washington 5 per cent. The experience of the US venture capital investments can be summed up as follows:

1. Limited Partnership is the Basic Organizational Form of Venture Capital Companies There are approximately 4 types of venture capital institutions in the US: investment companies affiliated to banks, investment companies affiliated to large businesses, medium and small-sized investment companies supported by the government, and independent venture capital companies. As independent venture capital companies generally perform better, investment companies affiliated to banks and large businesses are tempted to turn into venture capital companies with relative independence. According to the Taxation Law in the US, investment returns from partnerships are exempt from corporate taxes (only personal income taxes are imposed). This has encouraged most of the venture companies to adopt limited partnerships. In general, the general partners and

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Venture Capital Business and its Emergence in China

limited partners both invest in the venture capital fund, and the general partners only contribute 1 per cent of the total. The general partners are responsible for daily operation and management of the funds and hold unlimited liabilities over the fund, while limited partners do not participate in daily operations and management and hold limited liabilities. The partnership of a venture capital fund usually lasts for 10 years, with an average of 3 to 9 general palmers who are responsible for several independent funds at the same time.

2. An Effective Incentive Mechanism is the Key to the Success of Venture Capital Investments Fund managers and venture entrepreneurs are two important types of professional. The former (usually general partners) are often called venture capitalists who are professionals or experts in certain fields. They must not only select prospective projects from thousands of project proposals with their expertise and experiences, but also participate in the board meetings of the invested companies to monitor their financial status (i.e. to standardize the financial management and make decisions on key issues such as capital expansion, close-down, public listing, sell-out, etc). Besides, they must also help the invested company establish a strong and powerful management nucleus, including CEO, CTO, CFO, vice-president of sales and vice-president of marketing. Apart from a fixed salary from the annual management fee (2.5 per cent of the total volume of the fund), general partners can also draw 20 per cent of the investment returns of the fund. This pushes them to choose good projects, strengthen management of venture enterprises and improve the investment returns of the funds. Founders of venture firms (i.e. entrepreneurs) usually get medium cash salary, but compensated with common stocks or stock options. When a venture firm goes public, the usual employees get 25 per cent of the total shares, among which 5 nucleus managers get one third and CEO gets half among the five. Table 2.2 illustrates typical shareholding percentage and annual salaries of employees of US venture firms when they get listed. Table 2.2.

Shareholding Percentage and Annual Salaries of Employees When VC Firms Get Listed (with a total number of 150 employees and 25 per cent of shares)

Position CEO CTO CFO VP Sales VP Marketing Other employees in total

Shareholding Percentage (%) 4.01 1.5 1.0 1.0 1.0 16.5

Annual Salary (US$ thousand) 75–200 About 150 About 150 About 150 About 150 50–125

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3. Venture Capital should Support the Growth of High-tech Firms The US venture capital industry invests heavily in IT industry (communications,

electronics, information service, semi-conductor, software, etc.) and health care industry (biochemical, health care, medical instruments, medical information system, etc). The distribution of US venture capital investments from 1996 to 2000 by invested areas is as follows.

As is shown in Table 2.3, the focus of venture capital in recent years is on

IT industry (mainly telecommunications, software, and information service), taking up 55–60 per cent of the total. The investments in the service industry

increases rapidly while investments in the health care industry drops drastically. Table 2.3.

Distribution of US Venture Capital Investments From 1996 to 2000 by Invested Areas (per cent) 1996

1997

1998

1999

2000

20.7

21.6

22.7

21.3

26.4

Electronics

5.2

4.4

3.4

2.0

1.6

Information service

6.3

6.4

10.2

12.4

10.6

Semi-conductor

3.5

4.4

3.7

2.7

3.3

Software

19.7

21.7

20.3

16.3

18.2

Sub-total

55.4

58.4

60.2

54.7

60.1

Health Care: Biochemical

9.1

6.9

6.8

3.4

3.9

Health care service

7.2

6.7

4.3

1.0

0.5

Medical instruments

6.0

6.6

5.4

3.1

2.0

Medical information system

4.2

3.8

2.6

1.7

2.5

26.5

24.0

19.2

9.3

8.9

3.1

2.7

1.6

1.0

0.6

Services

7.1

8.2

13.5

24.6

26.8

Retails

5.4

4.9

4.0

9.8

3.0

15.6

15.7

19.1

35.4

30.4

2.5

1.9

1.5

0.6

0.6

100.0

100.0

100.0

100.0

100.0

IT: Telecommunications

Sub-total Product & Service: Products

Sub-total Other Total

Note: The data are taken with slight changes from the Pricewaterhouse Coopers Money Tree Survey in Partnership with Venture One.

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Venture Capital Business and its Emergence in China

Table 2.4.

Four Stages of US Venture Capital Firms

Stages

Number of Employees

Investment Amount (US$ 10,000)

Value (US$ 10,000)

Time (year)

Start-up

15

300–500

1,000

1.5–2

Growth (expansion)

75

1,000

6,500

1–2

Development

Maturity (IPO preparation)

40 120

700

2,000

3,500 12,000

1.5–2 0.5–1

It usually takes a venture capital firm 3–7 years from start-up to IPO or sellout, during which it goes through four stages: start-up, development, growth and maturity, with increasing demand for capital. The number of employees, the amount of investment, the value of the enterprise and the time needed are illustrated in Table 2.4. In 1997, 30 per cent of the total US venture capital is invested in the start-up stage, and 59 per cent in the growth stage (i.e. development and demonstration of scientific fruits to realize industrialization and commercialization).

4. IPO and Sell-out are the Major Divestment Methods of Venture Capital Investments When a venture enterprise grows, the investment company will cash in its owner’s equity through divestment. IPO and sell-out are the two major forms (i.e. to sell the venture capital company to big enterprises through M & A, and in some cases to employees or founders). Although venture firms grow fast, they remain quite small in size and require continuous fresh capital. As a result, their performance indices can hardly meet the standards of traditional securities market and a new securities market must be established especially to serve medium and small-sized enterprises (especially high-tech firms). In the US, for example, NASDAQ Small Caps houses 1,500 individually listed stocks. As listing requirements are low, it is especially suitable for the financing of medium and small-sized high-tech firms and provides a divestment exit for venture capital at the same time. Such a market is usually called the second-board market. After the listed companies get increasingly mature, they can upgrade to NASDAQ National (the main board where 4,000 stocks are listed). The second board also facilitates a second IPO after LBO. By 1998 NASDAQ has set up 400 thousand terminals in 60 nations around the world, where 530 market makers ca provide 60,000 competitive bids instantaneously and the computer system of NASDAQ will choose and show the best bid to the global investors. As the performance of the US venture capital investments is widely

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recognized among the investors, venture capital firms can usually generate significant profit when they are listed on the second board. In 1997, 134 venture capital firms were listed, with the financed capital up to US$ 5.39 billion. Their average rate of return since the listing day to the end of the year is 23 per cent. For instance, Excite is a search engine company founded by six Stanford graduates. It attracted venture capital and went public. Although the company still incurs losses when listed, the company stocks are preferred because investors are confident about its future. The major difficulty facing venture capital firms when they try to go public is its small size, which makes it hard to find a reputable underwriter.

5. The Government should Create a Favorable Policy and Regulatory Environment for Venture Capital The venture capital industry in the United States also experiences ups and downs. Venture capital investments grew rapidly in the 1960s, but shrank drastically from 1970 to 1978, due to the economic recession, the dim stock market, strict regulation over pension funds and oil crisis. After much lobbying activities of the venture capitalists and entrepreneurs, some congressmen and the Carter Administration worked strenuously to create a favorable policy environment for venture capital. The Congress passed 5 bills from 1978 to 1981, to promote the development of venture capital. The Revenue Bill in 1978, for example, reduced the capital valueadded tax from 49.5 per cent to 28 per cent, which provided stimuli for long-term equity investments. As a result, the venture capital commitments in 1979 grew 10 times than the previous year. The Economic Revival Tax Law in 1981 further reduced the capital value-added tax from 28 per cent to 20 per cent, thus doubling the venture capital commitments in the same year. The biggest lesson of the US venture capital development is the failure of small business investment companies (SBIC) supported by the government. In 1958, the US Congress passed the SBIC bill, authorizing SBC to stipulate and implement SBIC plans. The purpose is to establish a government venture fund, guide and lead private capital into the venture capital market to support the establishment and growth of venture firms and promote high-tech industry. Managed by the government, Venture funds provide low interest loans to support SBICs in their venture activities. SBIC is a private company authorized by the government. It makes independent decisions over project selection and investment. It can get 4 dollars of low-interest loan from the government for each dollar of its investment and also enjoys special tax treatment. In return for this, however, it is restricted in the investment size and other interests by the government.

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Venture Capital Business and its Emergence in China

Stimulated by the SBIC plan, the number of SBICs registered in SBA reached 582 by 1962, which managed over 400 million private capital. In addition, 47 SBICs went public. All these have contributed to fast growth of venture capital in the 1960s. However, the preferential loan supported by the government conflicts with the characteristics and development laws of venture capital. On the one hand, venture capital involves high risks and long period of investment, and on the other hand, SBICs were under pressure of debts when they were provided lowinterest loans. Many investors and managers of SBICs were more interested in short-term returns. All this put together made many SBICs loan out to industrial and commercial enterprises to earn interest rate premiums rather than to invest in innovative ventures. To make things worse, as they were largely supported by the government, SBICs lacked an effective incentive system to create or attract high-quality investment managers and often ran into debt. By 1967, as many as 232 SBICs had serious problems. But the government still insisted that the lack of supervision, rather than any structural problem, led to these problems. Therefore, the Congress passed a bill empowering the SBA with wider juridical and supervisory rights to strengthen auditing and supervision over SBICs. These measures, however, could not stop the decline of SBICs. By 1977, the number of SBICs shrank sharply to 276. The venture capital managed by SBICs in 1978 accounted for 21 per cent of the total in the US, and was further reduced to 1 per cent in 1989. Such government-led venture capital companies incurred total loss.

ORIGIN OF VENTURE CAPITAL IN CHINA AND ITS HISTORY Since the reform and opening up in China, many scholars were sent to the US for further study. Some of them, including the author, began to notice the US venture capital development and its role in promoting the US high-tech industrialization and tried to introduce the concept into China. In March 1985, Decision on the Structural Reform of Science and Technology was promulgated by the CCPC, stating that ‘venture capital can be established to support hightech projects with radical changes and high risks’. In September 1985, China New-tech Venture Capital Company was ratified by the State Council and became the first national financial institution in venture capital investment. In 1986, the State Commission of Science and Technology put forward for the first time the strategic guideline to develop venture capital industry in China in the Science and Technology White Paper. Later, some small companies were set up by local governments and government departments to finance science and

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technology related businesses. However, the venture capital industry developed very slowly in China due to the following reasons: conceptual and structural obstacles, non-synchronization between scientific and technological reform and economic reform, blocked channels of financing, immature capital market, incomplete contractual relationship, irrational distribution system, and obscure intellectual rights. Some venture capital companies even went astray and made speculations in usury, stock trading, future trading and real estate operations and were eventually closed by the government for serious violation of law. At the end of 1980s, Shanghai Science and Technology Investment Company was established and headed by a former vice-mayor governing science and technology in Shanghai. With a registered capital of RMB 200 million, the company aimed to promote the industrialization of high-tech products and the development of high-tech enterprises. Nonetheless, as it adopted an investment method similar to government appropriation for technological projects, it invested in quite a number of projects with only a few million yuan in each project and had problems to provide successive funding. Other science and technology investment companies in other cities were trapped in similar difficulties with a huge amount of capital sunk in a number of small enterprises and no capital for sustained development. Although they had successfully incubated a group of chicken crying piteously for food, they did not have enough money to purchase any food to feed them, or sell the chicken to purchase eggs to incubate a new group of chicken. With the deepening of the reform, overseas investors were increasingly interested in investing in China. Since the early 1990, they began to set up many China investment funds. These funds were usually registered overseas and run by professionals to invest primarily in mainland China. By 1998, the total amount of capital of such funds reached US$ 4 billion, including IDG Technology Venture Capital Fund and Walden China Fund. However, only 8 per cent of their investments were made in high-tech industries, while 65 per cent were in the reproduction expansion of mature enterprises. Rich in venture capital investment experiences, many fund managers believed that the market environment in China was not mature for venture capital and did not provide much capital support to start-ups and entrepreneurs. I personally began to study the venture capital development in China when I returned from my American studies in 1984. In 1987, I was invited to a research program on venture capital in the United States. Since then, I have been advocating venture capital in many places such as the National Committee of the People’s Political Consultative Conference and the Ministry of Chemical Industry. In 1995, with support of the State Planning Commission, Beijing Feng

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Venture Capital Business and its Emergence in China

Sen Technology Branch was set up under New Industrial Investment Co., Ltd. A group of senior scientists, including Shi Changxu, Wang Daheng and me, showed great interest in the new venture company. In 1996, while attending the Senior Seminar on Scientific and Technological Transformation organized by the National Institute of Administration, I wrote an article entitled ‘Scientific and Technological Transformation Calls for Venture Capital’, pointing out that venture capital is a very important means to support scientific and technological transformation. In the article, I also discussed the major characteristics of venture capital investments and put forward some suggestions on the development of venture capital industry in China. In the same year, I solicited papers in Science and Technology Daily , and encouraged the related parties to study the theory and practice of venture capital. In September 1997, I organized and presided an international symposium on venture capital operations. All the participants, home and abroad, agreed that the conditions to develop venture capital in China were mature. First, the socialist market economy under construction in China provided a solid ground for venture capital development in China. Secondly, there were a huge number of valuable research fruits that could be transformed into innovative products. Thirdly, a team of high-quality entrepreneurs was gradually formed. Fourthly, the private bank savings reached a gigantic number (over RMB 5 trillion yuan by then), which can immediately turn into direct investments. Fifth, the consulting services surrounding technology, finance and law were developing. Sixth, the securities market in China was getting mature. All these created a favorable environment for the development of venture capital in China. Based on all the above endeavors, the Central Committee of China Democracy Construction Party raised a ‘proposal to speed up the development of venture investment in China’ in 1998 at the Ninth National Congress of China’s National Political Consultative Conference. The proposal was listed as ‘No. 1 Proposal’ at the conference and received wide attention from the participants, and echoed actively throughout the country. At that time, the scientific and technological community was looking for ways to turn their innovations into commercial products, the business community was trying hard to develop new products and new market, the financial community was seeking to develop effective investment tools, and the nation was adjusting its economic structure to develop high-tech industry and nurture new economic growth points. Venture capital simple meets all their different needs. After the ‘No. 1 Proposal’ was raised, a surge of venture capital investments

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was started all over the country. First, many departments under the State Council responded actively. The State Planning Commission, for example, expressed its appreciation of the proposal in the reply. Second, some local governments took immediate actions. Beijing, Shanghai and Shenzhen took the lead in formulating policies and measures to propel venture capital. Third, venture capitalists at home and broad were optimistic about the prospects of venture capital in China. For example, the Ministry of Science and Technology, IDG and other related parties were seeking opportunities of cooperation. Some competitive investment companies, both at home and abroad, were excited about the emerging opportunity. Fourth, many domestic high-tech enterprises began to seek support of venture capital for further development. Fifth, studies and discussions about venture capital flourished: many seminars were held, the National Natural Science Foundation of China and the Ministry of Science and Technology developed important research programs on venture capital and put forward suggestions on the study of legislation, management and financial support in regard to venture capital. Sixth, the wide coverage in the media created a very favorable environment for the development of venture capital. After a decade of exploration and preparation, the venture capital industry in China began to leap forward since 1998 and has played an increasing role in the transformation of research fruits and development of high-tech industry.

STATUS QUO AND EXISTING PROBLEMS OF VENTURE CAPITAL IN CHINA If venture capital industry in China was still in the beginning stage in 1998, it has now entered its primary stage after more than 3 years of development. Under vigorous support and promotion of all parties, the venture capital industry in China has stepped on a smooth track. It is roughly estimated that there are about 160 domestic venture capital companies in China with a capital of RMB 18 billion. In addition, there are about 150 venture capital management companies and most are based in Beijing, Shanghai and Shenzhen. Beijing houses 40 venture capital companies and 40 management companies with a capital of RMB 4 billion. Shanghai houses 40 venture capital companies and 50 management companies, with a capital of RMB 5 billion. Shenzhen has 43 venture capital companies and 36 management companies, with a capital of RMB 6.6 billion. However, the actual input of domestic venture capital companies is very limited, with about RMB 3 billion in total, about one sixth of the total volume. The number of foreign venture capital companies in China is also increasing

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Venture Capital Business and its Emergence in China

noticeably. It is roughly estimated that up to now there are 30 international venture capital funds operating in China. Apart from such early birds as IDG, Walden, and China Economic Cooperation Company, some new venture capital funds are very active, including Cyber Investment Fund, Softbank, Barings Investment, Intel, Dow Jones, Suez Asia in Hong Kong and Shanghai Industrial Company-Solomon Smith Barney, Goldman Sachs, and Singapore Economic Development Bureau. All of them have announced their ambitious plans, but their actual input is limited, with a total of US$ 300 million. Recently with the decline of Internet investment wave, the inflow of foreign venture capital begins to slow. There are six problems in china’s venture capital development. 1. The size of venture capital needs expanding. Presently the aggregated amount of capital managed by venture capital funds in China is US$ 2.5 billion, with actual input of US$ 600 million. Both the total volume and actual input are quite small in size. 2. Relevant laws need to be stipulated or revised. The Standing Committee of the National People’s Congress is making active efforts to promote the legislation of venture capital. At the end of 1999, the Company Law was revised, allowing high-tech firms to be listed on the science and technology board under Shenzhen and Shanghai Stock Exchanges. The original requirements in size (registered capital should not be less than RMB 50 million) and 3 consecutive years of profitability were two major barriers to the listing of high and new technology firms. The growth of high-tech firms is characterized by small size and negative cash flow resulting from constant need for input. The revised Company Law not only creates an environment for high-tech firms to be listed, but also provides venture capital with an exit for divestment. The Standing Committee of the National People’s Congress has passed the Trust Law in April 2001, and is now drafting the Investment Fund Law, which covers the venture capital fund. The Investment Fund Law is expected to be submitted to the Standing Committee for the first review in August 2001 and the second and third review in 2002. Venture Capital Law is also on the agenda of the Congress. Nevertheless, due to its sophisticated nature and difficulties of co-ordination among different interest groups, the legislation will not be completed until 2005. Other relevant laws and regulations need to be revised. For instance, as venture capital funds need to be organized in limited partnership form, contents of limited partnership shall be added into the existing Cooperative Enterprise Law. The Tax Law shall also be revised such that only personal income tax (no corporate income tax) will be imposed in limited partnership businesses.

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3. Discrepancies exist in understanding of venture capital. This is reflected in three aspects: the features, focus and difficulties of venture capital. Not a few government officials and practitioners fail to recognize that venture capital is a high-risk, portfolio, long-term, equity and professional investment. Short-term behaviors are pervasive. The focus of venture capital investments should be placed on the start-up, development and growth stages, and used to support projects with reliable technology. Listing is merely a means of divestment for venture capital, rather than the focus of venture capital investment. Without the innovation in the upstream stages, the listing in the downstream stage is like a building without foundation. We believe that the key to the success of venture capital operations in China is hard work and innovation. Any attempt to deceive the investors with the prospect of listing is detrimental. What is the largest obstacle in developing China’s venture capital business? In my opinion, it is lack of neither capital nor exits but human resources, especially qualified venture capitalists. 4. Operations are yet to be standardized. The organizational forms, financing methods and operational mechanisms of venture capital companies in China are still at the preliminary stage, and a set of effective systems are not in place. What makes things worse is the lack of commercial credit in China, which leads to breach of faith, default of debt, violation of contracts and even defrauds. Some technology owners used to rely on the government without any conscious effort to be responsible for the investors and went as far as refusing supervision from the investors. This in turn prevented venture capital companies from developing new businesses. They preferred to invest in securities or real estates, which weakened the role of venture capital in supporting innovations. 5. Performances are indistinct. Cases of successful projects are very few. For one reason, most of the innovative projects are still in their incubation period and have no distinct future. For the other reason, influenced by the climate of international capital markets, some companies listed on NASDAQ and Hong Kong’s growth enterprise market have relatively poor performance. 6. Private participation is still lacking. It is estimated that 80 per cent of venture capital is from government and government-controlled SOEs, and private participation is rather limited. If the private source of capital can not be mobilized, venture capital will eventually turn into a government-guarantee type of investment and won’t exert its due influence. The problems facing venture capital in China can be analyzed from three levels. The first level is macro system, or structural problems. As China is

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Venture Capital Business and its Emergence in China

undergoing a transition from a planned economy to a market economy, the legal system, the management mentality of the government and the procedures and methods of administration can hardly meet the requirements of the new investment tool like venture capital. These problems have cultural and ideological origins and are formed in a long history. It is unlikely for us to find a solution in the short-run. It was reported that five enterprises in Beijing had attempted to practice stock options. In the end, however, only two of them tested the practice. Some venture capital companies wish to try stock options, but the managers prefer cash at the present rather than the invisible and untouchable stock options in the future. The stock option is a kind of ‘golden cuff’, and due to ideological disparity, it is difficult to be applied. The reform shall be progressive, and path-dependent. The reform in China has gone through 20 years, and after such a long time, there is no turning back to the typical American way of venture capital operations. Reform in venture capital industry must be a long and progressive task in China. It is not realistic to expect the solution of problems through legal and administrative means overnight. We must on the one hand promote the reform at the level of macro system, and on the other hand, make a bold experiment in venture capital operations. T h e s e c o n d l e v e l i s t h e m i c ro s y s t e m , i n c l u d i n g t h e p ro b l e m s i n organizational form and operational mechanisms of venture capital companies. In this regard, we can integrate international experience with China’s realities. The practices need to be standardized as soon as possible. Some problems must be solved through legislation. In most cases, however, the board of directors has the right to decide matters such as incentive system, and organizational form. Nevertheless, some reforms need to be approved by the related authorities, especially when the government is involved in the investment. The third level is practical operations. We can draw on international experiences and come up with ways that cater to China’s realities. At present, we should not expect to develop a standard on practices. Instead we should encourage people to make a bold experiment, and reach a consensus through practices and communication. The final paradigm shall be a framework agreed upon by all, but it is never compulsory. In the following text I will try to analyze the problems at the three levels.

VENTURE CAPITAL DEVELOPMENT STRATETY WITH CHINA’S UNIQUE CHARACTERISTICS Venture capital is new in China, and despite some foreign experiences, we need to come up with a development strategy for venture capital that takes into

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account China’s unique characteristics in social system, historical traditions and cultural background. The target of venture capital development in China is to establish a comprehensive system in the next ten years and increase the actual input to RMB 10 billion each year. To reach this target, three problems must be solved: selecting good projects, collecting necessary capital and achieving good returns. I suggest a three-step development strategy: 1. Establishing venture capital consulting and management companies to evaluate and recommend venture capital projects for investors at home and abroad and manage these projects when entrusted by investors. This is possible in the existing legal framework with the Company Law at the center. There are two sources of projects: first we can select some good projects out of 27,000 scientific research fruits that are not transformed among 30,000 each year; second, we can make use of the inventions and patens of overseas Chinese or scholars. Before relevant laws on venture capital are promulgated, these projects can be recommended to individual investors and joint-venture firms can be established. Evaluation of venture capital projects must be combined with their management to ensure the objectivity and accuracy of evaluation. When investors have sufficient capital, they can contribute capital to establish venture capital investment companies according to the Company Law on a voluntary basis, invite professionals to manage the companies and make venture capital investments. Such companies are mostly dominated by the government and established by investment companies affiliated to the government. The primary purpose is to boom the local venture capital and high-tech development. Weak companies usually need to seek co-investors or strategic partners from the outside. 2. Establishing venture capital funds and formulating relevant regulations and management rules to attract capital both in and outside China. In venture capital investments, a group of projects are selected and follow-up investments are required for promising projects. As the demand for capital is quite big, funds must be established to attract enough social capital to meet the demand. There are three types of venture capital funds in foreign countries: independent funds seeking capital from the public, funds affiliated with big corporations and funds affiliated with financial institutions. As venture capital fund is a special fund, special management rules must be developed to provide detailed regulations on financing, management, supervision, and end of the funds, and the qualification, rights and responsibilities of the fund raisers. With these rules and regulations in place, we can publicly raise funds among domestic

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and international investor, and turn consulting and management companies or investment companies into fund management companies. 3. Establishing a comprehensive venture capital system to encourage venture capital investments and provide an exit. The government must develop its supportive measures through legislation, including investment, subsidies, guarantees, interest subsidies, and tax reductions. Furthermore, it must promulgate relevant regulations over M & A and IPO of venture firms as well as rules governing various venture capital intermediaries. The second board can provide a divestment exit for venture capital firms and facilitate their further development. In the start-up and growth periods, risks are extremely high and financing can only be made through venture capital funds. We should not set up the second board until venture capital funds are established, or it will only increase the risk for investors and create a chance for speculators. In addition, the main board is yet to be improved, and it is difficult to set up a rational relationship between the second board and the main board. The urgent task is to launch venture capital funds as soon as possible and create favorable conditions for the upcoming second board. To realize the above strategic goals and tasks, continuous efforts shall be made to create the following basic prerequisites:

1. A Group of Entrepreneurs with Innovative Products Good investment projects should have huge market opportunities, state-ofthe-art technology with proprietary intellectual rights, convincing business plans, and powerful management nucleus. The international experiences show that many entrepreneurs come from schools of higher learning. The Silicon Valley is a good example, and its development is mainly pushed by the innovations of professors and students from Stanford University. The Computer Science Department in Stanford alone created a number of distinguished entrepreneurs, including Andy Bechtolsheim (founder of Sun Microsystems), John Hennessey (founder of MIPS), Jim Clark (founder of Silicon Graphics and Netscape), Jerry Kaplan (founder of Techknowledge, Go and Onsale), Scip Stritter (founder of MIPS), Len Bosack (founder of Cisco System) and David Cheriton (founder of Granite). The total market value of these companies is up to US$ 90 billion. Venture capitalists evaluate entrepreneurs on the basis of the following traits: 1. Upright and reliable. If necessary, an investigation must be made upon their past performance and credibility. 2. Motivation. If the overriding motive of an entrepreneur is to make money, he is not trustworthy. The entrepreneur must have a sense of achievement,

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and be crazy about his projects. He must impress others that he wants to do something rather than merely to make money. 3. Perseverance and vigor. A man who easily bends down should not be supported. 4. A clear mind and a keen insight. Venture capitalists believe that a clear and keen mind can explain his business model even in the elevator. If a man could not express himself, he is not worth supporting. Furthermore, he must be able to understand things quickly, and to integrate comments from all parties to improve his business plan. 5. Expertise. An entrepreneur should be knowledgeable and practical. He will not be qualified if he can only talk big and know nothing about practice. 6. Leadership. An entrepreneur needs to manage a business, and deal with interpersonal relations. He will not succeed if he has no leadership. To create entrepreneurs, we must first construct a social and cultural environment favorable for innovative spirits. The schools of higher learning shall be the major source of innovations and are the exact places for venture capital to find its target. The schools of higher learning shall also improve its postgraduate programs to cultivate innovative spirits and entrepreneurship with rigor and passion. At present, Beijing, Shanghai and Shenzhen are most likely to become the first bases of high and new technology enterprises. With Zhong Guancun as the center, Beijing has increased its support for entrepreneurs in the past decade. In Shanghai, Zhangjiang High Tech Park symbolizes the local government’s efforts to exploit the human and policy advantages and speed up the creation of an environment favorable for high and new technology industries. Shenzhen is also taking advantage of its annual High and New Technology Trading Fair and the upcoming second board to attract venture capitalists and entrepreneurs.

2. A Group of Outstanding Venture Capitalists The pressing task is to create a group of outstanding venture capitalists equivalent to general partners of venture capital funds in foreign countries. Although they contribute only 1–2 per cent of the total investment in the fund, they take unlimited responsibilities over management of the fund. They are professionals in one specific field and experts of management and finance as well. They are crucial to the success or failure of venture capital operations. Their major task is to use their expertise and experiences to raise funds and make investment decisions. They participate in the board meeting of the venture enterprise they supported and are responsible for important financial

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and personnel decisions. At the same time, they need to win the trust of their investors and get their remuneration with good performance. The main role of venture capitalists is to support entrepreneurs to start up and investors to speculate. To this end, venture capital investments must be run by professionals. The urgency of the problem has three reasons. First, there is a huge amount of research output that needs to be transformed. Their assessment needs a great number of professionals in technology, management and finance. Secondly, scientists and technicians have entrepreneurship, but lack knowledge and experiences in financing and management. A scientist may be very innovative, but still unable to develop an enterprise or commercialize his innovations without the support of a venture capitalist. Thirdly, both foreign and private investors are willing to make venture capital investments, but cannot find trustworthy agents. They always run into a dilemma where ‘the trustworthy is not capable, while the capable is not trustworthy’. Before they can find a capable and trustworthy agent, they won’t contribute any capital with ease. A venture capitalist fulfills the following five tasks in supporting an innovator: to evaluate the commercial prospect of innovations with his business experience and instinct; to help the innovator develop a business plan; to help the innovator to present his innovations to investors in a convincing way; to help the innovator to sign an agreement with investors to establish a venture firm; and to sit in the board of the venture firm on behalf of investors, to make decisions on important financial and personnel issues, and to take responsibility for restructuring and divestment of the venture firm. Venture capitalists should sit in the board of directors of the venture firm, and have the final say on such issues as when to increase investments, when to divest, and when to close the firm. This should be written into the agreement. In addition, they should also decide on the appointment of CEO, CFO, CTO and vice-presidents. This is very important in China. The innovators in China always take it granted that a man with good technological capabilities can be a good president. It is just opposite in reality. According to statistics from the US, only half of the innovators can still qualify as the presidents of their firms, and the other half are not suitable for the position. For example, Jerry Yang of Yahoo is not the CEO. The US venture capitalist Randy Komisar holds that an Internet technology development firm needs the president to have different qualities in different development stages. In the start-up stage, the president shall have innovative ideas and persistent spirits; in the growth stage, the president shall have strong leadership and keen sense of market; and in the maturity stage, the president shall have strategic management capability. He cannot only maintain

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the set strategic orientation, but also adapt to the changing environment. As it is rare for an entrepreneur to possess three qualities at the same time, the enterprise must choose the right president in different stages. Bill Gates is a technological expert, but also gives away the CEO position of Microsoft. The innovators in China should know their own limitations, and give up the position of CEO if they have no management competence, or they will ruin their firms. Venture capitalist can help the speculation of investors from four aspects: to select out of thousands of proposals the projects with good commercial prospects; to assess the quality, personality and capability of an innovator through interviews and preliminary cooperation; to join the board of directors on behalf of investors, and provide supervision and guidance for the enterprise; and to choose a right time to divest through IPO or by sell-out to achieve high returns for investors. A good venture capitalist should possess five qualities. First, he must have commitment, responsibility, and business acuteness. By intuition, he can immediately identify promising projects. Second, he has strong interpersonal skills and is good at identifying the quality, ability and credibility of a person. Third, he knows corporate management, financial operations and relevant laws and regulations. As a rule, innovators are very capable in technology, but lack knowledge in management, finance and law, and venture capitalist can fill this gap. Fourth, he must have expertise and practical experiences in more than one professional field. If a venture capitalist knows nothing about the professional field, he can not communicate effectively with innovators. While being abroad, I came across many venture capitalists who used to be technicians, but studied finance and management obtained an MBA degree later. They then went into venture capital industry. Fifth, he can maintain good relations with people in the financial, technological, legal and political fields. This is particularly important in China. Some highly-paid general managers of venture companies in China hold a doctorate and MBA degree, knows technology and management, and even have international experiences in venture capital investments. However, as they know little about the practical situations in China, nor can they maintain good relationship with others, they can hardly make good achievements. Some are even discharged of their positions. The creation of venture capitalists in China can rely on four factors. First, we must identify people with great potentials in our practice, and provide them with necessary training. Second, we must develop a plan to send people with some experience in venture capital investment abroad for further training. Third, we must attract the overseas Chinese who are experts in venture capital

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operations. Last, we must set up an effective incentive system for venture capitalists.

3. Sufficient Follow-up Capital In the US a venture firm usually requires US$ 3–5 million in the start-up, and

the amount is nearly doubled in each following stage. For this reason, adequate initial and follow-up capital is needed. As high risks (high returns also) are

involved in the start-up and development stages, only venture capital funds can satisfy their financing requirements. In the growth stage, the firm can win

the support of some insurance funds, pension funds and other institutional

investors. They can even win the support of the securities investment funds and even banks in their maturity stage.

The later the stage, the smaller the risk and the smaller the return. Venture

capital can be invested throughout the four stages, but real venture capital only focuses on the first and second stages. When we are developing our venture

capital industry in China, we must establish venture capital funds investing particularly in the start-up and development stages and seek new channels of financing for firms in the growth and maturity stages. Institutional investors

such as the insurance funds, pension funds and securities investment funds should be allowed to invest 1–2 per cent of their capital in venture operations. When conditions permit, banks and listed companies should be allowed to set up independent venture capital funds.

4. Exits for Divestment There are two exits for divestment: sell-out and IPO. Some argue that no venture

capital will exist in China without the second board market. This argument may not be plausible. In the US venture capital came into being as early as in

1946, but the second board market was not established until after 1971. Sell-

out of venture firms to big corporations, employees or entrepreneurs is now

increasingly popular (in 1997 sell-out accounts for 70 per cent, and IPO accounts for 30 per cent; while in 1998, sell-out accounts for 75 per cent and IPO accounts for 25 per cent). IPO is a very important exit of divestment, but not the only,

or most important one. In this sense, the saying – no second board, no venture capital – does not hold water. From 1990 to 1997, the percentage of venture firms that were listed in NASDAQ was around 23–41 per cent as is shown in the graph on the next page:

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41% 33%

38% 31%

26%

1990

37%

38% 23%

1991

1992

1993

1994

1995

1996

1997

From the above graph, we can clearly see that 59–77 per cent of venture firms took other divestment exits rather than IPO. Unlike stock investors who usually go by the trend, acquirers know business and can correctly assess the value of the target venture firms. In 1998 the top 5 venture firms in terms of the sell-out volume were sold between US$ 260–650 million, while the top 5 venture firms in terms of market capitalization had their market caps around US$ 128– 222 million only. Therefore, we should seek various exits of divestment rather than relying the future of venture capital solely on the opening of second board market. In the meanwhile, we must be aware that the establishment of the secondboard market will increase the confidence of investors. Preparation of the second board market must be made with enthusiasm and caution. Before it is formally opened, the following work must be done. First, the relevant laws must be revised. The Standing Committee of the National People’s Congress has revised the Company Law by the end of 1999, allowing high-tech firms to be listed on the high-tech boards in Shanghai and Shenzhen Stock Exchanges. But the second board is an independent market, and it supports not only high-tech firms, but also firms all other ‘high growth’ firms to finance through IPO. This conflicts with the revised Company Law. Besides, some articles in the Company Law are not consistent with rules of the second board market and must be revised accordingly. Second, the market structure must be designed with caution. I believe that it is not suitable to set up an independent second board in Shenzhen. We should establish a market structure similar to NASDAQ, under which the second board co-exists with the main board and OTCBB (Over the Counter Bulletin Board). Such a structure can help the market grow in scale, and attract more investors. It addition, it will facilitate the upgrade (entering the main board through buyback) and down-grade (transfer to OTCBB) of the listed companies. Third, the market risks must be prevented. The listing requirements for the

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second board market are comparatively low, with no strict requirements over the company size and performance, which gives rise to frauds and malicious speculation. For example, speculators can disclose false information to deceive investors, and the consequence could be very serious. To eliminate the risks of the second board market, serious and comprehensive study must be carried out on legal, technical and supervisory issues to maintain high standards. In particular, measures must be taken to ensure the faithfulness, accuracy and completeness of the disclosed information in the prospectuses. Heavy punishment must be imposed upon those issuing companies, sponsors and relevant intermediaries violating the disclosure regulation. To prevent malicious speculations and reduce market volatility, the market maker system can be introduced according to our own situations. Fourth, the timing is important. We need to take into account the international climate and China’s realities in regard to development of capital market. The best time should be when the overseas second board markets level up and the venture capital funds in China begin to be established.

5. A Favorable Policy and Regulatory Environment The government support is also very important to venture capital. It can take various forms according to international and Taiwan’s practices. 1. Legal protection. Examples are Small Business Act in the US High-tech Promotion Act in Japan, Small and Medium Start-ups Support Act in South Korea, and Venture Capital Regulations in Taiwan. 2. Grants and interest subsidies. For instance, The Ontario State in Canada prescribes that individuals investing in high-tech venture firms can get grants as much as 30 per cent of the total investment volume. The Singapore government prescribes that if companies investing in high-tech enterprises incur loss for three successive years, they can obtain subsidies as much as 50 per cent of their investment volume. 3. Provision of guarantee. The US stipulates that bank loan to venture firms can account for 90 per cent of the aggregated investment volume of the project. If the enterprise goes bankrupt, the government will put its asset on auction and pay off 90 per cent of the debt. The Ministry of Industry in Japan established ‘Incubation Center for R & D firms’ in 1975, whose major task was to provide guarantees to venture firms for 80 per cent of their loans from financial institutions. The Trade and Industry Department of England began to provide guarantees for independent small and medium enterprises with medium and long-term bank loans since 1981. The maximum volume of such loans is 100,000 pounds, with 2–7 years of repayment. If the debtor

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defaults at maturity period, the Trade and Industry Department will repay 70 per cent of the debt at an annual interest of 2.5 per cent. 4. Tax incentives. The U.S. prescribed in 1981 that 60 per cent of returns on venture capital investment should be tax free and the rest 40 per cent should enjoy a 50 per cent tax reduction. France prescribed in 1985 that earnings or net capital earnings from equities of unlisted companies held by venture capital companies should be exempted from income tax and the total tax reductions could be as high as one third of the taxable assets. Singapore prescribes that the first 5–10 years of venture capital investments are totally tax-free. Taiwan promulgated Venture Capital Regulations in 1983 which prescribes that companies that invest in high-tech areas can have 20 per cent tax reductions. 5. Establishment of a second-board stock market. Examples are NASDAQ Small Cap in the U.S., the Unlisted Enterprise Board in Britain, the Second Board Market in Japan, and the New Stock Market in Germany.

SYSTEM INNOVATION OF VENTURE CAPITAL 1N CHINA System innovation of venture capital in China should be favorable to the creation of venture capitalists, start-up of entrepreneurs, and investment of investors. As venture capital is a business activity rather than a charity event, it is meaningless when no investors are motivated to invest. At present stage, the venture capital companies in China need to experiment and standardize, the venture capitalists need to develop and self-discipline, and the venture entrepreneurs need to innovate and grow. Any system innovation must follow the above line.

1. The Organizational Form of the Venture Capital Investment Company in China First of all, the organizational form should be primarily limited liability company at the beginning and gradually transferred to limited partnership. After the Investment Fund Law is issued, study must be made on limited partnership. The most important feature of limited partnership is that venture capitalists as the general partners will contribute 1–2 per cent of the total capital and take unlimited responsibility of the funds as the managers. Second, under the framework of the corporate governance as is stipulated in the Company Law, the authority of the project manager should be increased. At present, the venture capital institutions are organized as companies and major decisions must be passed by the board of directors. Such a corporate governance can

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solve the conflicts of interests between the owners and the managers. However, if the project manager does not have enough power, no venture capitalist will be created. Major decisions must be passed by the board of directors in line with the Company Law, but meanwhile the project manager must have more power and more autonomy, which will help create venture capitalists in China, and a group of qualified general partners when limited partnership is adopted. Third, the Advisory Committee must be set up to reduce blind decision-making. Some venture investment companies are blind in the decision-making process. They tend to select projects with ‘good appearance’ without any serious investigation or evaluation, and decline projects with good prospects for fear of risks. Fourth, a flat, semi-autonomy learning organization must be established. The investment companies must not imitate those companies in vertical pyramidshape structure with lots of management layers such as departments, bureaus, offices, etc, but must be streamlined into a horizontal structure with only two levels of management: the general manager and the project manager. The organization must also be semi-autonomy, allowing the project manager to have bigger say. It must be a learning organization and can innovate continuously.

2. The Financing Method of Venture Capital Companies in China Venture capital investment companies in China, and the private companies in particular, can adopt a ‘soft commitment’ financing method. First, the shareholders contribute the legal capital, which is usually between RMB 30–100 million yuan. Second, 10–20 per cent of the registered capital is drawn as seed capital to support the start-up and prepare for the long-term development of the company. Third, contribution by the investors adopts the ‘soft commitment’ method. The investments are distributed according to the shareholding percentage and are transferable among the shareholders. Shareholders of the venture capital investment companies must promise that after the project recommended by the management is passed through the board of directors, the shareholders shall invest according to their shareholding percentage in the venture company and the right to invest can be transferred to other shareholders. The capital injected to a venture firm can be done through the investment company or by the shareholders themselves. The biggest advantage of the ‘soft commitment’ is that capital is contributed to the investment company only when it decides to invest in a project. This avoids the situation that the investment company has big money at hand, but cannot find a project to invest. In case this happens, the management is under a lot of pressure and eventually may take the risk in investing in real estate, futures and stocks instead of making venture capital investments. The ‘soft commitment’ can

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also prevent the moral hazard when millions of capital is at the hand of the management. Furthermore, the shareholders have preemptive rights to invest in the next round of financing and outside investors are invited when needed.

3. The Operating Mechanisms of Venture Capital Investment Firms in China The operating mechanisms of venture capital investment firms in China should include the following phases. (1) The project manager scans the project proposals. (2) The project manager helps the sponsor develop a business plan and submit it to the Advisory Committee for review. (3) The board of directors decides whether to invest and how much to invest, and requires the shareholders to contribute according to shareholding percentage. (4) If the outside investors are needed, the project manager accompanies the sponsor to make road shows and introduce the project to the investors. (5) The investors inject capital directly into the venture firm and the project manager participates in the board of directors. The direct injection of capital without the intermediary of the investment company can abbreviate formalities and put the investors at ease. The key to venture capital lies in the human power. The entrepreneurs, managers and employees should be motivated by an effective personnel and compensation system. The incentive system should include salary, welfare, bonus, stock rights and stock option. In the ‘Decision on Implementing the Reform of Personnel System in Scientific Research Institutions’ issued jointly by the Department of Organization of the CPC, State Personnel Ministry, and Ministry of Science and Technology, it is stated that a flexible and effective compensation and incentive system must be established in line with the realities of scientific research institutions. Such a system should be linked to position, task and performance. The methods of distribution of scientific and technological production factors must be enriched and improved to link compensation of the scientific and technological staff with their contribution and performance. The power of distribution in scientific research institutions must be increased to establish a flexible distribution and incentive system emphasizing performance and contribution. Preferential policies should be worked out for key positions and good performers. With the approval of the related authorities, research institutions should be allowed to recruit talents with competitive package. The scientific and technological staff should be encouraged to start up high-technology firms or take part-time jobs. The measures must be formulated to provide preferential policies for the transformation of research fruits, and to ensure that people involved will

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be rewarded. Professionals should be encouraged to get rich first through transformation of scientific products and promotion of technological progress. At present, some local cities are practicing the employee stock-holding and stock option plans in some high-tech enterprises on a trial basis, which will surely promote innovations. The incentive system must be established within the venture capital investment company. The annual management fee (including the employee salary and benefits) should generally account for 2–3 per cent of the registered capital; rewards of the employees shall be linked with their performances instead of equal distribution and account for 15–20 per cent of the returns in the same year. The project manager must be required to contribute 1–5 per cent of the capital into the project he is responsible. The employees should also be encouraged to hold shares in the investment company. In some companies, stock option plan can be a choice.

VENTURE CAPITAL OPERATIONS IN CHINA The basic responsibility of a venture capitalist is to select good projects. The venture capitalist has to ‘serve two masters’ at the same time. On the one hand, he must negotiate with the innovators in the interest of the investors. On the other hand, he must support the innovators and help them convince the investors and the board of directors to make investment decisions. The venture capitalist has ‘two faces’: he has to make profit for the investors and support the innovators in their entrepreneurial endeavor at the same time. The venture capitalist evaluates a project against six criteria. First, it must have a unique business model. Venture capital supports innovative ideas and creative business models, which should be unique. In the Monk and the Riddle, Komisar quotes a case. In the Internet fever, someone raised a proposal to sell funeral goods on the Internet. He hit upon the idea when he was arranging the funeral of his late father, as he felt the fee charged by the funeral parlor and the coffin was too expensive. This proposal is indeed a fresh idea as most sales on the Internet are electrical devices and books. However, the author thinks the business model is dim in the long run because it can be easily copied by others. Finally they change the business model into a free Internet website. When a person passes, his relatives all over the world can express their sorrows over the deceased in the website. The website puts on some banner ads for funeral companies and suppliers of funeral goods, and maintains its daily operations with the advertisement fees. This idea is totally different from the original one. The entrepreneur must have a unique business model, instead of one that is slightly different.

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Second, the technical base must be relatively mature. The technological innovations supported by venture capital, though not totally mature, must be relatively mature. The venture capital industry in the US is very developed and many strange proposals are made every year there. The Confessions of a Venture Capitalist written by Ruthann Quindlen describes one person who suggests a home-use nuclear station, which is a micro and portable nuclear station used in households. This might be a good idea but its technical base is rather weak. Third, the market prospects must be wide. Evaluation of the market prospects is very important when a venture capitalist makes an investment decision. Sometimes his evaluation is right, and sometimes his evaluation is wrong. If his evaluation is wrong, it could be that the venture capitalist fails to look at the problem from the perspective of innovation. For instance, Kenneth Olsen, founder of DEC, decided not to manufacture personal computers in 1977 because he believed that no one would use a computer at home. His conclusion is now proved to be totally wrong. DEC has missed a very good business opportunity. Take another example. When Xerox invented the copier machine, it was short of capital and asked IBM to invest. Experts at IBM thought that the copier machine was only a replacement of carbon paper, while the market for the carbon paper was very limited. They decided not to invest. The fact turned out that the copier machine can do much more than carbon paper and IBM again missed the business opportunity. In 1903, Ford wished to make cars and sought loans from the bank. One banker said that the horse can never be replaced and the ‘car ’ thing was just a perishable fashion. Then he refused to invest in Ford Company. Today, cars have replaced horses in most situations. The saying goes among the venture capitalists that it is more pitiful to miss a business opportunity than a project failure. Fourth, the economic benefits must be projected correctly. The business plans in China has a very big problem, that is, the projection of economic benefits is not objective. DCF (Discounted Cash Flow), NPV (Net Present Value), IRR (Internal Rate of Return) and other methods are used by many people to project the returns of their projects. However, we must be careful when we try to use them in venture capital projects. The future cash flow, sales prospects and market competitiveness are based on assumptions, and very often they are not at all objective. Therefore, venture capitalist will discount the economic benefits of the business plans in two ways. The first is called risk premium method, with which about 3–5 per cent of the risk premium is added to the original discount

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rate to lower the IRR. The second is the risk discount, with which 60–70 per cent of the estimated revenues are discounted to make a more realistic projection. Fifth, the financing needs may be satisfied. Some projects have a huge demand for capital. A venture capitalist tends to turn down when they think impossible. Sometimes, a project is extremely promising, but it would require hundreds of millions of investments. The venture capitalist must be very cautious. For instance, the Internet TV is a very good idea, and the person with the idea is very innovative. However, the business model underlying the idea may not be practical. An enhanced TV is a TV with enhanced functions, which can provide people with many services. But the investment needed by the enhanced TV is extremely big and the general venture capitalists can not satisfy its demand. Finally the innovator has to sell the company to Microsoft, because Microsoft has the capability. When Bill Gates went to Shenzhen of China to promote its on-top box, he has already bought the company. Six, the pricing of technology must be reasonable. The innovators always price their products too high. It is reported that one enterprise in china wished to buy a technology from a university. And the university wanted to have 96 per cent of the shares for its technology. Only the idiot will make such an investment! In the overheat of investment, some innovators tended to ask for a very high price for their innovations. We must pay due attention on this problem. The pricing of technology must be reasonable and changes in different periods. In the beginning stage when the technology is not proved to be mature and the market is not proved to be promising, overpricing is not acceptable. High price is only rational when the technology is proved to be successful. The percentage of technology shares should not exceed 50 per cent in the total in the beginning stage, because they are virtual while the capital contributed by venture capitalists is real. If the project fails, the innovator will not have a big loss. The venture capitalist is different, and his money will go forever. Therefore, the pricing of technology in the start-up stage must be reasonable and sometimes the entrepreneur must also contribute capital. The two parties can sit down and negotiate on the price. Neither of them should be allowed to decide the price alone. To develop the venture capital industry in China, we must draw on the international experiences, and at the same time take into account the realities of China. We should not copy others blindly, and instead we must come up with a way with Chinese characteristics. Second, we must make a bold experiment and standardize our behaviors through practices. Thirdly, we can think about setting up a venture capital association on a voluntary basis, and play an active

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role in training, publications, exchange of experiences and self-discipline of the industry. At present, we are preparing a bilingual journal – China Venture Capital, and compiling training materials – Series of Venture Capital Practices (10 titles in total). We also organize China Venture Capital Forum each year, and plan to establish a venture capital research center. Fourth, the venture capital market in China must be opened steadily. Opening up is the irreversible trend, and in today’s world, venture capital will not develop if we close our door to the outside world. However, the opening up should be gradual, and consistent with our supervisory capabilities. The degree of opening up is based on our capabilities of supervision. Opening up without good supervision will lead to chaos, while too much supervision will kill the economic vitality. The government should exercise proper supervision over venture capital. Experience of the past two years has showed that venture capital is very promising in China. However, we must be aware that we will have to go a long way before we can see the important role of venture capital, the creation of a highly developed market economy. We must try audaciously and make unremitting efforts. Venture capital will invariably become the engine driving the wheel of innovations to the promise land of prosperity. Completed on 27 May, 2001

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3

Chapter

Fictitious Economy and the East Asian Financial Crisis

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In late 1997, the East Asian-financial crisis broke out in Thailand and quickly swept through the world. The financial crisis can be roughly divided into the following six stages:

Stage 1: Early Clues Compared with the Mexican financial crisis in 1994, the East Asian financial crisis is much more astonishing. The Mexican financial crisis occurred when Mexico had not yet emerged from the Latin American debt crisis of the 1980s and when the economy was sluggish and the political climate unstable (the annual growth of per capita GNP in Mexico from 1985 to 1995 was only 0.1 per cent). The East Asian financial crisis, however, broke out when Asian economies were enjoying rapid growth. The average GNP growth rates among the most successful countries were typically above 7 per cent, and so most people were shocked at the suddenness of the crisis. Unexpected as it was, there were warning signs. During the Mexican financial crisis, some economists warned about the possibility of a similar crisis in East Asia. For example, P. Krugman, professor of economics at the Massachusetts Institute of Technology (MIT), foresaw the inevitability of an East Asian crisis in 1994. He argued that the so-called economic miracle in East Asia did not stem from the growth of productivity, but from excessive input, overinvestment, overly speedy capital inflow, and irrational labor capital injection. Such an ‘economic miracle’ was unlikely to be sustainable. In the article ‘Who’s Next after the Mexican Crisis’, which appeared in Fortune magazine on 6 March 1995, the author asserted that a financial crisis like that in Mexico loomed over the Philippines, Indonesia, Brazil, Malaysia, Thailand, Argentina, and Chile. In September 1995, Larry Lau, professor of economics at Stanford University, delivered a speech, ‘Will an East Asian Country Follow at Mexico’s Heels’, in which he pointed out that a financial crisis would occur in the Philippines, Thailand, Korea, Indonesia, and Malaysia, although mainland China, Taiwan, Hong Kong, and Singapore might escape such a fate. In August 1996, M. Goldstein, an economist with the International Monetary Fund (IMF), commented in one of his articles that with rapid economic growth in countries like Thailand, Indonesia, and Malaysia, massive current account deficits might lead to a financial crisis like that of Mexico. The rapid increase of Thailand’s current account deficit, in particular, would make the country more vulnerable to the impact of economic turmoil and market reversal. Unfortunately, these insightful analyses and comments did not receive the attention they deserved. Some of the signs indicative of an impending crisis included the following:

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♦ Balance-of-payment equilibrium was destroyed by growing deficits. From 1992 to 1996, the current account deficits of Thailand, Indonesia, the Philippines, and Malaysia increased from US$ 6.3 billion, US$ 2.8 billion, US$ 1 billion, and US$ 2.17 billion to US$ 14.7 billion, US$ 8.9 billion, US$ 4.8 billion, and US$ 4.7 billion respectively. ♦ Foreign debts, among which a large portion were short-term debts, increased rapidly. Between 1992 and 1996, the foreign debts of Thailand and Malaysia increased from US$ 37.4 billion and US$ 22 billion to US$ 97.8 billion and US$ 30.9 billion respectively. The proportions of mid- and short-term foreign debts in Thailand, Indonesia, the Philippines, and Malaysia were 69.6 per cent, 62.8 per cent, 60 per cent, and 45 per cent respectively. ♦ There was an overstock of real estate. In Thailand, loans granted by commercial banks to real estate businesses increased from Bt 77 billion in 1990 to Bt 142.6 billion in 1996, including a larger increase of foreign direct investment (from 2.9 per cent in 1992 to 42.6 per cent in 1995). At the beginning of 1997, there were around 850,000 unsold apartments in Thailand, and about half of the office buildings were also unsold. In Kuala Lumpur, the vacancy rate of office buildings reached 25 per cent, or a total area of 40 million square feet. The over-supply in the real estate sector led to significant bad bank debts. Before the financial crisis, Thailand’s bad debt rate was about 10 per cent. The bad debt rate of Indonesian national banks was 17 per cent. In Malaysia, it was around 6.7 per cent in 1997.

There were quite a few problems requiring special attention in other East Asian countries. For example in January 1997, Korea’s Hanbo Steel Group announced bankruptcy because of the insolvency of its US$ 6 billion debt, and was the first enterprise to shut down since the Korean economy had begun to flourish. In early May 1997, Japanese officials expressed their concern over the devaluation of the yen and indicated the possibility of raising interest rates, shaking investor confidence in the East Asian economy. There was a flurry of selling East Asian currencies, leading to turmoil in the stock and foreign exchange markets.

Stage 2: Initial Eruption The rapid economic growth of Thailand had for years been built on its export of electronic products. But in 1996, affected by the shrinking international market and the increase in domestic product costs, the export growth declined from 22.5 per cent in the previous year to 3 per cent, and the current account deficit reached US$ 16 billion. Moreover, the Thai government had completely opened its domestic capital market since 1992, adopted a high interest rate policy to attract foreign capital, and insisted on pegging the Thai baht to the US dollar. These practices led to a deluge of capital inflow from foreign countries, increasing the foreign debt from about US$ 20 billion to over US$ 90 billion, mostly in short-term debts. International funds were mainly invested in the real estate market, channeling 30 per cent of Thailand’s total bank loans into real

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estate businesses. Therefore, when domestic economic growth slowed down and real estate prices plummeted accordingly, bad debts and loan defaults began to accumulate and investor confidence was shattered. In February 1997, the first flurry of selling off Thai baht on the international financial market resulted in the plunge of the stock market. Thailand’s central bank spent US$ 2 billion, with the help of neighboring countries, to control the situation temporarily. In mid-May 1997, some international foreign exchange speculators had another flurry of selling off baht, driving its exchange rate against the US dollar to the lowest in recent decades. Thailand’s central bank had to spend US$ 5 billion to intervene. The exchange rate temporarily stabilized, but at a significant cost: the foreign exchange reserve shrank sharply, losing US$ 4 billion in May alone, and interest rates increased to a level almost unbearable to companies, leading to soaring commodity prices and plummeting stock indices. On 20 May 1997, Thailand’s finance minister announced his resignation. When only US$ 8 billion was left in foreign exchange reserve, Thailand had to declare that the central bank would no longer intervene in the foreign exchange market, while a floating rate would be adopted for the baht instead and the fixed exchange rate system, at which a basket of currencies was pegged to US dollar, would be eliminated. It also increased the prime rate of commercial banks to 12.5 per cent. In response, the Thai baht was devalued by 18 per cent on that day, heralding the arrival of Thailand’s financial crisis.

Stage 3: Rapid Spread Thailand is a key member of ASEAN (Association of South-East Asian Nations) and has a very close relationship with other countries in the region. After Thailand adopted the floating rate system, a strong impact was felt on the exchange markets in ASEAN countries, and Indonesia, Malaysia, and the Philippines were forced to devalue their currencies. Even Singapore, with its sound financial structure, currency system, and market mechanism, decided to devalue the Singapore dollar. The East Asian financial crisis was then full blown. In order to shore up the exchange rate of the Philippine peso (US$ 1 against P 26.4, with 1.5 per cent fluctuation), the central bank of the Philippines increased the overnight borrowing rate from 15 per cent to 32 per cent, and meanwhile intervened in the marketplace with US$ 1 billion in foreign exchange reserve. But its efforts seemed ineffective. On 11 July, the Philippine government was forced to allow the exchange rate to float within an unspecified ‘wider ’ range, and the rate therefore declined by 11.5 per cent. Following the devaluation of the Philippine peso, the Indonesian rupiah and the Malaysian ringgit also

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adopted a floating rate system after 11 July. As the Indonesian rupiah had been overvalued for a long time, speculation fervor could not be discouraged, despite the government’s decision to expand the floating range of the rupiah against US dollar from the original 8 per cent to 12 per cent. On 11 August, in order to cope with the financial crisis, the Thai government decided to accept the US$ 16 billion emergency bailout package arranged by the IMF. International speculators shifted their attack to currencies in neighboring countries such as Indonesia and Malaysia, leading to significant devaluation of those currencies. On 15 August, the central bank of Indonesia was forced to allow the free floating of exchange rates on the monetary market. Once the news was announced, the Indonesian rupiah was devalued by another 7 per cent, leading to another round of exchange rate drops in East Asia. Affected by the plummeting Indonesian rupiah, the exchange rate of the Malaysian ringgit dropped to as low as M$ 2.825 to US$ 1 on 15 August. Following the consecutive significant devaluations of the Thai baht, Philippine peso, and Malaysian ringgit, the Singapore dollar – a model for the region – encountered tremendous pressure and had to be devaluated. From 1 July to 29 August, the Singapore dollar was devalued by 5 per cent. During the same period, the Thai baht, Indonesian rupiah, and Philippine peso were devalued by 38.5 per cent, 21.5 per cent, and 14.9 per cent respectively. In order to prevent further decreases in the exchange rate of the peso, the central bank of the Philippines decided on 27 August to increase the bank reserve rate from 5–8 per cent, in the hope of reducing the amount of peso in domestic circulation by 30 billion and thus discouraging currency speculation. When the Malaysian stock index reached a record four-year low, Prime Minister Mahathir prohibited the sell-off of more than 100 well-performing constituent stocks. The adoption of this measure, however, shattered investor confidence, and the index lost another 36 points that day. On 29 August, the Indonesian government set an upper limit for nonresidents in forward exchange and canceled the 49 per cent upper limit of equity that could be held by foreigners in a listed company.

Stage 4: Expansion In October 1997, the financial crisis in South-East Asia began to spread to East Asia. Starting with the devaluation of the New Taiwanese dollar, the crisis quickly gripped Hong Kong, then Korea and Japan, triggering the East Asian financial crisis and exerting great pressure on China to devalue the RMB. On 17 October 1997, the Taiwan authorities suddenly devalued the New Taiwanese dollar by 11 per cent, from NT$ 28 to US$ 1 to NT$ 31 to US$ 1.

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Taiwan had a relatively healthy economy, with a small surplus in its balance of payment. Its foreign exchange reserve amounted to US$ 80 billion, and foreign debt was a mere US$ 100 million. It had the ability to keep its currency from devaluation. Unfortunately, in order to protect its own interests, the Taiwan authorities made the unexpected devaluation decision at the expense of its neighbors, and hence aggravated the financial crisis. The devaluation of the New Taiwanese dollar put great pressure on the Hong Kong dollar, which was pegged to the US dollar. For this reason, the Taiwan authorities were condemned by some people for its ‘lack of accountability’ and ‘vicious purposes’. In 1996, Hong Kong’s economy was bouncing back after a two-year cyclical adjustment. In 1997, Hong Kong’s economy enjoyed more rapid development. The growth rates of the first three quarters were 5.9 per cent, 6.8 per cent, and 6 per cent respectively, showing an unprecedented prosperity. Real estate, the barometer of its economy, also prospered. In the fourth quarter of 1996, a flurry of buying and selling luxurious houses occurred, leading to the wildly rising prices of mid- and small-size houses, office buildings, and shopping areas. In the first half of 1997, the return of Hong Kong to mainland China quickly became the hottest selling point and real estate prices increased by 30 per cent to 50 per cent within half a year, provoking an unprecedented speculation rush. In 1996, the record high of Hong Kong’s stock market was reset seven times, and the Hang Seng Index increased by 33.5 per cent within the year. In 1997, stimulated by a series of good news reports, Hong Kong’s stock market continued its upward spiral, and the Hang Seng Index reached a record high of 16,673.27 points on 7 August, a 26.3 per cent increase from the beginning of the year. In mid-August 1997, international institutional investors began to attack the pegged exchange rate, preventing the rise of the Hong Kong dollar. Only three days after the devaluation of the New Taiwanese dollar, international speculators waged an attack on the Hong Kong dollar and created the highest ever international sell-off of the Hong Kong dollar. On 21 October, the Hong Kong dollar encountered much more pressure not only in Hong Kong, but also in London and New York. In the following two days, the sell-off intensified. As a result, the spot rate of the Hong Kong dollar against the US dollar declined to 7.83:1, and the one-year forward rate of the Hong Kong dollar against the US dollar dropped to the record low of 8.5:1. While frantically selling off the Hong Kong dollar, these speculators accumulated considerable put options on the Hang Seng Index, then sold off stocks. Meanwhile they employed international funds to create an atmosphere of selling-off of Hong Kong stocks, leading to

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the plummeting of stocks under the pressure of high interest rates and panic. In this way, they earned huge profits from the short position. At that moment, the Hong Kong government declared its strong desire to protect the pegged exchange rate. It asserted that with its stable economy, robust banking system, sound financial market mechanism, and US$ 96 billion in foreign exchange reserves, it had the capacity to maintain the stability of the Hong Kong dollar. Through the fierce battle from 20 to 23 October, international speculators finally ‘retreated’ from the market. The Hong Kong government won the battle of safeguarding the Hong Kong dollar, but at a huge cost. Within this four-day period, the Hang Seng Index lost 3,200 points and the total value of the stock market was reduced by HK$ 800 billion. On 23 October alone, the Hang Seng Index decreased by 1,211 points, a record for the sharpest one-day point drop. On 28 October, the plunge of the Hong Kong stock market triggered the slump of stock markets worldwide, which in turn led to a further fall of the Hong Kong stock market by 1,438 points, setting a new record. Meanwhile, real estate prices also began to plunge. In May 1998, the prices of residential buildings in Hong Kong dropped by approximately 35 per cent compared with the peak time in the second quarter of 1997. The value of overstocked private houses decreased from HK$ 3,871 billion at the peak to HK$ 2,516 billion, incurring a loss of HK$ 1,355 billion, about half of the total deposit in the local banking system. The real growth of Hong Kong’s GDP was reduced by at least 2 per cent. Owing to the tight monetary policy and currency devaluation, the financial status of most Hong Kong companies worsened. Some extremely aggressive companies were forced to close, go bankrupt, or shrink their business significantly. Typical examples included a run on the International Bank of Asia, the closure of Hong Kong Yaohan International Holdings, BNP Paribas, Peregrine, and other big groups, which greatly shook the confidence of Hong Kong investors. Because of high interest rates and the stock market plunge, investment and consumption in Hong Kong shrank markedly. All the important economic sectors, including retail and department stores, the food industry, restaurants, hotels, and tourism were severely affected. Hong Kong’s economy sank into a deep recession and in the last quarter of 1997, the growth rate of Hong Kong’s economy was reduced to 2.7 per cent. In the first quarter of 1998, its economy experienced a negative growth of 2 per cent, and the growth rate further dropped to negative 5 per cent in the second quarter. Its unemployment rate increased to 5 per cent, reaching the highest level in 15 years. In mid-November 1997, the financial crisis broke out in South Korea, which led to the resignation of the finance minister. Then its exchange market dropped from W 880 to US$ 1 to the lowest record of W 1,953 to US$ 1.

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In order to save South Korea from the crisis, three presidential candidates, including Kim Dae Jung, co-signed a loan agreement with the IMF, applying for US$ 57 billion, the biggest loan package since the IMF was founded in 1994. Japan’s financial crisis, which began in the early 1990s, was intensified by the East Asian financial crisis. In November 1997, the four major financial institutions – Sanyo Securities Co., Hokkaido Takusyoku Bank, Yamaichi Securities Co., and Tokuyo City Bank – announced bankruptcy. The money market and the stock market plummeted at the same time. On 25 November, the Nikkei Index dropped below 16,000 points and closed at 15,867 points, 60 per cent lower than the record high on 29 December 1989. On 28 December, the exchange rate of the Japanese yen dropped to ¥ 130 to US$ 1. The legend of ‘no bankruptcy for Japanese financial institutions’ was broken, and the East Asian financial crisis further intensified.

Stage 5: Deterioration In May 1998, when the East Asian financial crisis was easing up in most countries, Indonesia’s declining economy triggered a domestic political crisis, causing a sharp decrease in its currency and stock market that adversely affected its neighbors. On 12 May, Indonesia’s situation was worsened by violence and the social instability immediately influenced neighboring financial markets and created a wave of sell-offs by investors. Almost at the same time, a financial crisis suddenly erupted in Russia. The exchange rate of the Rouble against US dollar broke through the upper limit prescribed by the government — US$ 1 to Rb 16.21, causing a flurry of selling of Roubles and buying US dollars and other foreign currencies. The Russian financial crisis aggravated the crisis in Japan. On 26 May, the US finance minister agreed to maintain the exchange rate of US$ 1 to more than ¥ 140. The news caused the yen to plunge and the exchange rate dropped to lower than ¥ 146.5 to US$ 1 in mid-June. On 17 June after US president Bill Clinton spoke with then Japanese Prime Minister Hashimoto, the US sold off US$ 2 billion on the international exchange market to shore up the yen and prevent its further drop. This was the first direct market intervention by the US after the outbreak of the East Asian financial crisis. Through the direct intervention of the US, the yen stopped slipping down and stabilized at US$ 1 to ¥ 138. On 14 August, Hong Kong encountered a second round of attack from international speculators. From 14 to 28 August, the Hong Kong government used a great deal of foreign exchange reserve to counter international speculation. It entered the stock market directly and bought HK$ 118 billion worth of constituent stocks, stabilizing the Hang Seng Index and causing big losses to speculators on the index futures market.

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On 17 August, a spokesperson for George Soros’s Quantum Fund announced that the fund incurred a loss of US$ 2 billion in the Russian stock market. The next day, international speculators suffered great losses due to the direct intervention by the Hong Kong government in the stock market and the exchange market.

Stage 6: Global Diffusion In late 1998, the East Asian financial crisis spread beyond Asia and reached Russia, South America, and Africa. Even the US and Europe felt the threat. In August 1998, the Russian financial crisis intensified. On 26 August, financial turmoil swept through Russia. Worried about the worsening economic and financial situation, Russian people struggled to sell off their Roubles and stocks, causing a mn on foreign currencies. The exchange rate dropped to Rb 18.26 to US$ 1. Triggered by the plunge in the exchange market, the Russian stock market, after closing twice, declined by 9 per cent and reached a record low of 63.2 points. The Russian financial crisis sent shock waves worldwide. On 27 August, the Dow Jones Industrial Average dropped by 357.36 points, and the stock markets in Western Europe also suffered a downslide from 3 per cent to 6 per cent. In Eastern Europe, the stock markets in Hungary, Czechoslovakia, and Poland also declined by 14 per cent, 7 per cent, and 6 per cent respectively. On 23 September, in order to ward off a domino effect, the US Federal Reserve Board organized a syndicate of 15 international banking groups to inject US$ 3.5 billion into LTCM (Long-term Capital Management Company), which had debts of US$ 125 billion and was veering towards bankruptcy. The 15-bank syndicate was composed of investment banks (Merrill Lynch, Morgan Stanley, Dean Witter, Goldman Sachs); major financial groups (Travelers Group, J. P. Morgan); and multinational banks (Barclays Bank, Deutsche Bank). The extensive membership indicated the significance of the crisis. When the news was announced the next day, the Dow Jones Industrial Average immediately fell 152 points. Only after the US Federal Reserve Board reduced the interest rates on 29 September and then on 15 October did the Dow Jones bounce back to 9,000 points. Despite its relatively loose economic ties with East Asia, Europe was also affected by the East Asian financial crisis. On 20 October, the Berlin Economic Research Institute and five other major economic research institutions published a report stating that due to the crisis, Germany’s exports had decreased by 2 per cent and its GDP had dropped by 0.5 per cent. Other European countries such as Britain and France encountered a similar impact as well.

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In the second half of 1998, the crisis spread to Latin American, and Brazil was the worst victim. In August, the stock index of the São Paulo Stock Exchange dropped by 39 per cent. From 1 to 10 September, about US$ 1.5 billion in foreign capital was taken out of Brazil every day, and the country’s foreign exchange reserve was thus reduced from over US$ 74 billion to US$ 45 billion. In August, Argentina’s stock market declined by 38 per cent in one month. From January to August, Mexico’s stock market decreased by 57.4 per cent and the Mexican peso was devalued by 34 per cent. A flurry of buying US dollars also broke out in Venezuela. On 30 November, the IMF issued a report entitled Global Economic Prospects which stated that ‘the possibility of a global recession still existed’ and that there had been a marked drop in the estimated growth rate of the global economy. In 1998, the global economic growth slowed down from 4.3 per cent to 2 per cent, the lowest growth since 1990. After Global Economic Prospects was issued, G7 finance ministers and governors of central banks held a meeting in Washington on 3 October to discuss how to prevent a world recession. On 5 October, a meeting of Group 22 countries was held to discuss the establishment of a new system to provide funds to developing countries, in which the IMF would play the key role. The US had recognized that with the globalization of the world economy, it would be impossible for the US to stand alone. M. Camdessus, president of the IMF, expressed his support of the Federal Reserve Board’s decision to reduce interest rates. He also called on developed countries to adopt aggressive economic stimulation measures and prevent currency devaluation in order to further stem the crisis. From 7 to 8 September, the third Manila Framework Group Meeting was held in Kuala Lumpur and representatives of finance ministries and central banks from 14 countries or regions – Australia, Brunei, Canada, china, Hong Kong, Indonesia, Japan, South Korea, Malaysia, New Zealand, the Philippines, Singapore, Thailand, and the US – attended the meeting. There were also representatives from the IMF, the World Bank, and the Asian Development Bank. The major topics discussed were the regional financial crisis, the reform of the global monetary system, and counter-measures for the crisis-affected economies. A statement after the conference announced that the participants had noticed some favorable trends in East Asia, such as stabilizing financial markets, decreasing interest rates in industrialized countries, and stabilized exchange rates in crisis-affected countries. But the participants also recognized negative factors in the region, such as the worsening external financing environment,

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the slowing down of the global economy, and the challenges of financial reconstruction facing the crisis-stricken countries. The statement also noted that the effort to keep the RMB exchange rate stable provided an important guarantee for the stabilization of regional finance. The economic forecast issued by the IMF in December 1998 revealed that the interest rate cut initiatives by US and European banks had contributed much to the stabilization of the global financial market. However, the market was still quite vulnerable. According to the forecast, the global economy would grow at a very slow pace. The 1998 and 1999 economic growth rates would reach 2.25 per cent and it was expected that in 2000 the global economy would return to normal levels and the growth rate would reach 3.5 per cent. According to the IMF report, the recessions in South Korea and Indonesia would continue. Thailand, however, was likely to get out of the crisis first, and its prospective economic growth rate would be 1 per cent. The Indonesian economy, after dropping 15.3 per cent in 1998, would further decrease by 3.4 per cent in 1999. The South Korean economy would shrink by 7 per cent in 1998, and would still have a negative growth of 1 per cent in 1999.

ROOTS OF THE CRISIS The shock of the East Asian financial crisis impelled many to analyze its root causes. Various ideas and theories were put forward, incorporating literary metaphors, theoretical analyses, and philosophical thoughts. Creating lively metaphors is a common way of thinking for Asian people. By metaphor, we can express complicated ideas with both simplicity and layers of meeting. Examples are as follows: ♦ The Earthquake Theory. Some see the financial crisis as an earthquake, in which various conflicts and contradictions accumulate quietly beneath a tranquil surface. Eventually, sparked by external factors, they suddenly erupt, causing tremendous and lasting harm. ♦ The Disaster Theory. The article ‘Viewing the Financial Turmoil Through Disaster Theory’ by Qi Changming published in People’s Daily on 27 August 1998 was the major source of publicity of this theory in China. The author considered the financial crisis as a kind of social catastrophe and a systematic disease, mainly stemming from the chain reflective structure of the social system. He suggested that the social catastrophe should be prevented strategically. This view is based on tile ‘cause and effect network’ and the ‘conductive mechanism’ in system dynamics theory. ♦ The Indigestion Theory. This was put forward by David Chiang, who compared the cause of the financial crisis to ‘over-feeding the goldfish’. According to his theory, the cause of financial crisis in certain countries is excessive private capital inflow,

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which results in redundant industrial and service capacity; overvaluation of real estate, stocks, and local currencies; over-dependence on export growth; borrowing more money to repay old loans; and enormous current account deficits. Moreover, the financial systems of these countries are not sound enough, and their governments are ineffective in regulation and over-enthusiastic about infrastructure construction. As a result, a serious financial crisis finally broke out due to ‘indigestion’.

Although vivid metaphors are enlightening, they still need further theoretical analysis. In recent years, scholars around the world have done extensive research on the financial crisis. According to incomplete statistics, more than 3,000 articles have been published, providing a wide spectrum of views about preventive measures and solutions. These views, despite their differences, can be roughly grouped under three theories.

Fundamentalism Theory This theory was developed mainly by G. Corseti, P. Krugman, P. Pesenti, N. Roubuni, et al. They asserted that the ‘economic miracle’ in East Asia was in fact a bubble, inside which were shaky economic foundations, unbalanced growth of fundamental economic elements, and misleading macro-economic policies. When something went wrong with the fundamental economic elements in these countries, an economic crisis was unavoidable. Financial crisis was not only a reflection of this economic crisis. They quoted the following six factors as the main causes of the financial crisis:

(1) Overvalued currency Since many East Asian countries adopted fixed exchange rate systems in which local currencies were pegged to the US dollar, coupled with large amounts of capital inflow, the local currencies were overvalued.

(2) Large current account deficits This kind of deficit mainly resulted from the overvaluation of local currency, the weakening of the Japanese economy from 1990 onwards, and the strong position of the US dollar. The overvalued currencies in turn reduced export competitiveness and the demand for export goods decreased sharply, ushering in the continuous increase of current account deficits.

(3) Over-investment The buoyant East Asian economy sparked over-optimism among investors, leading to irrational investment and capital inflow from outside. Besides, the governments of some East Asian countries for political reasons introduced

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massive foreign capital to maintain high economic growth. Banks and other financial institutions, out of self-interest, over-borrowed and granted too many loans. Economic bubbles were thus created. Over-investment not only reduced investment efficiency, but also resulted in a large number of non-performing loans and bad debts and increased the current account deficit.

(4) Excessive government support of banks Owing to the guarantee given by the governments of some East Asian countries to their financial institutions, a so-called ‘moral hazard’ arose from banks seeking profits without assuming corresponding accountability. This kind of moral hazard certainly caused over-borrowing and over-lending activities. The unsophisticated banking system and the lack of appropriate regulation in mm expanded the moral hazard.

(5) Backing long-term investment with short-term borrowing and lending Since the capital markets were underdeveloped, banks acted as the major financing intermediaries in some East Asian countries, supporting long-term investment with short-term borrowing and lending. Owing to the lack of alternative financing measures, banks continuously borrowed new debts to pay back old debts to bail out low-profit and time-lagging investments. Serious issues occurred once no new loans could be made.

(6) Lack of appropriate financial regulation system Owing to vigorous economic growth, huge capital inflow, and buoyant stock markets, the governments of some East Asian countries became over-optimistic and neglected the problems in their financial institutions. They liberalized their domestic financial systems too early, without sound systems in place to monitor the inflow and outflow of foreign capital. Therefore, they had no effective measures when facing the attack of international speculative capital and the escape of large amounts of foreign capital. In short, although the causes of East Asia’s financial crisis are quite complicated, it is clear that the fixed exchange rate system, massive capital inflow, and moral hazard combined to lead to the problems that triggered the crisis. After the outbreak of the crisis, however, East Asian countries all used currency devaluation as their major tool to get through the crisis, resulting in a vicious circle of devaluation. The trend in devaluation swept away relative export advantages for any country that made the first devaluation decision. In order to realize the export advantage, further devaluation was necessary. Hence,

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another round of devaluation occurred. In the end, all currencies were devalued and no country enjoyed the benefit in export from devaluation.

Financial Panic Theory The Financial Panic Theory was represented by J. Saches and S. Radelet, who disagreed with the view that the existing problems in economic fundamental elements were the major factors contributing to the financial crisis in East Asia. They argued that the crisis was mainly caused by external elements. It was the impact from international capital flow that led to an over-pessimistic estimate of East Asia’s financial markets and economic prospects. According to this estimate, investors viewed problems in individual countries as problems common to all of East Asia and as a result they suddenly withdrew their capital. This was the beginning of the crisis. The proponents of the theory summed up the following five factors that caused the East Asian financial crisis:

(1) Over-zealous investors With the vigorous economic growth for years in East Asia and preferential government policies toward the inflow of foreign capital, investors became over-zealous about East Asian economic development and expected high returns. They made major investment decisions so hastily that no evaluation of the solvency of the borrowers was performed. Once problems arose, they panicked and became over-pessimistic. They withdrew their capital in a hurry, going from one extreme to the other.

(2) Instability in the financial market This sort of instability stemmed from the shaky internal structure of international borrowing and lending systems, which caused a ‘self-made crisis’ in which every individual lender complied with rational behavior and decided whether to extend his loan based on his judgment. With this kind of individual rationality, however, the market in general reflects an extreme and totally unnecessary over-panic, ushering in adverse capital flow. Besides, the asymmetry of information among lenders is one of the most important causes of financial market instability and in turn leads to a crisis of confidence. Admittedly, the current international financial system is not well developed and not suitable for the entry of emerging economies.

(3) Incorrect evaluation of the crisis The financial crisis in East Asia was by nature a liquidity crisis. The borrowers did not have sufficient cash to immediately pay off their debts. Many people viewed

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this as an insolvency crisis, in that the borrowers did not have enough capital to repay their debts. The countries involved in the crisis had problems in their internal economies, yet these problems did not include insolvency in short-term debts and therefore were not considered serious enough to cause so formidable a crisis. Until the summer of 1997, the fixed exchange rates of East Asian countries were not rational, but it was not necessary to adjust them because of the crisis. In fact, the international financial market overreacted to the crisis.

(4) Changing international market conditions The changes include worsening terms of trade, the economic growth and increasing export competitiveness of China, and the emergence of free-trade treaties. These changes resulted in the export decrease of East Asian countries, thus inducing lenders to withdraw their capital from East Asia.

(5) Liberalization of domestic financial markets The financial liberalization of some East Asian countries led to the expansion of financial institutions. Since the regulation system was lagging behind, the situation therefore lost control. Under these circumstances, the crisis was doomed to happen when great amounts of foreign capital accumulated in a short period and entered such a fragile financial system.

Capital Flow Phenomena This theory was mainly proposed by P. Alba et al, who argued that in order to understand the causes of East Asia’s financial crisis, the status of international capital flow should be carefully studied. International capital flow in East Asia was characterized by an increasing proportion of private capital inflow, with the major category shifting from industrial investment to financial securities investment. Since many East Asian countries maintained fixed exchange rate systems and moderate fiscal policies, their domestic fiscal deficits remained stable, thus leading to the deceptive appearance of a stable domestic economy. When enormous amounts of capital pour into a vulnerable economy, it is likely to trigger a crisis. The following are the four major causes of the East Asian Financial crisis according to Alba et al:

(1) Incomplete financial system The incomplete financial system includes banks, financial intermediaries, and financial markets. Moral hazards and deficiency in management and regulation all contributed to the weakness of this kind of financial system. The trend of liberalization in financial management, however, added to the vulnerability of

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this incomplete financial system. For example, financial liberalization in nonbank financial institutions, which were usually less controlled by the financial administration, increased significantly.

(2) Oversized and centralized conglomerates In each of the largest 10 private non-financial companies in East Asia, more than 50 per cent of shares were held by the three biggest shareholders. This hindered transparency, prevented appropriate control, prevented the protection of smaller shareholders, and took advantage of the market motivation mechanism.

(3) Over-encouragement of external borrowing From 1994 to 1996, the international financial environment and governments of many East Asian countries encouraged the private sector to borrow money from foreign countries, thus ushering in large-scale capital inflow. This inflow affected the change of domestic economic cycles, prompted excessive demand, fresher stimulated the over-heated economy, and fueled inflation in domestic economies.

(4) Vulnerable macro economy When the macro-economic structure and the corresponding regulation system of a country are incomplete, it is highly risky to liberalize the finance sector. Financial liberalization promotes capital inflow, which is basically aimed at investment, and banks expand their scale of loans. The investment expansion leads to increased asset prices, which in turn results in increased consumption. All these factors increase the fragility of the macro economy.

SYSTEMS ANALYSIS In researching East Asia’s financial crisis; I have tried to use system theory and complexity science to find its deep-rooted causes. I have started from the perspective of a fictitious economy. The following is a description of the results of my study.

1. The Emergence and Development of the Fictitious Economy A fictitious economy is a new concept that has emerged in recent years. Its definitions are quite varied and can be broadly classified into three categories: transactions of capital such as securities, futures, and options, called the fictitious economy; the economic activities conducted with the tools of information technology, called the virtual economy or the digital or information economy; and, the visual economic activities simulated by computers, called the visual economy. Here we shall limit ourselves to the first category.

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The concept of fictitious capital was first put forward by Karl Marx in his famous work Das Kapital . He argued that fictitious capital emerged from credit capital (interest-bearing capital) and the credit system of banks, including stocks, bonds, and mortgages. Fictitious capital had no value in itself, unlike real capital, but it could generate a kind of surplus value through circulation, in common with real capital. Although many new concepts and new phenomena have appeared with the development of the world economy, Marx’s analysis of fictitious capital still remains as a guideline in researching fictitious economies. In my view, the fictitious economy refers to the economic activities related to the circulation of fictitious capital mainly based on the financial system. In its simple expression, it is the activity of money generating money. The origin of the fictitious economy can be traced back to commercial borrowing and lending among individuals. For example, A is in urgent need of a material or commodity but does not have enough money, while B has some extra money in hand. Therefore, A borrows money from B, promising to return the money within a certain period and to pay interest. Through this activity, A has gained the right to use the money and can take the money as means of payment to achieve profits through real economic activities, while B, with the debit note in hand, has guaranteed his title of ownership to the money and has also been entitled to claim back the principal and interest from A. At this stage, the debit note in B’s hand is an incipient form of fictitious capital, and its value can be increased through the cycle of borrowing and lending money. In this case, B is not engaged in real economic activities; rather, he makes profit through a kind of fictitious economic activity. From this example, we can see that the first stage of the development of a fictitious economy is the capitalization of idle money. In other words, idle money becomes interest-bearing capital. The second stage is the socialization of interest-bearing capital, with banks as the intermediaries that borrow the idle money and then lend it to generate interest. People can also buy all sorts of securities with their idle money to generate interest. At this stage, the deposit certificates and securities are fictitious capital. The socialization of interestbearing capital can channel money from the hands of those who are not engaged in real economic activities, such as production, into the hands of those who can use the money in real economic activities. It can also merge small amounts of money among individuals into massive amounts and put them into relatively large scale economic activities, thereby increasing the efficiency of money. The third stage in the growth of a fictitious economy is the development of a securities market in which securities can be traded for their expected returns. In this way, financial markets (e.g. stock markets, bond markets, etc.) for the trade of fictitious capital have been established. The emergence of securities markets

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can channel the capital into industries with relatively high returns, thereby further improving the capital efficiency. The fourth stage is the globalization of financial markets that enables fictitious capital to take part in multinational exchange. This process can be traced back to the mid-nineteenth century when governments of debtor countries and railway companies issued fixed-rate bonds in the financial markets of Britain, France, and Germany. However, only since the 1920s have international securities investments become large scale and only after World War II, advocated by the Bretton Woods Agreement and General Agreement on Tariffs and Trades, that the giant international financial markets have come into being. The globalization of financial markets can attract capital to profitable industries on an international scale, thereby greatly improving capital efficiency and creating a new form of financial market, the exchange market. Futures exchanges have also become more and more fictitious and buying futures has become a tool of speculation. Since the 1960s, futures exchanges have extended gradually to financial commodities such as stocks, bonds, and foreign exchange. In 1973, options exchanges were introduced. The integration of international finance is the fifth stage of a fictitious economy, in which the financial markets of individual countries and the international financial market relate to each other and influence each other much more closely. The emergence of floating exchange rates after the US dollar broke away from the gold standard resulted in enhanced financial innovation, rapid progress in information technology, increasing financial liberalization, and the promotion of economic globalization. In this manner, fictitious capital flows at a much faster pace in financial markets, and in much greater amounts. The scale of a fictitious economy is continuously increasing. It has been reported that since the 1980s the average annual growth of the world economy has been about 3 per cent; international trade has grown at an annual average rate of 5 per cent, and international capital flow at 25 per cent. In 1997, the total value of the global fictitious economy reached US$ 140 trillion, about five times the aggregate GDP of all the countries in the world. The average worldwide daily fictitious capital flow is more than US$ 1.5 trillion, about 50 times the worldwide daily average real trade value. It can be estimated that with the development of e-commerce and e-currency, the scale of the fictitious economy will continue to grow.

2. Characteristics of the Fictitious Economic System According to system science, the fictitious economy is the result of the interaction between internal structure and external environment. This system is characterized by the following:

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(1) Complexity Complex systems are commonly characterized by their large scale, high coupling, low transparency, and dynamic and open status, but their most basic characteristic is that their components have intelligence. Namely, they can understand their environment, predict its changes, and take actions according to the original goal. This is the internal cause of biological evolution, technological innovation, economic growth, and social development. A fictitious economic system is a complex system, and its major components are natural persons and legal persons (investors, investment recipients, and financial intermediaries) who are engaged in fictitious economic activities in financial markets following certain rules. Although each one has the freedom of making independent decisions based on his own knowledge of the environment and his goals, individual decisions must be influenced by the decisions of the others. Although the non-linear interaction between system components is likely to result in chaotic phenomena, the system may demonstrate a certain order and stability based on its self-organization.

(2) Metastability A metastable system is one that is far from balanced, but is able to maintain relative stability through the exchange of matter and energy with the outside. In system science, it is called a system with dissipative structure. This type of system can reach stability through self-organization, but its stability can be destroyed by a tiny disturbance from outside. The system may float between stability and floating status after the stability is disturbed. From the macro perspective, the system is stabilized to a certain extent; that is, it has a regional stability. However, the system may have severe fluctuations or even collapse when it loses its stability. After its collapse, the system may regain its metastability through an in-depth restructuring process, or otherwise disappear. Typically, the greater inertia the system has, the less chance there is that it will collapse. A fictitious economic system is a kind of metastable system that has to keep relative stability by means of capital exchange with the outside. There are a lot of causes for its metastability, among which the most basic one is the internal instability of fictitious capital. The internal instability of fictitious capital stems from its inherent fictitious nature. For instance, tradable securities do not have value in themselves. They are merely certificates of ownership, representing the right to get a return, granting the holder a legal title to the part of surplus value corresponding to the capital paid when buying the securities. Since securities do not have value

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in themselves, the determination of their prices when they are traded on the markets is not subject to the objective law of value but to people’s subjective expectation of future prices. The prices are also influenced by supply and demand, which keeps the prices farther apart from the efficiency of real economic activities. When the prices of fictitious capital are irrational, economic bubbles will result. In this case, the system has to resort to continuous capital injection from the outside to maintain its stability, which is fragile and deceptive. The instability of fictitious capital also results from making currency lose real value in itself. Since the abandonment of the gold standard, it no longer has value that can be measured by physical substance, although currency still has its value as a means of payment. At this stage, the value of currency can only be measured by its purchasing power, while the purchasing power is under the influence of the amount of currency issued, interest rates, exchange rates, consumer behavior, etc. Therefore, fictitious currency will increase the instability of the fictitious economy. The instability of fictitious capital can also be attributed to positive feedback for the fictitious economy. For example, the more people buy stocks, the more people will be stimulated to buy. This interactive influence is referred to as positive feedback, which has an amplifying effect and results in the dramatic ups and downs of the cost of fictitious capital.

(3) High risk In economic activities, risk refers to the difference between the expected return and the actual return that is caused by uncertainty in the objective world and the limitation in people’s ability to understand the world. The fictitious economy, while involving high risk, is also likely to bring about high return. The high risk of the fictitious economy comes from its inherent complexity and metastability. Firstly, the internal instability of fictitious capital results in its price fluctuation, which is intensified by the expanding trade scale and increasing variety of trading on the financial market. Secondly, people are unable to find a satisfactory way to estimate expected return due to their insufficient ability to forecast the market and environmental change, and therefore make wrong decisions. Thirdly, many people have a very limited ability to take risks, and when faced with huge risks, they feel at a loss or even exaggerate the risks due to the positive feedback effect. Finally, a lot of people are willing to take high risks in pursuit of high profit, thus promoting the continuous innovation of high-risk and high-return financial tools such as interest rate futures, stock index futures, price index futures, and options.

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(4) Parasitism The fictitious economy is closely related to the real economic system in that the fictitious economy emerges from and depends on the real economic system. The real economic system includes the production of materials and the relevant economic activities such as distribution, exchange, consumption, and so on. It can be regarded as the circulation of capital. For example, after obtaining capital from the financial market, the manufacturer will use the money to purchase equipment, raw materials, and labor; use them to manufacture products; and then sell the products in exchange for money, thereby forming a cycle of capital. In the meantime, the manufacturer repays the principal and interest according to the contract with the capital and surplus value obtained through the process, and completes the circulation of fictitious capital. Owing to the close relationship between the fictitious economy and the real economy, the risks generated in the substantial economy, such as the overstock of commodities and corporate bankruptcy, will spread to the fictitious economy and result in its instability. Meanwhile, the risks in the fictitious economy, such as the plunge of stock indices and real estate prices, the significant increase in non-per-forming bank loans (NPLs), and severe devaluation of currencies, will impose significant impact on the substantial economy as well. Today, when the financial industry has become the core of the economy, it is impossible for the substantial economy go operate separately from the fictitious economy. Therefore, if we regard the substantial economy as the hardware of the economic system, the fictitious economy must be its software.

(5) Cyclicity The evolution of a fictitious economy is roughly cyclical. The cycle usually includes the following stages: the substantial economy accelerates its growth; bubbles start to form in the economy; currency and credit show gradual inflation; asset prices show an overall increase; people become over-zealous; stock and real estate prices continuously increase; external disturbance destroys the economic bubble; all financial indices drop sharply; people rush to cash in their real assets and financial assets; and the growth rate of the substantial economy decreases or even turns out to be negative. The cycle, however, is not simply recursive, but shows a forward-spiral progress.

3. Financial Crisis – The Collapse of the Fictitious Economy Financial crisis refers to the phenomenon in which all or most financial indices (such as interest rates, exchange rates, and stock prices) deteriorate suddenly and sharply. At that point, people rush to sell off real estate and cash in their

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fictitious capital, thus triggering economic and social turmoil. Typical examples are the Latin American financial crisis in 1982, the Mexican financial crisis at the end of 1994, and the recent East Asian financial crisis. Although these crises had different causes and scales, they all had great adverse impact on the countries in question. From the perspective of system theory, we can conclude that financial crisis is mainly caused by the inherent characteristics of the fictitious economy, coupled with external disturbance. To illustrate, the financial crisis can be compared to an avalanche in which the rocks under the snow can be regarded as the substantial economy, the snow layer covering the mountain as the fictitious economy, and the avalanche as the collapse of the fictitious economy. This view is mainly based on the metastability of the fictitious economy. Triggered by external factors, the internal dissipative structure of the system suddenly collapses, causing an effect similar to a rolling snowball. By studying the structure and evolution of the fictitious economy, we can classify the causes of the financial crisis into five categories:

(1) Abnormal operation of substantial economy systems The major symptom of abnormal operation of substantial economy systems is the loss of coherence between the speed, structure, and return of economic growth. It is usually the consequence of emphasizing rapid growth without paying due attention to the return and the rationality of the structure. For example between 1990 and 1997, before the East Asian crisis, five South Korean conglomerates, excluding Lucky Goldstar Group, tried to diversify their businesses with bank loans. As a result, each of them owned 30 to 80 related businesses involving at least a dozen industries. Their asset-debt ratios, however, were as high as 300–500 per cent. Moreover, the return on operating income (profit/operating income) of South Korean conglomerates had been dropping in recent years. In 1996, the return on operating income of the South Korean conglomerates listed in the Fortune 500 was only 0.77 per cent, and the ratio was further reduced to 0.33 per cent in 1997. In Malaysia, during the last 20 years of the twentieth century, the government implemented a policy of active intervention in the economy and market guidance. Under its muchadvocated ‘surpassing strategy’, the Malaysian government set its principal goal to stimulate high-speed economic growth and to depend mainly on the export-oriented economy to promote overall economic growth. It also used a lot of international capital, especially short-term capital, to support domestic credit, while neglecting the necessity of adjusting and optimizing the economic structure. Electronic products accounted for a great proportion of its exports.

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Since no timely adaptation to the decrease of international, market demands was made, exports plummeted. At that time, however, the government was still engaged in several large construction projects, regardless of the national capacity, and tied up a great amount of foreign exchange, thus driving the current account deficit to a high level. All these factors weakened the real economy, the base of the fictitious economy. The rapid economic growth stirred up an over-optimistic expectation of the future, which in turn led to overinvestment and irrational foreign capital inflow and thus hide serious problems. There are problems in the operation of the substantial economy, such as loan defaults among businesses, excessive but out-of-date production capacity, overstock of raw materials and finished goods, operational losses, and bankruptcy. These problems and losses, incurred by businesses when their financial speculation fails, will finally rock the fictitious economy in the form of bank loan default, making it more difficult to keep it stable.

(2) Government failure in macro-economic control The impact of government failure in macro-economic control on the operation of the substantial economy is well known, but the serious impact on the fictitious economy tends to be neglected. For example, before the financial crisis, most East Asian countries adopted fixed exchange rate systems and pegged their currencies to the US dollar. These countries also adopted high interest rates and encouraged banks to borrow money from foreign countries. These measures promoted foreign capital, and stirred up a wave of irrational investment, real estate development, and stock purchasing. Governments in some countries, for political purposes, spread the over-optimism and misled investors. Government encouragement and over-optimism among investors causes the fictitious economy to inflate continuously, creating more economic bubbles. The enormous capital inflow not only covers up the low efficiency of the real economy, but provides energy to maintain the dissipative structure of the fictitious economy. In view of optimistic economic prospects, the huge demand for local currencies, and the booming stock market and real estate industry, it seems easy to borrow money to repay old debts and banks are likely to take aggressive borrowing and lending initiatives. Therefore, the fictitious economy becomes over-inflated, aggravating its inherent instability.

(3) Vulnerability of the financial system East Asian financial systems, immature and incomplete, were quite vulnerable when faced with external shock and high risks. Owing to the unsophisticated capital markets, some East Asian countries took banks as their major financing

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intermediaries and supported long-term investment with short-term borrowing and lending. These banks, without alternative financing methods, continuously borrowed new debts to pay off old debts, and used compensation from lowprofit and time-lagging investments as lifesavers. In this scenario, serious problems occurred once no new debts could be borrowed. But owing to the government’s support of banks, a so-called ‘moral hazard’ arose from banks that sought profit without assuming corresponding accountability. The moral hazard, together with a close relationship between banks and firms, was likely to lead to over-borrowing and over-lending. The immaturity of financial institutions and the lack of appropriate regulation systems intensified the moral hazard. Some East Asian countries turned to financial liberalization without giving a thought to their rather immature financial systems. They allowed the free inflow and outflow of foreign capital, and even turned a blind eye to the turmoil created by international speculation in their financial markets. For instance, while there were only 74 banking institutions in Indonesia in 1988, there were 206 by 1994, all loosely controlled or monitored by the government. Although financial institutions were monitored in some countries, the regulation system became ineffective due to the corruption of government officials and the collusion of these officials with banks. Problems would not be exposed until they became quite serious. For example in 1998, several incumbent officials of the Japanese Finance Ministry were arrested for taking bribes, among whom 25 former financial procurators held directorships or even higher positions in 23 local banks. It was therefore questionable that they should have a strict supervision over the banks.

(4) Shaken investor confidence In the financial markets of every country, there are always thousands of investors engaged in fictitious economic activities. We can assume that every investor complies with a kind of rationality and will thus decide whether to keep or withdraw his investment based on his judgment of the market situation. Since East Asia had a continuous rapid economic growth for years, and the governments of many East Asian countries undertook a number of measures to attract foreign capital, investors became over-optimistic. With the prospect of high returns, they invested vast amounts of money too quickly to carefully evaluate the solvency of the borrowers. Once problems arose, the markets generally responded with excessive panic due to the disappearance of investor optimism and information asymmetry, and the capital was withdrawn quickly, leading to a reversed flurry of capital. Theoretically, debtors with solvency but

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without liquidity are able to borrow cash from the capital market to pay back their debts. The reason why they could not borrow money is that every creditor assumed that other creditors would not grant loans to these debtors. In this case, it was difficult for the dissipative structure of the fictitious economy to maintain its stability without an injection of new capital.

(5) Speculative capital – the troublemaker At present, there are at least 4,200 hedge funds in the US, with a total value of more than US$ 300 billion. Their capital leverage is as high as 1:300. The speculative funds constantly search for opportunities and try to create turmoil in which they can seek supernormal profits. They will present themselves at the shortest notice if a chance of arbitrage arises and leave immediately when there are no potential profits. East Asia’s financial crisis was first triggered by the attack of international speculative capitals on Thailand’s financial market. But this kind of external turmoil can only take effect through the internal dissipative structure of the fictitious economy. The fictitious economy is an inevitable result of the rapid development of the market economy, science, and technology. Only when the economy becomes fictitious can profound economic socialization be achieved. The fictitious economy is a two-edged sword, for it can promote the development of the real economy but can also do harm to the real economy. Its biggest hazard is the possibility of causing financial crisis, economic and political crisis, and social turmoil. Today, as the world is polarized and economics is heading towards globalization, we should study the evolution and development of the fictitious economy in order to prevent and eliminate its negative effects as much as possible.

PROFOUND IMPLICATIONS In my view, China’s capacity to maintain its momentum in economic growth and stay largely unaffected by the East Asian financial crisis should be attributed to its two ‘fire walls’ and four economic advantages. The first fire wall is that the RMB is convertible only through a current account and cannot be freely converted through a capital account; the second is that foreign capital can only enter into securities markets that are based on foreign currencies, such as B share markets, and is not allowed to enter into RMB-based domestic securities markets. China’s foreign currency and securities markets have thus not been completely open and have therefore effectively prevented international speculation from causing turmoil in Chinese markets. The first economic advantage is that China’s economy is generally healthy

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and has made a successful ‘soft-landing’, demonstrating a desirable trend of high growth with low inflation. In 1997, China’s GDP grew by 8.8 per cent and retail prices rose by only 0.8 per cent. Moreover, since China has a large-scale substantial economy and a relatively small fictitious economy, it has a lot of strengths in coping with risks. The second economic advantage is that China has had years of surplus in its international balance of payments. In 1997, its foreign trade surplus was over US$ 40 billion, and the net capital inflow was about US$ 34 billion. In 1998, it still maintained its foreign trade surplus. The third economic advantage is that China has a relatively rational foreign debt structure, in which short-term debts account for only 12 per cent of the total. The fourth economic advantage is that China has accumulated enormous foreign exchange reserves, which reached US$ 139.9 billion at the end of 1997 and US$ 145 billion at the end of 1998. It can therefore survive the great pressures of debt payment. The four economic advantages above are fundamentally built on China’s stable political structure, in which China’s various ethnic groups cooperate closely under the guidance of the late Deng Xiaoping’s theories and are led by the central committee of the Communist Party of China (CPC) with Jiang Zemin at its core. Chinese people all believe in the government’s ability to solve major problems in current economic growth, and have great confidence in future economic growth. For this reason, the East Asian financial crisis has not caused panic among Chinese people. The central leaders put forward a timely guideline to cope with the imminent crisis, which stated that China should ‘strengthen confidence, keep self-informed, plan ahead, remain calm, work hard, seek benefits, and avert harm’. They also promised the public that the RMB would not depreciate, accelerated the reform of the financial system, and also made a series of important decisions to increase investments, create domestic demand, and expand the domestic and foreign markets. Though struck by terrible countrywide floods in 1998, China successfully overcame the great challenge of the East Asian financial crisis. We should also notice, however, that some of the factors that caused the financial crisis existed to a certain extent in China. We should learn from the East Asian crisis and keep our vigilance. My study reveals that the crisis holds at least five important mandates for China.

1. Ensure the Healthy Development of the Substantial Economy The healthy development of the real economy is imperative to the stability of the fictitious economy and preventing financial crisis. It is of the utmost importance to balance speed, structure, and return of economic growth and to

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try to achieve an overall economic optimization. Theoretically, speed, structure, and return are three different economic dimensions and indices, but at the same time they are related to one another in the economic development process and can therefore be integrated. Desirable speed is based on rational structure and good economic return. At the same time, speed also serves as a necessary condition for rationalizing economic structure and achieving the greatest economic return. Since the adoption of its reform and opening-up policy, China has enjoyed rapid economic growth. From 1979 to 1997, the average annual growth rate of China’s GDP was 9.8 per cent, about three times the world’s average in the same period. But the economic returns were not so satisfactory. For example in 1997, the ratio of profit and tax to the fixed assets of independent accounting companies was 9.64 per cent, and the ratio of profit and tax to capital was only 6.92 per cent. From 1978 to 1997, the net value of fixed assets in state-owned enterprises with independent accounting increased from RMB 223 billion to RMB 2,589 billion, and total losses of unprofitable companies increased from RMB 4.2 billion to RMB 83 billion while the total profit and tax only increased from RMB 79.7 billion to RMB 290.8 billion. Between 1991 and 1997, the average annual growth of fixed-asset investments reached 27.6 per cent, and the average annual GDP growth was only 10.9 per cent. Economic restructuring progressed slowly. In 1985, the proportions of first, secondary, and tertiary industry in GDP were 28.4 per cent, 43.1 per cent, and 28.5 per cent respectively, while in 1997 they were 18.7 per cent, 49.2 per cent, and 32.1 per cent respectively. The proportion of tertiary industry had increased by only 3.6 per cent in 12 years. The high-tech industry accounted for only around 5 per cent of GDP. In addition, the fragile foundation of China’s agriculture, low returns on irrational investments, enormous chain debts between businesses, and massive overstocking all hindered smooth economic development in China and constituted a cause of financial crisis by driving bank returns even lower than the interest rate of deposits. To ensure the healthy development of the substantial economy, we should transform our economy from the extensive economic model to an intensive model, and focus on improving economic returns mainly by restructuring the industry, which is guaranteed by an appropriate growth rate. Detailed suggestions are as follows:

(1) Develop consumer markets and stimulate effective demand By the end of 1998, the total deposits in China’s financial institutions amounted to RMB 9,570 billion, a 16.1 per cent increase over the previous year, and private

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deposits reached RMB 6,000 billion. However, individual consumption rose rather slowly. About 75 per cent of commodities had a balance in their supply and demand, while the other 25 per cent were over-supplied. Therefore, the focus of our work for the economy in the future should shift from increasing the supply to stimulating the demand. On the one hand, the government should encourage businesses to strengthen their marketing concepts, conduct detailed market research, and try to enhance their competitive edge. On the other hand, it should also direct consumer behavior towards buying durable products such as houses and cars by means of installments and towards spending more on travel, entertainment, computers, communications, education, etc. The government may also import some desirable consumer products that are difficult to produce domestically. More importantly, the government should make the greatest effort to expand the rural market of 800 million people. Companies should carefully study the consumer behavior of farmers and supply appropriate commodities to meet their needs, improve their purchasing power by increasing agricultural productivity, expand the rural labor market, and reduce their burden. Furthermore, the rural financial credit system should be improved with experimental mortgage loans for chemical fertilizer, pesticides, agricultural plastic film, farming equipment, etc. Rural areas should also get rid of such out-of-date forms of commerce as itinerant peddlers and bazaars so that transaction costs can be reduced.

(2) Develop high-tech industry With the progress of economic globalization, the development of high-tech industry becomes a main force for increasing national competitiveness. Faced with the challenge of the knowledge economy, whoever develops high-tech will lead the competition. In recent years, for example, the domestic competition in the PC and VCD industries has been fierce, and prices have decreased sharply. However, computer chips, operating systems, and VCD decoders still need to be imported from foreign countries. So, we must depend on the development of high-tech industry to transform traditional industries and establish our own high-tech industries. We should also notice that China’s current economic growth mainly depends on trade exports, domestic consumption, and investment drive. However, owing to the East Asian financial crisis, our exports have encountered significant challenge. Domestic consumption is not vigorous enough, and the investment drive has also been constrained by capital source and market demand. Therefore, it is of practical value to develop high-tech industry and seek a new economic growth engine in China.

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(3) Cut down excessive capacity Faced with a stagnant consumer market, we should cut down out-of-date and excessive capacity following the policy of ‘encouraging the good and eliminating the bad’. Companies whose material supply is not guaranteed, whose product sales are not promising, who have no competitive advantage in the market, or who even incur a great loss when in operation, should definitely be shut down and we should take great effort to adjust the structures to become more reasonable. These measures might add to the existing difficulties, but they are beneficial in the long run. If these companies are not eliminated immediately, a favorable environment will not be created for the smooth development of good, which will finally result in a lose-lose situation.

(4) Encourage innovation, restructuring, and streamlining to increase efficiency and improve the competitiveness of companies and their economic performance Business enterprises are cells of the market economy. The macro economy can run smoothly only when most enterprises grow healthily. However, in a market economy, companies without a competitive advantage will find it difficult to survive. Therefore, corporate restructuring should focus on increasing competitive advantage. Competitiveness can usually be divided into price competitiveness and non-price competitiveness. Price competitiveness is mainly dependent on cost, while non-price competitiveness can be defined both in a narrow sense and in a broad sense. In the narrow sense, non-price competitiveness includes product quality, lead time, service quality, and flexibility. In the broad sense, besides the above variables, nonprice competitiveness also includes new product development and product planning, the characteristics of commodities, and their attractiveness to users. In order to improve competitiveness, companies should firstly increase their input and renovate their out-of-date manufacturing equipment by applying advanced, suitable, and reliable techniques. Secondly, they should enhance their management, and achieve cost reduction and ROI (return on investment) increase through strategic reconstruction, scientific decision-making, enhanced governance, and effective motivation. Thirdly, redundant labor should be made redundant to increase efficiency. Owing to changing market demands and the rationalization of internal corporate structures, labor turnover and layoffs are unavoidable. To ensure the success of reform, we have to pay these costs and undergo transitory pains. Fourthly, capital should be injected to maintain the corporate asset-debt ratio within a safe and reasonable range. Finally, in order to invigorate enterprises, unreasonable apportions and unjustified charges should be eliminated and the tax burden reduced.

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2. Strengthen the Macro-Economic Control Over the Fictitious Economy In order to ensure the healthy development of its substantial economy, China, as a developing country, should not only develop its high-tech industry to transform traditional industries and strengthen the competitiveness of companies, but also increase the supply of tradable products and try to expand the consumer market. Requiring huge amounts of money for all these activities, China will have the chronic syndrome of ‘capital thirst’ which is common in developing countries. Since the current return on China’s substantial economy is relatively low, and business entities do not have sufficient self-accumulation capabilities, it is very necessary to raise funds by issuing bonds and stocks and by attracting foreign capital. Therefore, the aim of the macroeconomic control for the fictitious economy should be not only to facilitate the substantial economy, but also to prevent it from over-inflation and to eliminate economic bubbles in a timely manner. Detailed suggestions are as follows:

(1) To regulate the securities markets and improve the quality of listed companies Issuing bonds and stocks is the main financing tool for businesses. China has experienced a rapid growth in its securities markets in recent years. At present, there are 830 listed companies and the total market value has reached RMB 2,300 billion, about 25 per cent of GDP. The Securities Law became effective in July 1999. It plays an important role in regulating China’s securities markets and promoting its healthy development. Meanwhile, it is imperative to improve the quality of listed companies and eliminate exaggeration in reported assets through asset evaluation and credit rating.

(2) To be cautious in adopting an aggressive fiscal policy Our government has successfully addressed inflation and achieved economic ‘soft-landing’. But owing to the East Asian financial crisis and the stagnant domestic market demand, China is facing the threat of currency devaluation. In this case, increasing the issuance of treasury bonds, expanding the budget deficit, and stimulating market growth through investment are necessary measures. However, we must be aware that investments go to infrastructure, which can stimulate the production of capital goods, reduce the pressure of unemployment, increase tax income, and enhance social purchasing power. It can also increase the finance deficit and national debts and finally lead to inflation, as the direct economic return is relatively low and most of the risks are taken by the government. For this reason, it is important to conduct

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careful research and select proper projects, ensure project quality, improve the efficiency of investment and capital employed, exert a strict control over the size of deficit (normally not exceeding 20 per cent of government fiscal income), and try to gradually reduce the deficit as much as possible.

(3) To develop proper monetary policies In order to further expand domestic demand, it is necessary to increase the money supply within a reasonable limit. By the end of 1998, China’s M2, M1, and M0 had reached RMB 10,450, RMB 3,895, and RMB 1,120 billion respectively, or 15.3 per cent, 11.9 per cent, and 10.1 per cent higher than the previous year. It signaled that the Chinese government is starting to stimulate the economic growth through monetary policies. However, it is still important to study carefully the relationship between money supply and other factors such as interest rates, investment, and consumption, and to gradually understand how to exercise effective macroeconomic control by the combination of tools including money supply, interest rates, exchange rates, tax rates, and government spending.

3. Open Up At the Right Time and Scale Opening to the outside world is an important measure in adapting to the trend of economic globalization and promoting the growth of China’s economy. But we should take the initiative in this process and set the right speed and scale for opening up according to the international and domestic environment. Detailed suggestions are as follows:

(1) Actively and cautiously promote the full convertibility of RMB Full convertibility means that any holder of local currency can freely convert the local currency into a major international reserve currency at the market exchange rate. On 1 December 1996, China realized the convertibility of RMB under a current account that was required by Item 8 in the IMF Agreement. This was an important breakthrough in reforming the exchange rate system. The long-term target of China’s exchange system reform is to achieve the full convertibility of RMB, that is, to realize its convertibility under a capital account. To reach this target, it is important to make a careful study and to take gradual steps based on China’s current situation and strength. Since China’s financial and international trade systems are still in the process of reform, the conditions for convertibility under a capital account are not yet ripe. It is necessary to have a gradual and steady transition that occur as follows: ♦ Deregulating capital account transactions resulting from commodity and labor

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transactions, such as trade credit, remittances from non-residents, income from investment, and subsidy for employment in local companies. ♦ Removing the restraint on direct investment – first capital inflow, then capital outflow. ♦ Lifting the limit on the liquidity of short-term capital. ♦ Deregulating credit transactions between state-owned financial institutions and nonresidents in credit management, and allowing non-financial institutions to enter into the international financial market. ♦ Opening the capital market beginning with the bonds market and then the stock market, and integrating the A share and B share markets. (Non-residents should declare the number of shares purchased.) ♦ Limiting the currency exchange among residents in the money market, and guiding non-residents to buy treasury bonds. ♦ Expanding the major trading force on the exchange market from designated banks to big companies, residents, and then non-residents, but still setting a limit on the variety of transactions.

The general principle is to open the market only when reasonable control can be imposed. Therefore, the government should take into account domestic as well as international circumstances and define the major steps and timetable accordingly. The government might consider increasing the exchange quota for individuals after realizing the convertibility under a current account, meanwhile repressing black-market transactions, in order to satisfy the reasonable desire for studying, travelling, medical care, and doing research in foreign countries. However it is important to notice the massive exchange flow in individual accounts, and to prevent the illegal inflow and outflow of foreign capital.

(2) To exercise macro-economic control over the size and structure o f foreign debts and foreign capital investment By the end of 1997, China’s total foreign debts had reached US$ 131 billion, with about 13.9 per cent in short-term debts. China should take advantage of a hardened RMB to further reduce the proportion of short-term foreign debts and exert strict control over short-term and high-interest commercial loans. For midand long-term international commercial loans, China should control the balance of foreign debts through balance management. At the same time, we should gradually place the debts borrowed by foreign invested companies under the scope of foreign debts management and provide them with the same treatment as national debts in order to effectively control them. China has made significant strides in attracting foreign capital in recent years. Until the end of 1998, the government approved the establishment of

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324,000 foreign invested companies, and contracted foreign investment reached US$ 572.52 billion. Although some foreign investors become more cautious about investing in Asia because of the outbreak of the East Asian financial crisis, many people realized that Asia still has a promising future. Therefore, China should keep on attracting foreign capital with its unique advantages and further improve its environment for investment.

(3) To adjust the exchange rate system at the proper time Currently, China applies the single pegging exchange rate system in which the RMB is pegged to the US dollar. This system helps to stabilize and develop foreign trade. However, the weakness of this system is that it is harder and more costly for the central bank to exercise macroeconomic control, and the value of RMB will also be too dependent on the economic situation of the US. My suggestion is to take the East Asian financial crisis and the creation of the single European currency (Euro) as an opportunity to transform China’s exchange rate system to the weighted pegging exchange rate system in which RMB is pegged to the US dollar, the Euro, and the Japanese yen, adjusting the weighting according to the economic situations in the US, Europe, and Japan.

(4) To encourage investment abroad In order to alleviate the adverse impact of the East Asian financial crisis on China’s foreign trade, China should promote investment abroad when the RMB is strong. China should employ its comparative advantage and move the processing of some export products abroad or establish factories in foreign countries to make the urgently needed products it lacks (e.g., liquefied natural gas, potash fertilizer, etc.). Meanwhile, China should enhance the supervision of overseas investment projects and encourage private companies to invest abroad.

4. Strengthen the Construction of and Supervision over the Financial System The financial system, mainly composed of financial markets and financial institutions, is the main place where people make profits from fictitious capital. If we regard finance as an industry, its products are various financial tools (e.g. tradable securities). Financial institutions are factories where these products are manufactured, and financial markets are places for trading these products. A complete financial system should have a rational structure, effective mechanism, and strict regulation. The following are detailed suggestions:

(1) To allow the central bank to play a key role A rational financial structure should be a complete financial system consisting

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of the central bank, commercial banks, specialized banks, and other financial institutions. The central bank is the financial administration of a country, formulating and implementing national monetary policies. It should play the role of national bank, issuing bank, and bank for all other banks. The central bank should develop monetary policies independently, adjust the money supply and credit amount according to the national economic situation and economic goals, and take responsibility for financial regulation.

(2) To set up an effective mechanism by improving the transparency, regulating power, adaptability, and risk-awareness The central bank should help commercial banks and other commercial financial institutions to be independent legal entities, assume sole responsibility for their profit and loss, and coordinate between the government, banks, and companies effectively. Government intervention in commercial banks will often reduce market efficiency and lead to a great number of non-performing loans and bad debts; however, with excessive government support, commercial banks will be likely to operate aggressively or break the rules, shifting their operating risks to the government. Too close ties between bankers and businesses will result in a rash over-borrowing and over-lending. On the other hand, the central bank should regulate the operating procedures and mechanisms of commercial banks. Currently, the internal management of China’s commercial banks is in disarray. Banks can juggle their financial statements, deceptively increase or decrease deposits and loans, engage in illegal call loans, offset interest by loans, indirectly increase interest rates, operate off-the-balance-sheet assets, and withdraw deposits without the owner ’s permission. These activities can result in huge losses and affect social stability, and therefore should be severely punished.

(3) To deal with bad debts of banks in a timely and careful fashion Since the financing in China is mostly fulfilled through banks, which are leveraged in their operation, bad bank debts are a time bomb that can explode the stability of the financial system. In China, bank loans have been given five different grades, and the ‘bad debts’ grade is estimated to be huge, although no one knows the exact amount. To deal with bad debts, China should not only use administrative measures, but also employ economic and legal methods, together with corporate restructuring and bankruptcy processes. It is not advisable for banks to increase the provision for bad debt themselves nor to entrust this to their own financial asset management companies, as this will lead to moral hazards and the dependence of companies on banks. I suggest that banks split off their bad assets and entrust them to investment companies through

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competitive bidding. For instance, banks can swap their loans into shares and restructure the debtor companies. The capital required in the restructuring could be financed by issuing convertible bonds that are guaranteed by banks.

(4) To prevent illegal foreign capital flow China should regulate the inflow and outflow of foreign capital and prevent the inflow of large amounts of illegal foreign capital from imposing the pressure of appreciation on the RMB or weakening government control over the basic currency. For this purpose, we should enhance our effort in monitoring the import and export registration and verification system, and prevent settling capital account foreign currency under trade accounts and financing indirectly by letters of credit. Meanwhile, China should strengthen contract management over joint ventures and cooperative companies, prohibit the practice of paying fixed rates of return or paying at fixed exchange rates to foreign investors, and should not allow them to cash in their property rights in advance. In addition, China should control implicit foreign debts, and especially prevent foreignbased Chinese institutions from borrowing money abroad and investing in China in the form of foreign capital. Currently, it is also an important task to prevent various kinds of foreign exchange fraud or illegal foreign exchange transactions, and to cut off illegal foreign capital outflow.

(5) To develop the money market steadily The capital market and money market are the two major interrelated components of the financial market. The capital market mainly satisfies the demands of long-term financing, while the money market mainly serves shortterm financing (for liquidity). The development of China’s money market is lagging behind that of the capital market, which adversely affects capital flow and position adjustment, the improvement of capital efficiency, the prevention of illiquidity risk, and the execution of currency policy. Therefore, China should make an effort to foster the money market and achieve a united development with the capital market. The money market is the market for issuing and transferring short-term (within one year) credit tools. The three major tools of monetary policy – the rediscount rate, the legal reserve rate, and open market operation – all need to be implemented through the money market. Currently, China should focus on the development of the short-term treasury bond market and the interbank borrowing market, and should also gradually develop short-term notes confirmation and the discount market. At present, all Chinese treasury bonds are mid-term and long-term fixed rate

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treasury bonds, which are poor in liquidity and in luring short-term idle money. China can study the feasibility of issuing three-month and six-month shortterm treasury bills, and calculate the interest through the discount method. The Central Bank can use the open-market counter and wholesale the bonds to large financial institutions through auction on a periodic circulating basis. Since the actual practice is to periodically pay the old debts with new debts, it can achieve the effect of reflecting the dynamic market and adjusting the market supply and demand in a timely fashion. Through competitive bidding, the market can have a weighted average execution price (i.e. the interest rate of short-term treasury bills). This widely accepted risk-free interest rate can be used as the benchmark interest rate and is helpful in regulating the financial market.

(6) To accelerate the application of information technology in the financial industry F i n a n c i a l re g u l a t i o n , w h i c h i n c l u d e s t h e s u p e r v i s i o n o v e r f i n a n c i a l institutions such as banks and control over the financial market, is important in guaranteeing the economic safety of a country. Today, when financial engineering and information technology are highly developed, the application of information technology to the financial industry has become an important condition for effective regulation. Therefore, we should make more effort to enhance the clearing system, deposit system, credit card system, and business information center for banks, and also ensure information security. Meanwhile, we should improve financial information disclosure and reduce the panic caused by information asymmetry among investors.

5. Promote the International Financial Cooperation An important implication of the East Asian financial crisis has been the strengthening of international financial cooperation, monitoring the movements of international speculation capital, and establishing an efficient and sound international financial system. The focus of international financial cooperation is to strengthen the regulation of the movement of international speculation capital. The rampancy of international speculation capital was one of the direct causes of the East Asian financial crisis. At present, the total daily transaction value of the international financial market (including short sell and short buy) is over US$ 1,500 billion, and the total speculation capital (hot money) in the market amounts to at least US$ 7,200 billion. Financial speculators are constantly looking for chances to create turmoil and pursue high profits. Therefore, even some proponents of financial liberalization have begun to realize the necessity of executing proper

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control and regulation. With the aim of gradually opening up China’s capital market, we should do research on how to monitor large foreign exchange transactions and stock transactions (especially futures transactions) by establishing a registration system. For the inflow and outflow of large amounts of foreign capital, a registration and declaration system must be established. For large financial derivative transactions, the market should require real name transaction and charge a relatively high margin. It is also useful to establish a computerized monitoring system (e.g. a spot clearing system). China should also enhance information communication and capital financing among international central banks, with the aim of coping with the transitory liquidity crisis and setting limits where international speculation capital may exploit the loopholes. Since the beginning of the 1970s, the declining economic power of the US, the increasing variances in inflation in major industrial countries, and the consequent collapse of the Bretton Woods System have all contributed to the coexistence of the floating rate system and the fixed rate system and the instability of the international currency system. In my point of view, in the next five to ten years, with the maturing of the Euro and the recovery of the Japanese economy, the position of the US dollar as the dominant currency of settlement is sure to be challenged. In addition, considering the acceleration of economic globalization, China should try to establish an international currency system characterized by stability, balance, and equality. This will not only help to prevent financial crisis, but also promote global multi-polarization.

PROSPECTS Analysts hold different views of the future of the East Asian financial crisis. Until 31 December 1998, except for a few pessimistic analysts, a large number of international organizations and analysts expressed cautious optimism about the development of East Asia and the global economy. In my view, the future of the crisis and global economic growth mainly depend on three questions – whether the economic miracle of East Asia is true or sham, whether Japan’s economic power is strong, and whether the US economy has a promising future. Since Europe does not have a very close economic relationship with East Asia, and is in the progress of currency integration, it is not much discussed in this article.

1. An Economic Miracle in East Asia? Is the economic miracle of East Asia true? Analysts have divergent views over

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this issue and someone has even called the economic growth of East Asia a ‘paper tiger ’. The economic miracle of East Asia is basically sound, but also has deceptive elements. In the past 20 years, East Asia has achieved steady progress in its economy. No other region in the world has made such significant progress nor seen such rapid growth and so many achievements in such a short period. J. Stiglitz, vice president of the World Bank, has commented positively on the economic growth of East Asia. He has noted that the rapid economic development in East Asia is true and that East Asian countries have high savings rate, less government deficit, and low inflation. East Asia’s economic miracle has also been reflected by the significant GDP increase, rising living standards, longer life expectancy, and the improvement of health and education. Through the East Asian miracle, millions of people have risen out of poverty and bettered their lives. The GDP per capita in South Korea increased almost 10 times from about US$ 1,100 in 1965 to almost US$ 10,000 in 1995. The growth rates of GDP per capita in Malaysia, Thailand, and Indonesia have also greatly exceeded the average of developing countries. In 1975, six out of 10 people in East Asia earned less than US$ 1 per day, while in 1997 only two of 10 had a daily income below US$ 1. South Korea, Malaysia, and Thailand have basically got rid of abject poverty, and Indonesia is getting closer to this goal. The average annual income of the poorest 20 per cent of people in these countries has increased greatly – 100 per cent up on average from 1970 to 1995 in the Philippines and Thailand, and about 150 per cent up in Indonesia and Malaysia. The most amazing example is South Korea: its annual income per capita increased from US$ 303 in 1970 to US$ 2,071 in 1990. The average life expectancy in Indonesia was 48 years in 1970, while in 1995 it was 64 years. Life expectancy in other countries has also increased. In the same period, illiteracy rates in adults over 15 years old have dropped drastically. For example, in Malaysia the illiteracy rate dropped from 40 per cent to 15 per cent; in Indonesia, from 46 per cent to 16 per cent; in South Korea, from 12 per cent to 2 per cent; in the Philippines, from 17 per cent to 5 per cent; and in Thailand, from 21 per cent to 6 per cent. Such progress is truly marvelous. However, the East Asian economic miracle was also deceptive in terms of the irrational structure of the real economy and the over-inflated fictitious economy. As mentioned above, it was these unreal elements that caused East Asia’s financial crisis. But since East Asian countries and regions have enhanced their economic strength in the past 20 years, they will enjoy healthy development after compressing economic bubbles and restructuring their economies. Of the Four Dragons and the Four Tigers, Indonesia’s recovery has been slowed by political turmoil, while Singapore and Taiwan are much less affected. The other

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four countries and Hong Kong have got through the most difficult stage and are slowly rejuvenating their economies. For example, the foreign exchange reserve of South Korea has increased from its low of US$ 8 billion to more than US$ 40 billion. Thailand’s economy has also been improving. The ASEAN countries have been strengthening their economic relationships and cooperation with each other. However, the economic recovery of East Asian countries and regions is a chronic process and will certainly be affected by the political situation of each individual nation as well as the international environment.

2. The Economic Strength of Japan As the country with the largest amount of foreign exchange reserve, the biggest creditor country in the world, and the major source of investment and loans in East Asia, the ups and downs of Japan’s economy have always had important influences on the financial markets in East Asian countries and regions. Since the beginning of the 1990s, Japan’s economy has fallen into recession due to the collapse of the bubbles in its stock market and real estate sector. The bankruptcy of the Hokkaido Bank (the tenth biggest bank in Japan) and Yamaichi Securities Co. (one of Japan’s ‘Big Four ’ securities firms) has revealed the weakness in Japan’s financial system. It was reported that non-performing loans of Japan’s banking system totaled US$ 650 billion, of which US$ 276 billion was lent to East Asian countries and regions. Since October 1997, the Japanese government has implemented a series of economic stimulation schemes and financial reform plans. For example, on 24 April 1998, Premier Ryutaro Hashimoto announced a ¥ 16.6 trillion (about US$ 128 billion) economic rejuvenation package to cut tax, increase public investment, and bolster the financial market. However, because of a scandal in the Japanese finance ministry, insufficient public confidence, and the declining support for the Hashimoto administration, the Japanese stock market and exchange rates continued to plummet, which certainly affected the economic recovery of the crisis-hit countries in East Asia. However, Japan still has a strong economy. According to the statistics of Japan’s Fuji Chimera Research Institute on the national economic indices of OECD (Organization for Economic Cooperation and Development) countries, Japan’s nominal GDP is US$ 2,999.9 billion (by parity of purchasing power), ranking second place; its overseas net assets amount to US$ 974.3 billion, ranking first place; its foreign exchange reserve amounts to US$ 205.8 billion, ranking first place; the ratio of current account to GDP ranks eleventh place; the unemployment rate is the second lowest; the ratio of total government debts to GDP is 87.1 per cent, ranking fifteenth; the ratio of government net debts to GDP is 18.4 per cent, the third lowest; the ratio of fiscal deficit to GDP is 3.4 per

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cent, the highest among the 22 countries; its long-term interest rate is the lowest; the consumer price index is the tenth lowest; and its real economic growth rate ranks 21st. The above indices reflect that Japan is still a world economic superpower, and its economic situation is not as bad as people thought. The key to Japan’s economic recovery is whether the government can fulfill the critical task of restructuring its financial system and policy management system, and recover the confidence of its people and the world in its economy. The lack of confidence of the world in Japan’s financial system may be attributed to the decision-making system of the Japanese government; therefore Japan should undertake effective reform in its financial system and policy management system. Priority should be given to addressing bad debts. The process will certainly be accompanied by the painful experience of bankruptcy or the merger or acquisition of financial institutions. However, it will benefit rather than imperil Japan’s economy in the long run. The problem that Japan is now facing is insufficient demand rather than shortage of supply. The Japanese government must recognize that Japan’s economy is threatened by deflation; therefore, it is important to stimulate the demand effectively, adopt more aggressive fiscal policies, and restore public confidence through a variety of actions. The recent decline of the Japanese yen can be regarded as the depreciation of the yen against the US dollar rather than the devaluation of its purchasing power. The underlying reason for the depreciation of the yen is Japan’s domestic economic recession and low interest rates, which resulted in the fleeing of great amounts of foreign capital. In short, although Japan’s economy is sluggish at present, it is still powerful in the world. As the conference held between finance ministers and central bank governors from G7 countries concluded in its statement in early October 1998, ‘Japan’s economic recovery is crucial to Asia and other regions in the world.’ With the economic recovery, Japan is likely to play a more important role in the Asian economy or even the global economy.

3. The Prospect of the US Economy The US is the world’s strongest economy, and its economic future has a huge impact on the global economy. Until December 1998, the US economy had been growing for a consecutive 92-month-period, and the momentum still continues. In 1998, the growth rate for the whole year was 3.9 per cent, and it was 6.1 per cent for the fourth quarter. We should carefully study the reason why the US economy can make such achievements while East Asia is experiencing a serious financial crisis. The economic growth in the US should first be attributed to the economic

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restructuring commencing in the mid 1980s and the effort in developing its high-tech industries. Through restructuring and deregulation, economic efficiency and return have been improved, at the cost of losing 44 million jobs. In this context, the US used venture capital to win public support for technological innovation, develop high-tech industries, and create new markets and new businesses, thereby creating 73 million new jobs and enabling the economy to have a continuous growth in the 1990s. The second reason for US economic growth is that the public showed greater confidence in the future of the US economy. Public enthusiasm for investment has been increasing both in high-tech industries and consumption. The spending on consumption has amounted to 68 per cent of GDP, and the number of houses sold increased 13.5 per cent in 1998, providing underlying support to economic growth. The third reason for US economic growth is its mature and sophisticated financial system. Although there are often ups and downs in the stock market, the Dow Jones Index rose from 2,000 points to over 9,000 points in 10 years. The P/E ratios for some IT firms have exceeded 1,000, containing serious bubbles. However, owing to its great scale and flexible self-adapting mechanism, the US financial system is like a huge sponge that can absorb various shocks and thus maintain the stability of the fictitious economy. Finally, the sluggish global economy is helpful rather than harmful to the US economy. The increased purchasing power of the strong US dollar has not only helped the public in consumption and investment, but also promoted its capital outflow. Therefore, it has been said that the US is the biggest beneficiary of East Asia’s financial crisis. To conclude, the US economy is generally promising in the long run. The inflation of its fictitious economic system may result in economic fluctuation, but it can still retain regional stability and will not collapse. This will have a positive impact on the recovery of the East Asian economy and the growth of the global economy. While remaining cautiously pessimistic toward the prospect of the global economy, we should also pay much attention to the trends in different countries throughout the world and map out timely measures. In the field of finance, there is never a perfect policy, nor an unchanged policy. Any policy is a result of balancing at the right time and place. A successful policy today may cause a future crisis. Therefore, China should strengthen its effort in studying financial issues, and continuously adapt its fiscal and monetary policies. Completed on 3 March 1999

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An Analysis of the Complexities of Enterprise Management and its Implications for China

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CHALLENGES FACING ENTERPRISE MANAGEMENT IN CHINA According to the traditional definition, an enterprise is an economic entity engaged in production, circulation, and service activities with independent accounting. In economic terms, an enterprise is the cell of the market economy: although each individual enterprise is independent in management and decision-making, it will invariably be influenced by other enterprises and changes in environment. While the interplay between internal and external causes determines the success or failure of an enterprise, the interplay between enterprises will generate self-organization, thus promoting the development of the macro economy. It is a natural law that enterprises come and go, but without the healthy development of the majority of enterprises, the smooth operation of the macro economy is impossible. Unquestionably, the vicissitudes of an enterprise have both objective and subjective factors. Management is the software in productivity, and only through proper management can laborer, means of labor, and labour object be organized to effectively stimulate productivity. Without proper management, science and technology will never be converted into productivity and integrated with the economy. Enterprise management refers to various activities, among which are the processes by which managers, in a constantly changing objective environment, attempt to exploit human resources, materials, equipment, and information to fulfill their objectives. It is a science and as well as an art. It is reported that, among the world’s top 500 companies early in this century, only 3 per cent remain in the ranking while most of them have undergone dramatic ups and downs. Likewise, some businesses have been able to seize opportunities and accomplish remarkable achievements, while others have failed. Economic globalization means co-existence in the real sense and is an overwhelming trend in world development. Although scholars from different nations hold different views about the starting point and features of globalization, it has to be recognized that the process began with the birth of capitalism in the West. The twentieth century witnessed increasing economic contacts between various countries in terms of material purchase, commodity trading, technological transfer, and capital export. The world has relaxed since the end of the cold war. The increasing expansion of multinationals, fast development of science and technology (information technology in particular), and massive flow of capital have accelerated the process of globalization. The globalization of the fictitious capital markets (such as foreign exchange, securities, futures, and options) has led to the explosion of the fictitious economy. It is reported that the world economy

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has been increasing at an average rate of 3 per cent on a year-on-year basis since the 1980s, and the figure for international trade is about 5 per cent, and international capital flow ay 25 per cent. By 1997, the world’s fictitious economy reached US$ 140,000 billion in total volume, while the GDP of all the countries in the world put together was only US$ 28,200 billion. The world’s fictitious capital is flowing at a daily average rate of US$ 1,500 billion, 50 times that of actual world trade. This flow of fictitious capital has dramatically strengthened the interdependency of the world’s economies, of which the rapid spread of the East Asian financial crisis is a good example. It can be predicted that, with the development of e-commerce and e-currency, the fictitious economy will continue to inflate and the interdependency of the world’s economies will reach a dangerous pass. Economic globalization has created excellent opportunities for the development of the world’s economies. The free flow of capital, the international spread of information, and the optimized global allocation of resources all help to boost the commercialization of technological discoveries, increase social productivity, and sustain the long-term growth of the economy, which in turn contribute to the inflow of funds, talent, advanced technologies, equipment, and modern management expertise to developing countries. But it should also be noted that economic globalization creates risks as well as opportunities. The dangers lie in the inflated influence of confidence factors, the bubble economy, and the rapid spread of financial risks. The dangers are worse for developing countries: since the rules of the game of the international economy are decided predominantly by developed countries with economic and technological advantages, developing countries are usually cornered and their economic safety and state sovereignties are threatened. In order to grasp the opportunities and meet the challenges arising from economic globalization, every country has to renovate or even revolutionize its management of state and enterprises. In the last decade, worldwide enterprise management expertise has improved, aiming to meet the challenges of economic globalization and the arrival of the knowledge economy. According to a 1996 report by the OECD (Organization for Economic Cooperation and Development), the knowledge economy is a shortened term for ‘knowledge-based economy’. It is an economy based on knowledge and is directly dependent on the production, distribution, and application of knowledge and information. It has four key features: 1. Knowledge-based industries take up leading positions in the industry structure. Just as agriculture was gradually mechanized in the Industrial Revolution, knowledge plays an increasingly important role in agriculture

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and industry in the knowledge economy era, where information and financial services are all based on knowledge. According to the estimate by the OECD, over 50 per cent of the GDP of OECD countries is generated as a direct result of knowledge. 2. Knowledge becomes the dominant factor in the process of economic growth . In fact, as the fruit of human understanding, knowledge has been critical in economic development. In the agricultural economy, labor was the key to economic growth, while in the industrial economy, capital is the major force pushing the growth of economy. A real knowledge economy will not come until such knowledge as technology and management expertise accounts for the greater part of economic development. Currently, in developed countries, the comprehensive factors based on knowledge (including technology and management) constitute the majority contribution (over 50 per cent) to economic growth, far above that of capital and labor investment. An example is the plumules that pose such harm to cotton production. Farmers used to pick them by hand, which is a heavy work of labor. Later on, pesticides were used for the same purpose, thus reducing the demand for labor. However, the development and production of the pesticides required a large amount of capital. Pesticides, moreover, had their negative sides: the insects and other harmful organisms would develop resistance, thereby increasing the dose of the pesticides and creating environmental problems. Biotechnological means, on the other hand, can transfer the anti-plumule genes into the cotton plants. These genes kill the harmful organisms immediately. This illustrates the process of transferring from labor-intensive to capital-intensive and finally to knowledge-intensive economy. 3. Knowledge is a key element in productivity. The three key factors of productivity, as mentioned above, are laborer, means of labor, and labor object. The quality of laborers is closely related to their knowledge level. In developed countries, the demand for employees with knowledge is increasing, and many businesses only recruit candidates with a college education. The gap between white collar and blue collar is ever narrowing, which is an obvious sign of the emerging knowledge workers. As far as the means of labor are concerned, the requirements for machinery precision and reliability are getting tougher and tougher. Enterprises demand software as well as hardware, since they manage the production mainly through information systems and distributive control systems. Due to the progress in science and technology, the low-grade resources that failed to be exploited in the past are now exploitable and the exploitation and application of recyclable resources are also under way. Management is the software in productivity, and only through management can the three key factors be coordinated and integrated to optimize their function.

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4. Knowledge accounts for a marked share in the functions and cost of products. Currently, production in foreign countries has been specialized and even customized, and their products can meet the needs of different segments. For example, the same chemical would have different specifications and function requirements when applied in such different industries as textiles, paper-making, and film-making. Initially, the cost of labor was the highest, but when the wage cost was reduced with the introduction of machinery, the capital costs (such as depreciation and bank interests) went up in relation to the total cost. Now the technical cost (patent and license cost) that represents the value of knowledge is increasing. For example, the raw material for a CMOS chip is rather cheap, but the cost of precision processing techniques and special equipment is extremely high. In order to meet the challenges posed by the knowledge economy, developed countries have already undergone an adjustment of industrial structure. This adjustment has two features: enhancing the comparative edges of the knowledge economy and developing high-tech industries. The prevailing restructuring throughout the world in the 1990s was effective in most of developed countries, especially among the Fortune 500. The primary objective of Fortune 500 companies is to increase competitiveness and to lead domestically and internationally in certain fields. They prefer to opt out if they fail to accomplish this objective. In recent years, many multinationals have been active in mergers and acquisition in an attempt to restructure and optimize their resources and thus build up their competitiveness. With the development of the knowledge economy, remarkable changes will take place in ideology, organization, methodology, and tools of enterprise management. More attention will be given to management strategies; more emphasis will be placed on structural adjustment and mergers to increase core competence; competition will exist in parallel with cooperation; stress will be placed on ‘humanized management’; information and human behavior will be considered in decision-making; attention will be given to improve organizational quality and adaptability; and priority will be put on the informationalization within enterprises. For various reasons, management in Chinese enterprises generally leaves much to be desired. According to the 1998 International Competitiveness Yearbook released on 13 April 1999 by the IMD (International Institute for Management Development) in Lausanne, Switzerland, mainland China ranks 29 (Hong Kong ranking 7) among 47 countries and regions in international competitiveness, 36 in management (Hong Kong ranking 5), and 46 (Hong Kong ranking 20) in general productivity based on per capita GDP.

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A comparative study on the scale, efficiency, innovation, and international competitiveness between the 500 industrial companies in China and the Fortune 500 companies was done by China’s Development Research Center under the State Council. The study reveals that the total assets and sales volume of the Chinese top 500 in 1998 were 0.88 per cent and 1.74 per cent respectively as compared to the Fortune 500. The average ROI (return on investment) per capita revenue and per capita income of the Chinese top 500 was 24.6 per cent, 12.3 per cent, and 9.5 per cent of the Fortune 500 respectively in the same year. In general, the Fortune 500 attach great importance to innovation, and their investment in research and development accounts for 5–10 per cent of their sales revenue. Chinese industrial enterprises, on the other hand, mostly suffer from such problems as poor equipment and low development capacity, and their investment in research and development accounts for less than 1.4 per cent of their sales volume. Moreover, this percentage is declining. Most of the Fortune 500 are highly interdependent, while retaining strong international competitiveness. These enterprises are generally multinationals and global competitors in investment, production, and sales. The competitiveness of the Chinese top 500 is still confined to China and they cannot be considered ‘international or ‘world class’. Enterprise management is the major branch of international management science. Such management theories as reengineering, core competence, and harmonious management have been developed out of the management practices. Chinese scholars have paid increasing attention to the study of enterprise management, and have put forward many helpful proposals for the reform and development of the SOEs (state-owned enterprises). This chapter attempts to analyze the complexities in enterprise management in the belief that an enterprise is a complex system, and tries to propose corresponding strategies that hopefully will benefit Chinese enterprises in their management.

THE ENTERPRISE AS COMPLEX SYSTEM Since system science emerged in the 1930s, people began to realize that a system is beyond the summation of its components, possesses hierarchy and functional structure, develops and changes continuously, exchanges mass, energy, and information with its environment. Frequently a system can also stabilize itself (self-organization) even it is far away from equilibrium, a determinative system is of intrinsic randomicity (chaos), while a stochastic system is of intrinsic deterministic nature (emergence). These discoveries have strong impacts on the conventional concepts of classical science. New sciences have emerged one

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after another, for example, system theory, information theory, cybernetics, phase transition theory (concerning formation and evolution of balanced structure), dissipative structure (concerning phase transition under non-equilibrium and self-organization), catastrophe theory (concerning discontinuous consequences resulting from continuous procedures), synergetics theory (concerning the evolution of the system and self-organization), chaos theory (concerning the intrinsic randomicity of determinative systems), hypercycle (concerning the theory of self-organization on the basis of evolution in the behavior of life systems) etc. This tendency has made many scientists feel puzzled, and provoked some of the far-sighted scientists start to ponder and explore new routes. It was in such a background that the complex system and systematic complexity were proposed. Complexity science is a scientific category proposed in the 1980s, concerning research into complexity and complex systems, which in its germination, was praised by some leading scientists as ‘the science of the 21st century’. Many scientists have proposed various definitions for ‘complex system’. Some argue that a complex system refers to a system composed of many hierarchical components, others maintain that it is a system of variety, and still others believe that it is a strong coupling system or a system with human participation. To us, a complex system is characterized by the intelligence of the components. It has the capability to understand circumstances, predict change, and fulfill scheduled goals. This is the internal force for biological evolution, technological innovation, economic growth, and social progress. The idea of complex system poses a threat to traditional economic theories. It no longer takes economy as the result of a stable market and equilibrium between demand and supply, but rather as the result of the constant adjustment of relations between many interacting agents in unstable conditions. Every individual unit takes action in response to future predictions and to other units, and takes to consistent learning and adaptation. This gives rise to new economic structures and models, and the institutions, behaviors, and techniques that form the economy are constantly developing and restructuring. Some components of the economy achieve a momentary equilibrium while other components are continuously evolving. The complexity science poses a threat to traditional management theory as well. It no longer takes an enterprise as an independent accounting economic unit composed of such factors as labor, capital, materials, equipment, and technology engaged in production, circulation, and service provision. An enterprise is now considered to be a complex system comprising such intelligent agents as the owner, management, professionals, and workers, who are closely

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related. The interaction among them will generate a kind of self-organization and give form to the hierarchical and functional structures, which in turn constitute the internal factors affecting the development of an enterprise. The external environment, on the other hand, will have favorable and unfavorable impacts on the development of an enterprise. As a complex system, an enterprise shows its complexities in the following ways: 1. The constituent units of an enterprise are extensively and closely connected and thus form a network. A change in one unit, therefore, will be affected by and cause change in other units. For example, when the management of an enterprise decides to start a new business, it will not only lead to changes for the work of various functional departments, but also solicit favorable and unfavorable opinions from the owners and employees, the results of which might have a decisive impact on the new business. 2. An enterprise is a multi-level and multi-function structure. A large enterprise, for example, typically consists of such levels as head offices, business departments, factories, workshops, and workshop sections, and every level is a basic unit of the upper level. At the same time, an enterprise also contains such sub-systems as sales, production, personnel, and finance in terms of functions, and these functions can be found at every level. 3. An enterprise is a dynamic organization. In order to attain its scheduled goals, an enterprise involves itself in constant development and restructuring, and continues to learn and adjust its hierarchical structure and functional structure in the process of development. 4. An enterprise is an open organization. It is closely connected to and interacts with the environment, and develops in the direction that better fits in with the environment. Moreover, an enterprise claims for itself a power to predict the future development of the environment. Therefore, problems can be identified and corresponding strategies can be developed only when the management of an enterprise is studied in the context of complexity science. To us, it is essential to adopt the systems science approach under the guidance of material dialectics with an integration of qualitative judgment and quantitative calculation, micro analysis and macro synthesis, reductionism and holism, and scientific reasoning and philosophical reflection. When the management of an enterprise is examined through complexity science, the enterprise is considered not only as a system, but also as an organization with life, or as a ‘person’ consisting of numerous individuals. 1. Objectives are the soul of an enterprise. As an organization with life, an

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enterprise has to develop its visions, missions, and strategic objectives. This is the basis for enterprise management, since visions determine the missions, missions determine the strategies, and the strategies determine the enterprise structure. Without common visions and missions, it is simply impossible to establish an excellent enterprise culture that motivates the employees to work for the ultimate success of an enterprise. 2. People are the rudiments of an enterprise. As an enterprise is a group composed of numerous individual members, its overall quality will be determined largely by the quality, efforts, and interactions of its individuals. Thus, it is essential to give full play to the initiative of each member and to develop a mechanism and approach to ensure the consistency between the personal objectives and the organizational objectives. On the other hand, internal behavior norms need to be set for the whole organization in the form of discipline and ethics. 3. Management is the core of an enterprise. Since an enterprise is a large scale and multi-level dynamic system, its development process must include such evolutionary features as non-linearity, strong coupling, self-organization, and adaptability. In addition, the emergence of chaos is often inevitable, and the key responsibility of the management is to accomplish the enterprise’s key objectives, guided by and controlling the chaos. The quality of the managers will have a significant impact on the chance of success for the enterprise. 4. Environment is the stage of an enterprise. As an entity existing in a certain time and space, an enterprise is inevitably closely connected and interactive with the external environment. An enterprise can by no means attain success without the constraint of objective conditions, but it can exploit opportunities and overcome difficulties to excellent effect within the limits of objective conditions. A successful enterprise should be able to handle relations with the public, customers, colmnunity, government, and banks, and establish an outstanding image for itself. 5. The science and art of management guarantee the healthy development of an enterprise. Management is a science of precise laws, and at the same time an art of magical application. Therefore, a manager should combine scientific approaches and artistic applications in order to ensure the healthy development of the enterprise. The science of management can be acquired through training, while artistic application can be fully understood through continual practice. Every successful manager has his or her own unique management style. In the automotive industry in the US, for example, Henry Ford, A. P. Sloan, and L. A. Iacocca enjoyed their respective leads in the industry for several years, but they were different in their management styles since they worked in different

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environments. People can understand the art of management only by observing their methods of handling such specific issues as organization, incentives, marketing, and competition.

COMPLEXITY OF ENTERPRISE MANAGEMENT IN CHINA SOEs are playing a significant role in the development of China’s economy. In the process of establishing and improving the socialist market economy, the reform and development of SOEs constitute a critical issue. There have been three stages in the reform of SOEs. The first stage, from 1978 to 1986, focused on decentralization and increasing the autonomy of enterprises and achieved apparent results. In terms of enterprise management, however, the Chinese government was still constrained by the traditional planned economy mechanism and relied heavily on administrative intervention. Government administration was not separated from enterprise management in a real sense. The second stage, from 1989 to 1992, saw the practice of various contracting models. The tide of contracting enterprise spread rapidly throughout the country, which promoted the development of enterprises. However, the fundamental problems with management and operating systems remained untouched, and short-term behaviors prevailed. Management tended to focus on short-term benefits, without any consideration of long-term development. For example, technological development was not put on the agenda, and some enterprises tried to whitewash their performances by sacrificing state-owned assets. This led to substantial loss of state-owned assets, and created great difficulty for future management. The third stage started in 1993 and is still going on, focusing on corporate reforms and the establishment of a modern enterprise system. The reform of SOEs has achieved considerable progress, but still leaves much to be desired. The imperfection is reflected in three aspects: 1. The growth of the state-owned economy. From 1993 to 1997, the gross industrial product of SOEs increased by 28 per cent, while collective enterprises and other types of enterprises increased by 163 per cent and 425 per cent respectively. Obviously, the growth rate of SOEs was too low, even when their large base is taken into account. By 1997, the gross product of SOEs accounted for less than one third of the GDP. 2. The growing losses experienced by the SOEs. In 1987, the figure rose to RMB 6.1 billion, nearly 6 per cent of the GDP. In 1997 losses even surpassed the national deficit. A series of measures have been taken by the central government since 1998 and in 1999 in particular, including interest rate reduction and tax

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rebates for exports. This has helped improve the performance of SOEs, but the problem of severe losses remains and some SOEs have serious financial difficulties. 3. The decreasing percentage of state-owned shares in listed companies. From 1994 to 1998, the percentage fell from 42.7 per cent to 34.1 per cent. The China Securities Regulatory Commission (CSRC) is stringent in giving approval, and it is especially hard for non-public enterprises to be listed publicly. A number of listed companies have been acquired by non-public enterprises as a result of their poor management, which is responsible for the decrease in the percentage of state-owned shares in listed companies. The approval system in China has contributed to a higher cost of listing as compared to acquisition. In summary, the reform of the SOEs is a pressing issue. The future of the state-owned economy and state-owned enterprises will be endangered if serious efforts are not made and drastic measures are not taken. At the Fourth Plenary session of the Fifteenth National Congress of the CPC (Communist Party of China), The Decisions on Major Problems for the Reform and Development of the SOEs (hereafter called the Decisions) were passed, which reveals the importance that the central government attaches to the SOEs and illustrates the urgency and complexity of reform and development. As China has long operated according to a planned economy system, the government was simultaneously the owner and head of enterprises. As a result, enterprises would turn to the government for help when problems arose and rely heavily on its administration. Under this system, managers could be promoted but not demoted; employees could be recruited but not fired; salaries could be increased but not decreased; welfare could be improved but not lowered; and enterprises were not allowed to close down. Such mechanisms lagged far behind the requirements of a socialist market economy. Due to their long dependency on the government, SOEs failed to develop the spirit and ability to survive in the market economy, while the government intervention and ‘care’ further increased such dependency. Under the planned system, managements of enterprises were comprised of semi-officials with administrative ranks. They could be transferred to other enterprises or government departments even when their performances were very poor. They invested most of their time in building good relations with the government and banks. When the enterprise was in trouble, they tended to expect government transfers through banks. They paid little attention to strengthening internal management. Many of them knew little about modern enterprise management concepts and skills, and were ill-informed about governance systems, financial engineering, capital operation, business process

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reengineering, and performance measurement. Some of them were even ignorant of balance sheets and basic financial terms. Such managers were essentially unqualified. As the major channel for employment for many years, SOEs were typically overstaffed. Salaries, bonuses, housing, pensions, and health care had become burdensome to enterprises and ‘iron rice bowls’ to their employees. Without an incentive and a supervision mechanism, people were deprived of the impetus for learning and innovation, which contributed to their dependency on the enterprise and the government. SOEs have long lacked a corporate governance mechanism. Their leaders considered themselves as representatives of the owners, which has led to the serious problem of ‘insider control’. Most enterprises were swollen as they had too many levels and departments. Some even had schools, nursing homes, hospitals, fire brigades, and police officers which were irrelevant to their business. It was not rare for an enterprise to keep several different books and maintain a private bursary. China is now in a transition from the traditional planned economy to the socialist market economy. This is an arduous, even painful, process which involves changes not only in ideology, but also in operation, enterprise management, and corporate culture. Numerous problems will crop up during the process and will need to be taken seriously, especially when they concern adjustment and repositioning of management and employees. These problems cannot be solved by empty talk. They demand great care and a change of the mindset of the people involved, who should be guided through the process in a well-planned manner. The transition is also a ‘path dependent’ process, which means that the steps already taken will have an impact on the outcome of the ensuing steps. For instance, the decentralization and contracting system have reaped considerable benefits, but have also given rise to certain problems. When profit-sharing was shifted to tax-levying, the relevant concepts had not yet been clarified. Profit stands for the performance of an enterprise, and taxes represent the obligation that an enterprise has to the state. If all an enterprise’s profits were converted into taxes and submitted to the state, the initiative of the management would be dampened. As a result, the decision was given up. The contracting system was helpful in stimulating the enthusiasm of the management, but was also likely to solicit short-term behaviors. The management of an enterprise was mainly concerned with the objectives within their term in office, and showed little interest in the future development of their enterprise. The Decisions point out that ‘the development of a proper enterprise

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system and operating mechanism as required by the market economy is critical to the setup and improvement of the socialist market economy system that can integrate the public ownership with the market economy’. In terms of management science, the strategic measures proposed in the Decisions fall into four levels. The first level concerns the strategic adjustment of the structure of the state-owned economy, making it clear that the state should be active in some fields and inactive in others. Effective actions shall be taken in four fields: industries concerning the national security, industries with natural monopoly, industries that provide important public goods and services, and backbone enterprises in the pillar and high-tech industries. The control of the stateowned economy shall be strengthened while retaining the economic system with the public ownership as its core. The second level outlines the adjustment of the ownership structure through diversification of share rights ranging from exclusive ownership to majority ownership and equity participation. The third level promotes the modern enterprise system, characterized by ‘separation between ownership and management, division of rights and responsibilities, separation between government administration and enterprise management, and scientific management’. The fourth level reinforces the internal management of enterprises. Obviously, the first level falls into the category of macro-management, and the last three into enterprise management. It is essential to formulate a scientific management system appropriate in the Chinese context by critically inheriting the good practices of traditional Chinese enterprise management and selectively absorbing modern Western management theories in light of the realities of China. Only through this can we improve the management in Chinese enterprises and develop their international competitiveness.

DEVELOPING STRATEGIC OBJECTIVES Strategic management is the primary task of modern management. In developing strategy, priority should be placed on the setup of strategic objectives, and on environmental and resource analysis. Environmental analysis focuses on society, industry (competitors), and the market (customers), while resource analysis focuses on such resources as labor, capital, materials, and technology. The strategic objectives shall be modified if the analyses are unfavorable to their attainment, or specified if they are attainable. Further adjustment is needed in implementation in line with changes in external conditions. As the soul of an enterprise, strategic objectives are usually formulated

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on the basis of an objective estimation of the long-term development of the enterprise. From the perspective of development trends in world management, strategic objectives have four levels:

Level One The first level comprises general performance objectives, including growth objectives in scale and profit. Many enterprises in China show stronger preference for scale growth objectives. According to the lessons drawn from foreign enterprises, especially from the East Asian financial crisis, however, priority should be given to the growth of profits, which is most critical in measuring enterprise management performance. The study of the East Asian financial crisis and the analysis of the Fortune 500 enterprises in 1996 and 1997 have highlighted a problem: the yields on business revenues (the ratio of yields to business revenues) of Asian enterprises rank the lowest in the world. In 1996, the year before the financial crisis broke out, the Fortune 500 had an average yield of 2.9 per cent. Among these enterprises, the 162 American enterprises claimed an average yield of 6.1 per cent, the 34 British enterprises claimed an average of 7.22 per cent, and the 41 German enterprises enjoyed an average of 2.36 per cent. At the same time, the average of the 126 Japanese enterprises was 1.23 per cent, and that of the 13 Korean enterprises was only 0.77 per cent. In 1997, the average yield of the Fortune 500 went up to 3.2 per cent, of which, however, the average of the 112 Japanese enterprises and the 12 Korean enterprises went down to 0.52 per cent and 0.33 per cent respectively. The underlying fact is that the Japanese and Korean giants paid too much attention to expansion and growth rate while neglecting the increase in profits. The development of the Korean enterprises is typically dependent on government support and huge bank loans. Furthermore, the Korean economy is mainly based on conglomerates, which hold that growth in scale and market share is critical to the objective of rapid development. To them, profit is the secondary objective. The resulting problems are overexpansion in scale and operations, which in turn overshadow their core business. In 1996, the 49 largest businesses in Korea realized a sales volume equivalent to 97 per cent of the GDP, but their total profit was less than US$ 65 million. If the bankrupt Hanbao Group is taken into account, the top 50 Korean enterprises had a net loss. The government is skewed in policy in favor of the conglomerates, and requires banks to grant unlimited loans to them. As a result, leverage prevailed and businesses were enthusiastic about expansion with little thought as to the optimization of the assets structure, reduction of the asset liability ratio, and

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maximization of profit. At the end of 1996, the self-owned assets ratio of the top 30 conglomerates in Korea was only 18.2 per cent, whereas 82 per cent of their capital came from loans. In this case, businesses have to pay off their debts first when they make any profit, which will greatly reduce their returns. Enterprises with such a low profit rate and high asset liability ratio are extremely vulnerable and easily get into trouble. According to data released by the Korean government, by the end of November 1997, external debts reached as high as US$ 153 billion, among which short-term debts (with a maturity below one year) accounted for 62.2 per cent and one third were direct external loans for the conglomerates. The remaining two thirds of loans were arranged by banks. When the exchange rate in Korea fell from US$ 1 to W 900 to US$ 1 to W 1800, the liabilities of enterprises doubled — a hard blow indeed. The lessons from the East Asian financial crisis are bitter: an enterprise must place the profit objective above the scale objective. Many Chinese enterprises, however, are still more interested in rapid expansion and diversification. In conducting feasibility research, they tend to be arbitrary in their market and profit analysis, without serious considerations for such factors as product substitutes and competitors. In consequence, one third of the projects fail to attain the goals in the feasibility report or even report losses after construction. It does not mean that expansion and diversification are negative, but they are beneficial only when they generate profit. Past experience shows that related diversification will meet with fewer risks.

Level Two The second level is the objective concerning the owner ’s equity, which essentially means assets less liabilities according to the basic principles of accounting. Long-term performance depends on the increase of the owner ’s equity. The performances of high-tech companies in their development stage, for example, tends to be poor. The American experience shows that a hightech enterprise will have to go through four stages of growth: establishment, development, expansion, and maturity, with the demand for a double investment in each phase. Because of the large demand for capital, the cash flow is always negative, and the short-term economic benefits are far from satisfactory. Therefore, the focus of venture investment is not on the short-term benefits of high-tech businesses. The venture capitalists are more interested in cashing the owner’s equity. By growing, an enterprise increases its owner’s equity, and venture capitalists can realize exceptional returns when the company gets listed or is sold. But it might take three to seven years before their objective

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is fulfilled. Therefore, the shareholders of many foreign high-tech companies set their sights on the increase of the owner’s equity rather than on short-term performance. A good example is Amazon.com, the famous online bookstore in the US. In 1998, it had a sales volume of US$ 293 million, with losses of up to US$ 61.7 million. The reason is that the company had to invest heavily to set up an information network during expansion. However, as the shareholders are more interested in the increase of the owner’s equity and the potential returns, Amazon.com is still robust in the American stock market, with a market value of over US$ 30 billion. In summary, enterprise management should focus on the increase of the owner’s equity rather than on short-term performance, or it could be a disaster. Under the contracting system, a serious problem was that some managers tried to whitewash their performances by selling the tangible and intangible assets of their enterprises. On the surface, their short-term profit rates were high, but the owner ’s equity dropped sharply. When the contracting term expired, the managers would escape with a bonus while the enterprises had to tackle the serious problems that remained.

Level Three The third level is the objective in customer benefits. With the progress in science and technology and the improvement of living standards, customers have become increasingly demanding over products and services. Therefore, an enterprise should maximize not only its interests, but also the customer ’s benefits, which include customer service, product customization, and customer satisfaction. The market economy is essentially a buyer ’s market. Customer ’s cash can be likened to votes to be cast in favor of enterprises that can satisfy them. In this sense, the competitiveness of an enterprise is its ability to win the votes of customers, and constitutes the basis for its survival and development. It does not refer only to price competitiveness or to cost. At present, a number of Chinese SOEs are still focusing on price competitiveness, which is obviously inadequate. An enterprise should also develop the non-price competitiveness in its narrow and broad senses. Non-price competitiveness in the narrow sense includes product quality, delivery term, and service quality (pre-, during-, and after-sale service, product quality warranty, business management, and maintenance capabilities), which is increasingly important in market competition. Some Chinese businesses often complain that customers would rather buy imported goods, even when their products meet the quality standards set by the state and are offered at lower prices. Therefore, they

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demand economic and administrative intervention by the government under the pretext of protecting national industry. In fact, the problem does not lie with the customers, and the solution does not rest upon protective measures by the state. The crux here is to increase the non-price competitiveness of enterprises. Our field study in the Pearl River Delta shows that most of the customers were satisfied with the quality and price of Chinese domestic fine chemical products. But three problems were almost fatal. The first was the oversimplification of product specifications. The classification of Super Grade, Grade A, Grade B, and Grade C was inadequate for some customers. Imported products, on the other hand, were classified according to their usage, such as for the making of paper, textiles, or film, and their performance-price ratio was more attractive to customers. The problem of domestic specifications was worsened when customers used imported equipment and had higher requirements for raw materials. Moreover, some customers also complained about the unstable quality of the domestic chemical materials. Yellow dyes are an appropriate example. Products of different dates varied slightly in their colors, which led to inconsistencies in the quality of customer’s final products and even affected their product reputation. Foreign dye manufacturers had a ‘homogenizing process’. Products were not sold until they were mixed and uniformed to meet the specification in color. Because of inadequate cash flow, domestic manufacturers had to deliver their products as soon a batch was completed. As a result, their product quality was inconsistent. The second problem concerned the delivery date set down in the contract. The domestic manufacturers often delayed the delivery using such excuses as power cuts, system overhauling, or transportation difficulties. Even if the contract included penalty terms for delivery delays, the losses incurred in the customers’ production and reputation could not be compensated with the penalty, as the cost of the fine chemical materials only accounted for 1–2 per cent of the final products. Foreign manufacturers, on the other hand, attached great importance to timely delivery of their products. Some of them even had their own warehousing and transportation facilities in Hong Kong, and could deliver the goods in containers by the afternoon if customers placed an order in the morning. The third problem was the service quality. When placing orders with foreign businesses, the salespeople were usually very familiar with the product specifications and production processes. They could easily understand the customers’ needs and could even help their customers to select the most appropriate products. If any problem occurred after delivery, they could send maintenance people to solve the problem on site. If the products failed to meet the specifications, they provided the refund warranty. Domestic manufacturers

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lagged far behind in after-sale service. Most of them did not pay enough attention to service quality, and a few of them even insisted on ‘rejecting to take back the product as soon as it is sold out’. As a result, customers were scared away and had to resort to legal action to obtain a refund. Many foreign enterprises also value non-price competitiveness in the broad sense. One example of this is the ability to develop new products. A product that remains the same for 10 years cannot compete. An enterprise needs to launch new generations of products or new products to maintain its leading position in the market. Intel, for example, is the leading manufacturer of chips. When it is marketing the first generation, the second generation is ready for production and the third is under development. When the new generation is launched, the price for the older generation drops dramatically. By creating a competitive edge an enterprise also creates new demands through product innovation. A second example is planning ability, or the ability to deliver goods after receiving orders. If an enterprise is able to produce and deliver customized goods, its competitiveness will be greatly enhanced. This requires flexible production. Opportunities will be lost if an enterprise rejects customers with small orders and high demands. A third example is product differentiation. If an enterprise can differentiate itself from others, it can build a strong brand and increase competitiveness. A fourth example is the attraction of the goods to the customers. If an enterprise can attract customers by the color, shape, function, and auxiliary parts of a product, it will enjoy a competitive advantage over its rivals. Price competition is losing its significance as the multinationals achieve economies of scale and develop rigorous and meticulous measures for production management. Therefore, Chinese enterprises need to invest in increasing their non-price competitiveness if they want to compete in the international market.

Level Four The fourth level is the objective in social benefits. An enterprise cannot survive in the long run if it fails to win social support and neglects social benefits, which can be grouped into three broad categories. The first is the community. An enterprise should be able to contribute to the community by, for example, providing employment opportunities, sponsoring community activities, and improving public relations. If possible, an enterprise can also set up museums and organize visits for the residents and teachers and students from local schools, offering them a chance to learn about the history of the business and study related scientific knowledge. The second category is the environment. This does not only mean pollution control and environment

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protection, but maintenance of the biological balance and protection of natural and anthropological sights. Efforts should be made to help solve global environmental problems, such as protecting the ozone layer, reducing the greenhouse effect, and preventing desert expansion. The third category is the public. If an enterprise takes into account the long-term benefits of the public, and is committed to providing the best services for the public, it will finally win the approval and support of the public, from which it will develop future customers. Obviously, this will bring about unexpected benefits for the business. An example is the Internet portals that provide free services to the public in the belief that the chances of winning advertising business will be greatly increased if they have more visitors. Microsoft is a leading manufacturer of software, and by developing and selling Windows, it has achieved enormous success. Today, its market value is over US$ 500 billion, equivalent to half of China’s GDP. In order to maintain its monopoly position, Microsoft has refused to disclose the source code of Windows. The users are helpless when they encounter problems. They have to wait until Microsoft launches the latest version, and sometimes even have to pay for this new version. Now there is another operating system software, Linux. The primary idea is that the developer provides all the source codes of the software so that any user is entitled to use, copy, expand, and modify the software. At the same time, users are obliged to publish their post-modification program code. This practice has pooled and exploited the collective knowledge of thousands of users (including hackers); the producer is able to reduce the price and ensure the service quality. Launched in May 1994, Linux increased the number of its users to 7 million by 1997, doubled them in 1998, and was expected to generate a customer base of 30 million in 1999. According to the statistics by Lianbang Software, the leading computer software retailer in China, TurboLinux overtook Windows 98 and Windows 2000 and became the market leader between midAugust and mid-December 1999. Many people now argue that the only threat to Windows is Linux. Of course, it will be a long time before Linux can compete with Windows. In this light, an enterprise should value the social benefits as its long-term strategic objective in order to create a better future. The four levels of strategic objectives mentioned above are closely correlated and supplement one another. After setting up their strategic objectives, businesses should develop steps and strategic measures to fulfill long-term objectives according to their real conditions. They should be ambitious and strive for a leading position in their field. By motivating their employees, improving their operating systems, and increasing their awareness, businesses can accomplish their long-term strategic objectives.

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IMPROVING THE OVERALL QUALITY OF AN ENTERPRISE The overall quality of an enterprise is the macro quality developed through the correlation and interactions between the various constituent parts in the enterprise system. As the internal force for development, it includes innovation, core competence, and corporate culture.

Innovation The innovation theory was first put forward in an article published in The Theory of Economic Development (1912) by J. A. Schumpeter, an Austrian economist. According to his theory, ‘innovation’ refers to the ‘fresh combination of the production factors by the entrepreneur’, which can include developing a new product, adopting new processes, opening a new market, acquiring or controlling a new source of materials or semi-products, and implementing a new organization form. There are three kinds of innovation: technological innovation, management innovation, and system innovation. Technological innovation refers to introducing a new product, process, or service into the market and realizing its commercial value. Management innovation refers to introducing a new idea, method, approach, or organization form into the management of an enterprise or country and achieving positive results. And system innovation refers to introducing a new relation, system, or mechanism into social or economic activities, and boosting the development of society and the economy. Technological innovation is the ability to introduce or develop new technologies, new products, and new services; satisfy or create market demands; and develop competitive advantages. The success of technological innovation depends on the research and development (R & D) capacity of an enterprise and its sensitivity to market demands. R & D refers to the whole process, from the formulation of scientific suppositions to the fruition of a technical process or the manufacturing of a product in the industrial scale, entailing such steps as basic research and applied research and development. R & D includes technical process improvement (such as solving the problems arising in production, eliminating bottlenecks, reducing operation costs, improving product quality, improving operation parameters, and eliminating environmental pollution); process development (such as creating a new process for an existing product, developing a new process for a new product, managing to exploit the byproducts of an existing process); product development (satisfying the customer’s need for a particular function technically and economically); applied development (discovering new

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applications for existing products); background research, also called applied basic research (promoting the understanding of the nature and principle of a particular product); and providing technical support for the sales department. Sensitivity to market demand is reflected in the ability to improve old products or develop new products according to market demand. The American company Du Pont is a good example. When it first launched nylon, it was only used in producing parachute and stockings. The product was extended to the production of light yarn in 1945, to tire curtains in 1948, to ventricular yarn in 1955, and to carpet yarn in 1959. Through innovation, the company was able to increase its sales and extend the product’s life cycle. The sensitivity of an enterprise to market demand is also shown in its ability to forecast the future of a new technology or product, seize the opportunity for development, and dominate the market. For example in the early 1960s, IBM foresaw the future of the CMOS chip technology and invested US$ 5 billion in developing the second generation of computer products in which the CMOS chip technology had taken the place of transistor technology. The new products helped increase computing speed and reduce costs. This four-year effort gave IBM a lead in file market for 20 years. (However, the company missed an excellent market opportunity by failing to purchase the patent for the 914 photocopier from Xerox in the late 1950s.) By increasing technological innovation, an enterprise can develop its intellectual capital and come up with products that are unlikely to be copied and which will in turn contribute to the competitiveness of the enterprise. Management innovation refers to the ability to be innovative in production, finance, human resource, marketing, research and development, and information. These innovations depend on the evolution of science and technology on the one hand, and on changes in the external environment on the other. The development of science and technology, especially information technology, stimulates the management innovation of an enterprise. For example, the application of information technology makes possible information sharing (through network and various databases); rules sharing (through various databases of norms and rules); method sharing (such as computer-aided design); and experience sharing (such as the expert system). By automation and control intelligence, team members can work on the same task in different locations, while even a single worker can accomplish the complicated tasks that would otherwise require the labor division of multiple workers. In the meantime, it dramatically reduces the layers of organization. Changes in the management environment and changes in norms and standards in particular, also contribute to the management innovation of an

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enterprise. For example, the establishment and implementation of ISO9000 and ISO14000 standards by the International Standards Organization have raised the requirements for enterprise quality and environmental protection, and pushed them to innovate in both aspects. System innovation in an enterprise refers to its ability to motivate and control the behavior of its members, regulate relations between team members, and coordinate the objectives and actions of various members. It is an important factor for the survival and development of an enterprise. Complexity science regards innovation as an obtrusive phenomenon resulting from a combination of knowledge and components. According to this theory, innovation marks a fundamental change in science and business practices and, as a result, an enterprise has to give top priority to the development of knowledge and intelligence. Based on research on how to generate knowledge, innovation, creativity, and intelligence through the interaction of employees (components), scientists have discovered that innovation depends on the motivation of employees to care for the whole enterprise and not just the outstanding intelligence of a particular employee. As the old Chinese saying goes, ‘Three cobblers think better than a mastermind.’ Innovation does not result from the brainstorm of a particular talent but from the adjustment of a system to adapt to changes in the environment. Therefore, the capacity for system innovation lies at the core of an enterprise. Only when system innovation has stimulated the initiatives of all the components within the enterprise and coordinated their behaviors can the objectives of technology and management innovation be accomplished.

Core Competence Core competence is a concept put forward by two American scholars, C. K. Prahalad and G. Hamel, in 1990. With rapid changes and increasing competition in the market, they argued, the sustainable development of an enterprise cannot be built solely on its capacity for technological innovation. Instead, an enterprise has to provide purposeful guidance for technological innovation, cooperation, and introduction, and develop its core competence by the integration of all three. In a sense, a diversified enterprise is a big tree of which the core product is the trunk, the business departments are the branches, the end products are the leaves, and the core competence is the root system that absorbs nutrition for the stable growth of the tree. Business leaders of the 1990s needed to acquire the ability to identify, develop, and apply the core competence of their organizations, the ability to realize sustainable growth, and the ability to integrate the technological resources to adapt to the external changes.

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The rapid growth of NEC in the 1980s illustrates the importance of core competence. In the early 1970s, the management of NEC put forward an unequivocal proposal to integrate computer technology and telecommunications technology. They made every effort to sell their idea within the organization, and at the same time set up a cross-functional department – a ‘Computer and Telecommunication Committee’– to develop the core product and the core competence. After a careful study, they identified three development lines, including the transformation of mainframe computer technology into distributive processing, the transformation of the ordinary IC components into super large-scale integrated circuits, and the transformation of the mechanical crisscross switchboard telecom technology into the complicated digital systems. They realized that these three business lines were closely interrelated, and any enterprise with the ability to serve the three markets would enjoy immense opportunities. To this end, NEC mobilized all its resources and integrated technology development, technology cooperation, and technology introduction in an attempt to develop competence in these areas at the lowest cost. This strategy was a great success. In 1980, the company’s revenues were US$ 3.8 billion, while its key competitor GTE had sales of US$ 9.9 billion. By 1988, however, NEC had increased sales to US$ 21.9 billion, while GTE sales were only US$ 16.5 billion. In the 1990s, many large enterprises began to realize the value of core competence and came to understand that it was the expertise developed by integrating various advantageous factors in technology, management, and culture. Core competence is difficult to copy, but can easily be extended to other fields and can help an enterprise develop new products and new technologies and become a market leader. For example, Intel, Microsoft, and Sharp have developed not only a competitive edge in CMOS chips, Windows, and liquid crystal display respectively, but also a unique management system and corporate culture.

Corporate Culture Corporate culture, also called organization culture or company culture, is a novel management concept put forward by Western scholars in around 1980. The birth of this concept can be attributed to the increased importance of human factors in enterprise management and also to the popularity of mergers and acquisitions and strategic alliances, the development of multinationals, and cross-cultural differences, which demand greater attention by the senior management of enterprises. In the past 20 years, extensive research has been done on corporate culture. However, no consensus has yet been reached. To put it simply, enterprise

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culture refers to the mental attitude shared by all members of an organization. It includes four categories: audio-visuals (such as internal jargon, logos, and uniforms); models (such as the founders or the inventors of key technologies); rituals (such as anniversary ceremonies, celebrations, and honor conferring meetings); and values. The first three categories constitute the external features of the corporate culture while the last is the core. Values refer to people’s preferences reflected in their choices of objectives, manners, and actions. From the point of view of complexity science, the values of an organization are developed through the interplay among all its members. Therefore, as the core of corporate culture, the values of an enterprise depend on the original values of the individual members and on their interactions within the enterprise. Prior to joining an enterprise, an individual is shaped by his/her sex, ethnic group, class, profession, and personal experience in the formation of values. Studies have found that each different ethnic group is different in its attitude towards authority, norms, career, and long-term benefits, and that the values of a particular individual have been formed by the age of 10. When an employee joins an enterprise, he will be ready to accept the corporate culture if his values are commensurate with those of the existing members. Otherwise, the resulting culture shock will create trouble for the management. In general, the reform of the acquired values of an employee requires long-term efforts and the management of an enterprise should be capable of guiding that employee towards fulfilling the strategic objectives of the enterprise. Corporate values are developed through the interplay and interactions of individual employees and are reflected in performance orientation, humanism, collectivism, liberty, degree of control, and flexibility. These features are determined by the nature of the industry, and the development path and experiences of the enterprise. They are also determined by the history, traditions, culture, and level of development of the country in which the enterprise is located. Business leaders also play a key role in the formation of corporate values. Thanks to their authority and influence, employees are ready to accept their strategic objectives, action guidelines, and management concepts. Culture shock is also likely to occur, however, when the values of leaders are in conflict with the existing values of their subordinates. For example, American employees in a Japanese enterprise would find it hard to accept the daily ritual of raising the corporate flag and singing the corporate anthem. Likewise, foreign executives in joint ventures in China would come across resistance from the local employees if they tried to implement management concepts that they believed to be right.

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From the perspective of management science, corporate culture can be regarded as a sophisticated management tool, since most significant management issues of an enterprise (such as the structural reform of the SOEs, organizational adjustment after acquisition, and regional coordination of the multinationals) are closely related to corporate culture. These issues cannot be solved without a proper application or change of corporate culture. In learning and practicing Western management concepts and skills, an enterprise needs to consider the influence of corporate culture. Therefore, if the 20 th Century was a century during which empirical management gave way to scientific management, the 21 st Century will be the century in which scientific management evolves into cultural management. Last but not least, humans are the foundation of an enterprise. An important task for any enterprise is human resource development. An enterprise needs, on the one hand, managers with management capabilities, knowledge of business, and vision and, on the other hand, employees with the requisite knowledge and skills, a fondness for learning, and teamwork. Without improving the personal quality of employees, the overall quality of an enterprise will never improve.

IMPROVING THE MANAGEMENT SYSTEM The management system of an enterprise refers to the arrangement between the owner and management to direct the interactions among various components within the enterprise system to fulfill the strategic objectives. It includes corporate governance, enterprise organization, employee incentive, and performance evaluation.

Corporate Governance Also called the enterprise legal person governance structure, corporate governance refers to the system arrangement determining the distribution of basic rights (including the appointment of top management, distribution of company resources, and distribution of net earnings), or dictating when and who owns these rights. It is designed to bridge the gap in objectives between owner and management after ownership is separated from management. Some academics argue that corporate governance is a whole set of system arrangements to supervise and control the management and performance of an enterprise. According to modern enterprise management theory, the factors affecting the performance of an enterprise include market structure and enterprise behavior. Enterprise behavior includes the quality of business leaders, level of

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internal management, and business strategies, which are all closely related to corporate governance. In addition to the history, culture, laws, and economy of a particular country, corporate governance is also influenced by the ownership structure, decision models, and strategic objectives of the enterprise. Ownership refers to property rights and other related rights of a company’s legal personality. Property rights are the rights granted to the legal personality in economic benefits, including real rights, quasi-real rights, credit, and intellectual property rights. The ownership structure is meant to distribute property rights and other related rights. In general, the property rights of the legal personality are shared among owners in proportion, and so are the related rights. Obviously, a clear ownership structure is the basis upon which to build and improve the corporate governance mechanism. The clarification and adjustment of the ownership structure is a key issue in the reform of SOEs in China. In theory, the state is the owner of the SOEs, but in terms of governance, the state is only a macro owner, or ‘virtual’ owner. This is because it is difficult for the state to exercise an owner’s rights, even though it owns all the property in the SOE. This has two drawbacks. First of all, the agent system will give rise to the serious problem of ‘insider control’, since the state cannot exercise its rights as the owner in the real sense. The director or manager of an enterprise will both assume the management rights and act as the agent of the state (owner), and tend to prioritize his own interests or the interests of the enterprise. The following Chinese joke illustrates the phenomenon: foreign bosses would end their life instead of changing their job when their business goes bankrupt, while Chinese managers would change their job instead of ending their life. The obvious reason is that Chinese managers are not the owners, and they can transfer to other posts even if they have made a mess of the enterprise. The state controls the SOEs through the government at different levels and, as a result, many government officials consider themselves to be the managers and the agents of the owner. The inevitable consequence is over-intervention by the government and over-reliance of the enterprises on the government. This in turn increases the difficulty for an enterprise to act as a legal personality with independent management and operation. It is also detrimental to the consolidation and development of the socialist market economy system. The key to the adjustment of the ownership structure in SOEs lies in the diversification of stock rights. As the Decisions points out, ‘The diversification of stock rights is helpful to develop a standardized corporate governance structure. Except for a few enterprises where the state must maintain its monopoly, a multiple ownership economy should be encouraged.’ The

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diversification of stock rights is not only helpful in implementing the policy of developing a multi-ownership system with the public ownership at its core, but is also helpful in solving the problem of over-reliance of enterprises on the government and the unlimited responsibility of the government for the enterprises. The same approach can apply to the problems of indistinct ownership and confusion of ownership and management in collective and private enterprises. Theoretically, in an enterprise with diversified stock rights, the shareholders’ meeting has supreme authority. In reality, however, the board of directors tends to exercise the rights on behalf of the shareholders, characterized by a great number of shareholders and excessive mobility (the stock rights are traded too frequently on the stock market). Therefore, the authority, structure, and working style of the board of directors becomes critical in corporate governance. Laws in different parts of the world are more or less the same concerning the authority of the board of directors, and mainly include the right to appoint the top management and the right of overall supervision over corporate strategy and finance. However, differences can be found in the board structure. The board of directors in such countries as the US and the UK have on average 10 members, consisting of the external directors (including senior managers, lawyers, professionals, and financial experts), and the executive directors (the executives within an enterprise). In the US, external directors account for 80 per cent of the board of directors, while in the UK it is 40 per cent on average. In Germany and northern Europe, the board is on average composed of 12 to 22 members, who are divided into the management and the supervisory committees. The management committee is composed of the senior managers within the enterprise. In the supervisory committee, half of the members are elected from among the shareholders while the other half are elected from among the employees. The board of directors in Japan consists of 20–30 members, 90 per cent of whom are the present and former senior managers of the company. Most Japanese companies do not have external directors. The ‘Company Law’ promulgated on 1 July 1994 stipulates that the board of directors in limited liability companies shall be composed of three to 13 members elected at the shareholders’ meeting. The key responsibility of the board of directors is to appoint the general manager and exercise macro supervision over and provide guidance to enterprise management. The board is responsible for the selection of the general manager and for the consequence of the selection as well. As mentioned above, the static and dynamic qualities of business leaders are the key factors affecting the

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performance of an enterprise. Static quality refers to an individual’s original personal quality, or his virtues and talent, and the dynamic quality refers to the initiative of an individual to work and learn after being selected. The board of directors tends to select a general manager based on the information about the static quality of the candidates. The dynamic quality will not be known until the general manager is in office. In addition, it is often related to the incentive and supervision of the board of directors. The difficulty in choosing a general manager based on static quality lies in the trade off between ‘virtue’ and ‘talent’. As the popular saying goes, ‘The talented are not reliable and the reliable are not talented’. This is a dilemma. For example, some government officials tend to take ‘reliability’ and ‘obedience’ as the first criteria in selecting leaders for SOEs, which is one of the reasons why the performance of SOEs has been so poor. To solve this problem, dynamic quality has to be taken into consideration. An improved incentive and supervision mechanism should be able to make the talented reliable. Otherwise, the reliable will become unreliable. From the perspective of complexity science, cooperation and contradiction between the board of directors and the general manager exist in parallel, which is in fact the key to a better corporate governance mechanism. At present, the problem of ‘insider control’ is serious in many Chinese enterprises, especially in the SOEs, and the board of directors is only an ornament. In other enterprises, the board of directors interferes too much with the routine operation of enterprises. According to international findings and experience, the following points should be taken into consideration in setting up and improving the corporate governance mechanism: ♦ The board should show more concern for the long-term development of an enterprise and prevent the general manager from harming the long-term benefits of the shareholders by pursuing short-term performance. ♦ If possible, the chairman of the board and the general manager should be different people. ♦ There should not be too many senior managers on the board (generally less than a third), and it is better to have some external directors. ♦ The board needs to divide responsibilities among its members in exercising supervision over the enterprise management and proposing guidelines, and direct intervention in daily management should be avoided. ♦ If not authorized by the board of directors, the chairman shall not act as the deputy of the board. He shall not be the general manager’s superior, dictate to the general manager, nor transfer the resources of the enterprise.

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The Organization System The organization system refers to the form and development mechanism of an organization. An enterprise is a group composed of many members, and the way it is organized is the organizational structure. In modern organization management theory, the organizational structure is not developed out of the authoritative ‘design’ of business leaders. Behind it lies the corporate culture and, more importantly, the interactions and interplay between the members and small groups within the organization over the distribution of powers. The interaction will ultimately reach an equilibrium, which conforms to complexity science. The organizational structure of an enterprise is constantly changing with the development of society, the economy, technology, and the innovation of management concepts. With the emergence of public companies, the separation of ownership and management, the emergence of professional managers, and the further division of labor, the operation management system becomes increasingly multi-level and multifunctional. A number of multinationals, for example, have adopted a management system with the factory as the cost center, the business divisions or strategic business units as the profit center, and the head office as the strategic decision-making centre, with the chief executive officer (CEO) at the core. In the 1980s, social and economic development and technological progress impacted in many ways on the technological revolution that has been going on for nearly 300 years. The above mentioned modern enterprise management system is also under threat by the following: ♦ Conflicts between labor division and contracting. In many enterprises, the overdetailed labor division has given rise to a multifarious formalities, frequent handovers, and low efficiency. These problems are worsened by the increase in product variety and the decrease of production batch size, leading to inflexibility in production and low utilization of manpower and equipment. In addition, the initiative and collectivism of the employees are suppressed. In some cases, reducing the labor division or even contracting a job to a single person will increase efficiency. ♦ Conflicts between centralization and decentralization. Over-detailed labor division also leads to the centralization of management, since the conflicts between various departments have to be coordinated by managers responsible for the whole process. All departments have their own interests and tend to view matters from their own perspectives, which increases the difficulty of coordination among them and slows down the decision-making process. In this case, an enterprise needs to reduce the levels of management and delegate coordination to the lower levels, so that employees at all levels will be motivated. ♦ Conflicts between demand and technology. With increasing competition, demandoriented management sometimes fails to create competitive advantages because,

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when an enterprise develops a new product after identifying the market demand, its competitors might have already made the first move. To maintain market leadership, an enterprise not only needs to predict market demand, but also needs to keep a close eye on each new technology and to identify potential new demands. With the arrival of the knowledge economy, knowledge is playing an increasingly important role and all businesses should prioritize the development and application of new and high technologies. ♦ Conflicts between stability and change. Businesses are operating in an increasingly complex environment, with the rapid development of science, technology, and social economy and the globalization of the world economy, which demands the constant adjustment of organizational structure and business strategies. They need to become learning organizations and increase their adaptability.

To meet the challenges posed by these conflicts, American scholars M. Hammer and J. Champy put forward the concept of Reengineering the Corporation in 1993, which immediately started a massive campaign in corporate reengineering in Western countries. Corporate reengineering means a fundamental redesign and reconstruction of business processes, organizational structure, management systems, and corporate values and culture. From the perspective of management science, corporate reengineering can be defined as the integration of the enterprise system to optimal effect. With the development of complexity science, more emphasis is placed on the evolution and adaptability of an organization. To survive and develop in a complex and changing environment, an enterprise should be able to obtain accurate and updated information from outside, and adjust its internal structure promptly to adapt to environmental changes. To this end, a number of management models have been proposed, such as the informal organization without fixed boundaries, the flat organization with few levels, the network organization in which members can communicate effectively, and the semiautonomous organization in favor of internal innovation. P. Senge argued in The Fifth Discipline that organizational quality is a fundamental advantage, and its development and improvement depends on continuous learning. An organization is a dynamic and complex system, and has to be considered and analyzed from the perspective of a system. The core of learning lies in the systematic thinking on the basis of self-improvement, better communication, shared vision of the future, and sincere cooperation. This idea wins the approval of some famous entrepreneurs. In his book Only the Paranoid Survive , for example, A. S. Grove, former CEO of Intel, emphasizes the ability to adjust the business strategy in line with a changing environment, leading from chaos to order.

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The Incentive System The incentive system is critical in motivating employees and improving the performance of an enterprise. As stated above, the dynamic quality of the senior management of an enterprise largely depends on the incentive system. Motivation and control are interdependent. Proper motivation can increase the overall quality of the senior management and in a sense is the best control. A good incentive mechanism can motivate employees to work hard and place the interests of the organization over everything else. This will be helpful in creating a favorable environment for internal innovation and improvement, and in phasing out idlers to improve performance. In China, further research is needed on how to set up a proper incentive system in enterprises, and in SOEs in particular. We need to take into account history and tradition, culture, and level of development, as well as the readiness of employees, society, and social justice. To this end, we propose a model of a dynamic incentive system with five levels: 1. Salary is the basic income of the employees of an enterprise. It represents the enterprise’s recognition of the value of the employees and in principle is not affected by the performance of the enterprise. The compensation system of an enterprise (including promotion methods) should be developed by the board of directors under the guidelines of the state. The major factors include position, capability, education, and qualification. The average salary of the employees shall be at least five times higher than the minimum life guarantee (unemployment pension), while the lowest salary shall be three times higher. The salary of the top management shall be three to five times the average salary of the employees, and that of mid-level managers and technical personnel shall be two to three times the average. 2. Welfare represents the obligation of an enterprise to its employees, most of which is compulsory, such as pensions, medical insurance, and accident insurance. These are set up according to the relevant government stipulations, regardless of the performance of individual businesses. Some other welfare programs, such as lunch subsidies, are determined by businesses themselves. 3. Bonus is the reward for short-term (typically one-year) performance. The total bonus is closely related to the performance of the enterprise and is usually decided by the board meeting or shareholders’ meeting. It should be 5–20 per cent of the shareholder’s dividends, and the top management shall take up to 30 per cent of the total. Bonuses should be differentiated according to individual performance; egalitarianism should be avoided. 4. Stock rights affirm the long-term value of employees. Granting shares

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to the employees not only increases the employees’ sense of ownership of the enterprise, but also contributes to the diversification of stock rights. However, the percentage of shares held by the existing employees should not be too high (30 per cent at most), or innovation and risk-taking will diminish. 5. Stock options are the reward for long-term performance. It is the right of employees to buy a certain number of shares at a certain price in the future. Such a practice will encourage employees to contribute to the long-term performance of the enterprise, and also help retain people with rare talents (dubbed ‘golden cuff’ in the West). In the meantime, it also encourages top management to focus on the long-term performance of the enterprise. The implementation of a stock option program requires a professional design and change of mindset. According to some reports, among the first 10 experimental enterprises in Beijing, two have dropped the option plan, which shows the complexity of its implementation. The incentive system should be dynamic and improved through practice. Particular attention should be paid to democracy in the implementation process and arbitrary decisions by any minority should be avoided. Efforts should be made to ensure justice, fairness, and openness to give full play to the incentive system.

The Performance Measurement System Performance measurement provides an important basis for the improvement of work and overall quality of an enterprise, and the basis for the implementation of the incentive system. It includes measurement criteria and measurement processes. For some time now listed companies have been disclosing information on their performance through annual reports, but this traditional method of measurement by means of financial data has been under hot debate in recent years. The public is easily taken in and misled by the management of enterprises, as most people do not have financial expertise, which increases the public’s doubts about the disclosed information on business performance. The board members and senior managers in a number of enterprises have realized the insufficiency of performance measurement based solely on financial indices in the context of cut-throat competition. A complete performance measurement system should also include product quality, customer satisfaction, market share, and innovation. According to the technical principle of measurement in systems engineering, the purpose of measurement is to determine the overall quality of the target system. Therefore, a measurement system shall include several indices

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(sometimes at different levels); definition of the indices; and the criteria, means, and results of measurement of each index and their overall expression. A good system should be able to integrate the strategic objective, overall quality, and public image of the enterprise, and provide the momentum to move to a new level of achievement. The development of an overall and effective performance measurement system is a highly complex issue attracting the attention of many companies and scholars, who have put forward various index systems. The balanced scorecard developed by R. S. Kaplan, professor at Harvard, and D. P. Norton, CEO of Global Revival Strategic Group, has been used extensively. Its basic idea is to observe corporate performance from the perspectives of customers, internal business, learning and innovation, and finance. It is a complete measurement system based on the realities of the enterprise. Each perspective should include several indices that are in line with the actual condition of the enterprise, and there should be objectives and measurement approaches for each index. The results of measurement should be benchmarked against the best companies of the industry to form a better judgment. This approach prioritizes customer satisfaction, one of the most important factors involving the public image of an enterprise. It has also turned such slogans as ‘the customer is God’ and ‘the priority is to provide value for customers’ into measurement indices that truly reflect customer satisfaction. The issues that customers are concerned with include delivery time, service, product quality, product performance, and price. Businesses should clarify their objectives in these regards, and turn them into concrete and quantitative measurement indices. For example, if the objective of an enterprise is to provide a new product to satisfy customer need, then the measurement index can be the new products’ percentage of revenues of the total sales volume. If the objective is to deliver goods on time, then the measurement index can be the rate of timely delivery. The measurement indices from the other three perspectives are connected with customer satisfaction, and need to be determined in light of the actual conditions of an enterprise. The measurement index from the perspective of internal business should focus on factors with the biggest influence on customer satisfaction, including the production cycle, quality, employee skills, productivity, and core competence. The measurement index from the perspective of learning and innovation should emphasize business directions that can provide more value for the customer, including factors involving the introduction and development of new products, entry into a new market, and introduction of new management approach. The measurement index from the

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perspective of finance should attempt to keep a balance between the owner’s equities and customer benefits, and win support from both the shareholders and the customers. Such financial indices include cash flow, sales growth, market share, and returns on stock rights, all of which have an impact on the survival and development of an enterprise. The experience of over 100 American enterprises in the past several years has revealed that the balanced scorecard can serve not only as an effective performance measurement, but also as a new strategic management tool that integrates long-term objectives with short-term performance. Therefore, the enterprise management can add four procedures: describing the company’s vision and reaching a consensus between the top management on the company’s strategy through formulating a system of measurement indices; connecting the system with the objectives of each department and individual through communication; integrating the business plans with the financial plans and coordinating the company’s actions through confirming the system; and making continuous improvement through implementing the system. With the development of the socialist market economy in China, an overwhelming majority of enterprises have been faced with the buyers’ market and, as a result, customer-orientation has become their necessary strategic choice. To this end, the business and academic communities should work together to develop, on the basis of international experience, an effective performance measurement system, which will help Chinese enterprises to acquire a competitive advantage in the face of increasing market competition.

BUILDING A CORPORATE IMAGE The public image of an enterprise includes its impression on and relations with the public. It is an enterprise’s intangible asset and represents the confidence of the public in the enterprise. Once the enterprise loses the trust of the public, it will decline or even die. The public includes those with direct relations with the enterprise (such as the shareholders, customers, suppliers, and the families of employees) and those with indirect relations to the enterprise. In developed economies, these two public groups are highly interchangeable. If a company has a poor image, the shareholders will sell their shares, the customers will turn to other enterprises for the same products, the suppliers will increase their quotations or even stop their suppliers, and the employees will quit their jobs. In this case, the performance of the enterprise will decrease dramatically. On the other hand, if the public image of the enterprise is strong enough, the second public group is

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willing to get connected with the enterprise and the enterprise performance will increase naturally. As public image has a strategic importance for the development of an enterprise, public relations (PR) has emerged as a branch of management science in the last few decades. It has been included in the curriculum of many international business schools and a number of professional public relations organizations have been created. The American Public Relations Society has even organized tests and practices an accreditation system in public relations. The impression an enterprise leaves on the public is formed by the contact between the enterprise and its members on the one hand and the public on the other. The first impression has a far-reaching effect. A head office building with an exquisite and unique design will surely leave a good impression on the public, while a messy interior would in turn disappoint the visiting public. An industrious and helpful employee will leave a good impression of the enterprise on the public, while a rude telephone operator is very likely to offend an important customer and lose a large order. An encounter with a rude technician would most probably prevent a customer and his relatives from buying a company’s products again. A sincere and practical general manager will create confidence in the enterprise, while a bragging and pompous general manager is not likely to impress the public. For these reasons alone, an enterprise should require its members to start from the smallest of details to improve the public image of the enterprise. Business leaders need to take initiative and to set good examples for others. The public image of an enterprise also depends on the behavior of the enterprise as a legal person in society. If an enterprise abides by the law, pays taxes as required, shows concern for public causes, cares for the benefits of the residents in the surrounding communities, keeps its promise to the customers, and observes the legal rights of the customers, it will ultimately develop a good public image. The crux in developing a good corporate image is to increase communication between an enterprise and the public. This should be two-way: businesses need, on the one hand, to promote their performance and achievements and to disclose relevant information through advertisements and press conferences and, on the other hand, to listen to the comments and proposals of the public and understand their impressions and expectations of the enterprise. The PR department of an enterprise should not only serve as the mouthpiece of the enterprise, but also as its eyes and ears. The major responsibility of the PR department should be to design effective activities, and any decision in this regard should take into consideration purpose, object, content, place, timing, technique, and budget. Public relations activities are related, but not limited, to the marketing of an enterprise.

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ADAPTING TO THE EXTERNAL ENVIRONMENT A business must operate in a certain physical environment and, as a result, its activities and performance will inevitably be affected by that environment. Therefore, the strategic management of an enterprise should help develop an understanding of the external environment, forecast changes in the environment, avoid risks arising from those changes, and increase its adaptability to the environment. The major trends facing Chinese enterprises in the 21st Century will be as follows: Firstly, economic globalization has become an irreversible trend in the world economy, and China’s entry into the World Trade Organization seems imminent. Generally speaking, China’s entry into the WTO has more benefits than costs, and a late entry will call for higher costs. In the meantime, some industries and enterprises will face big challenges. After China’s entry into the WTO, Chinese enterprises will have to compete with foreign businesses in accordance with international practices. They will find themselves in a disadvantageous position during the initial stage since they lag far behind in technology and management and lack experience in international competition. At present, some industries and enterprises are looking for protection from the state, but what is more important is that they transform pressure into motivation and seek opportunities to grow themselves. Chinese enterprises should seize every opportunity in introducing capital and advanced technologies from foreign countries. This will contribute to the diversification of stock rights and the consolidation of the corporate governance system, and be helpful to the development of core competence. By joining the global manufacturing network of multinationals, Chinese enterprises can enter the mainstream international manufacturing industry and serve as a node in the supply network. They can also select some competitive products, put them into production in proper foreign locations, and nurture Chinese multinationals. Secondly, with the arrival of the knowledge economy, high-tech industries such as information technology, biotechnology, and new material technology will become the core of industry technologies. The development of high-tech industries is the fundamental source of increasing national competitiveness. Whoever develops high-tech will enjoy an advantageous position in technological competition. An example is the competition of PCs and VCDs in the domestic market. Although the prices of PCs and VCDs are decreasing, the IC chip and operating system for PCs and the laser reader and decoder for

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VCDs still depend on imports, which means the profits of foreign suppliers are not affected in this battle. Informationalization in Chinese enterprises is one of the most important infrastructure construction programs at present. All businesses need to learn to use the advanced manufacturing and management technologies based on information technology, such as MRPII (Manufacture Resource Planning), JIT (Just-In-Time), ERP (Enterprise Resource Planning), and supply chain management. Management information systems and decision support systems should be set up. In the meantime, businesses need to understand the market and compete in international markets through the Internet. Thirdly, the socialist market economy in China is improving and the implementation of the policy of ‘ruling the state by law’ will provide a powerful legal guarantee to enterprise management. The socialist market economy is in essence a means to ensure social equality through the state and allocate resources through the market. To this end, great efforts should be made to develop the financial, human resource, product, and service markets, and to give full play to the market mechanism. After years of development, the capital market in China is growing in size, and its further healthy development depends on the solution of such key problems as distorted information disclosure and market manipulation by the key players. The monetary market still lags far behind, and a number of means such as shortterm bonds, bill acceptance, interbank loans, and mortgage guarantees should be used to meet the enterprises’ need for working capital. As China has long operated under the planned economy system, government officials tend to be involved in enterprise management through administrative means and, as a result, the management autonomy of businesses is not ensured. It is true that any economic system needs macro control in case of market failure. It is the responsibility of the government to ensure social equality and protect national benefits. However, macro control should neither be abused nor be allowed to breach the three basic laws of the market. The first is the law of value. Price ceiling and subsidies can be effective in the short-term, but they will do more harm than good in the long run. The second is the law of demand and supply. This is an important market regulator. The third is the law of competition. Competition is an important tool to optimize the allocation of resources and increase competitiveness. In most cases, protecting monopoly is protecting backwardness. The legal system for China’s market economy is still under construction. It includes laws that regulate the behavior of the actors, basic relations, and order of competition in the market economy. The legislation process should be

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systematic, fair, scientific, and gradual, and efforts need to be made to prevent individual government departments from obtaining improper power through legislation. In formulating laws concerning the benefits of enterprises, voices from the business community should be heard. In trials and implementations, the proper rights of enterprises should be protected, and the intervention of the local government or departments should be avoided. Businesses should also learn to use contract law and administrative litigation law as weapons to protect their interests, and resist the unfair treatment or unreasonable burdens in, posed on them. Finally, the increase of per capita income and change of demographic structure will generate a strong effect on the market demands. Consumption demand has been changing with the improvement of living standards. With no worries about life’s necessities, most urban residents are increasing their consumption in housing, study, travel, and children’s education. Higher income families are turning their attention to high-level consumption such as cars, home theaters, pianos, and travel abroad. Facing these new changes, businesses should develop new products that can attract these consumers, or improve the functions of existing products and increase their added value. As for rural consumers with lower purchasing power, businesses should improve their products in function-price ratio and durability. According to one report, by October 1999, the number of people aged above 60 reached 126 million, some 10 per cent of China’s total population. Moreover, the aged population is increasing at an annual rate of 3 per cent, and it is predicted that by the middle of the 21 st Century, one out of four people will be aged. Particular attention should be given to the consumption demand of the elderly in health care, leisure, entertainment, and study. With the rise in women’s social status and their number in the workforce, businesses need to do some market research and try to satisfy their special needs. In addition, China’s population will continue to increase, and a great number of only children will still receive care predominantly from their grandparents. Their education, health care, and entertainment deserves the attention of our businesses. Surrounding enterprises are the macro environment and the micro environment. Businesses are not in a position to change the macro environment, but they can adapt to it. The micro environment will interact with businesses, and businesses should give full play to their initiative and create a micro climate favorable to their survival and development. They need to keep informed about local policies and regulations and priorities of development, and develop new products and services to meet local needs. It is important to win the support and understanding of the local government and local community for the development strategy of an enterprise.

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CONCLUSION In general, enterprise management in China is backward. This is shown by the fact that China has a very low ranking in terms of competitiveness and very few Chinese enterprises can compete with the Fortune 500 companies in core competence and management performance. Therefore, greater efforts need to be made in studying modem management theories and Chinese management traditions, and improving management by practice. As a product of human civilization, management science has evolved through time, practice, and science. When it was developed into an independent discipline in the late nineteenth century, F. W. Taylor emphasized scientific management, the core of which is to increase the productivity by scientific means and achieve a balance between the employer’s demand for low cost and the employee’s demand for high salary. It tended to observe and analyze various material factors from the perspective of industry engineering and economics. Beginning in the 1920s, E. Mayo focused on the study of the human factors in productivity, human nature, and needs, and the motives for behavior and human relations in production. After World War II, there emerged various schools of management science. According to H. Koontz, there were 11 schools by 1980, and their curricula included social systems, decision-making theory, systems management, empiricism, contingency theory, management process, and management science. These schools had their own theories, which sometimes overlapped. In the period from after World War II to the 1970s, the aim of management science was to increase the accuracy of decisions and efficiency of management by means of quantitative analysis. In a sense, management science is synonymous with systems engineering and operational research. Ever since the 1980s, more and more attention has been paid to social, economic, and cultural factors, and the interaction between individuals and the organization. Coupled with the fast development of information technology, the focus of management science has shifted to organizational behavior and contingency theory. With more emphasis on strategic management, management science has developed from the narrowness of operational research (management science) to the breadth of complex systems (management sciences). Based on mathematics, economics, and behavioral science, management sciences are classifies into three levels of basic management, functional management and strategic management, and many secondary disciplines. In the meantime, emphasis is given to the realities of country, industry, and business, and support is provided for decisions of various kinds at various levels. Western management classics and new management disciplines need to be studied critically and promoted in line with the realities of China. At the

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same time, efforts should be made to study the issues concerning enterprise management with the concepts and approach of complexity science. Based on the research of all related disciplines, we should clarify the relations between the individual quality of the employees and the overall quality of the enterprise, between the individual behaviors of employees and the organizational behavior of the enterprise, and between the performance of individual departments and the overall performance of the enterprise, and also develop an integrated model for simulation and optimization. Ancient China abounded in management concepts which, to our view, roughly fall into two categories: the Confucian management school and the military management school. The former focused on the management of the country and society, with the goal of ‘emphasizing state governance, taking the human being as the basis, laying stress on peace, and giving play to talents’. The latter, on the other hand, emphasized the strategy and tactics of management, with the goal of ‘thinking deeply and planning carefully, being ambitious and having a vision, adapting to circumstances, and fighting a quick battle’. The two categories interacted considerably over time. As Confucianism was mainstream in traditional Chinese culture, its management concepts are more likely to be accepted and understood. The management concepts embodied in the strategies and tactics of the military experts have been respected by Chinese rulers of all generations, and some of their wisdom is now deep-rooted among the people. They have even spread to other Asian countries and are extensively used in enterprise management. We should inherit this rare cultural legacy critically, and integrate it with Western management theories. At the same time, lessons should be drawn from the management experience in the 50 years since the foundation of the PRC, especially after China’s reforms and opening up. The management practices of the national capitalists in pre-1949 China also deserve our attention. The theories and approaches of management science must be based on practice. Some of the new management theories and approaches emerging in Western countries, such as corporate reengineering, core competence, and the balance score evaluation system, have resulted from in-depth scholarly investigation into sample enterprises and analysis of their problems and experiences, and have been improved after extensive experiments in a great number of enterprises. Chinese scholars should also be encouraged to do field research, work together with business managements, and develop an effective model of management theories and approaches in line with the realities of China. With concerted efforts, we can improve enterprise management in China. Completed on 13 February 2000

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The Theory and Practice of Managing Enterprises by Government

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A PRESSING ISSUE REQUIRING IN-DEPTH RESEARCH With the collapse of economies in the former Soviet Union and Eastern Europe, worsening financial difficulties in former industrialized countries, and the fast growth of government-guided economies in South-East Asia, a number of scholars, both in China and abroad, have begun to reevaluate the role of government in economic development. For example the World Bank’s World Development Report 1997 , the theme of which was ‘Government in the Changing World’, highlighted the effectiveness of government as the key to success. In terms of the role of government in enterprise management, however, many problems remain unsolved. In the 20 years since its opening up and reform, China has experienced fast economic development and prosperity and its people’s living standards have increased significantly. With the development of the socialist market economy, however, the controversies between productive forces and production relations and between superstructure and economic base, have become increasingly prominent. The reform of the political structure, in particular the reform of government institutions, have been placed on the agenda. President Jiang Zemin, also Secretary General of the Communist Party of China (CPC), warned in the report at the Fifteenth National Congress of CPC that ‘the overstaffed organization, integration of government administration with enterprise management, and grave bureaucratization will directly hinder the deepening of the reforms and the development of economy, and affect relations between the Party and the masses’. Therefore, the priority in the reform of government institutions should be the separation between government administration and enterprise management. The focus and core of China’s economic reforms is the reform of state-owned enterprises (SOEs), and the key to revitalizing SOEs is the separation between government administration and enterprise management. Under the planned economy system in the past, the government was directly involved in enterprise management and, as a result, businesses relied heavily on the government. This tradition was so deep-rooted that it was nearly untouched during the reforms. The heads of SOEs were appointed by the government and, while some were highly talented, most did not have any management training and could not formulate management strategies. Several developed personal networks and secured investments and loans through the back door without bothering to improve internal management. A few of them even exaggerated their performances to pander to government officials. As a result of a heavy reliance on the government, businesses became riddled with bad practices – managers could only be promoted, never demoted; workers could only be recruited, never

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fired; and salaries and benefits could only be raised, never lowered. The modern enterprise system, characterized by ‘separation of management from ownership; division of rights and responsibilities; and separation between government administration and enterprise management, and scientific management’, will not be established until the government has determined to change its function and to standardize its relations with enterprises. Ownership structure is also changing with the development of China’s socialist market economy, and the percentage of foreign-invested and private sector enterprises in the national economy is increasing. An important task for government at all levels is, therefore, to protect the interests of all types of enterprises in line with laws and regulations, to create an environment for fair play, and to exercise proper supervision. Given the realities of China, research on the role of government in enterprise management in a market economy is of great significance to both the economic and political structural reforms. Based on the experience of other countries, this chapter attempts to discuss the theoretical framework, ways, and means of government involvement in enterprise management and the existing foreign models. Through analysis and comparison, it will also propose an objective model for China.

THE ROLE OF GOVERNMENT IN THE MARKET ECONOMY SYSTEM: A THEORETICAL FRAMEWORK In-depth research on the role of government in enterprise management will not be possible without first understanding the role of government in the market economy system. To this end, a theoretical framework needs to be developed. The word ‘government’ has been used in both a broad and a narrow sense. The first sense refers to all institutions that exercise state power, including legislative, administrative, and judicial bodies, while the latter is limited to administrative bodies in the state regime. In this chapter, the word is used in its broad sense.

A Historical Review: Two Tendencies In the two centuries since the establishment of the market economy, there have been divergent views on the role of government. These fall into two major tendencies: the negative, ‘government impotence’, and the positive, ‘government omnipotence’. Adam Smith argued in his Wealth of Nations that free competition was ‘an invisible hand’ that could regulate the economy automatically, while the intervention of the government in economic life would

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only lead to disaster. An opposite view can be found in Sir James Steuart, who stressed the importance of effective demand and government intervention. To him, government must intervene to protect civil rights and ensure effective demand. The theory of ‘government impotence’ was dominant before the 1930s. Many scholars held that the natural law of production and exchange was an expression of eternal rationality and individual humanity, and that all individuals should have the freedom to make their own decisions in economic matters, free from government intervention. John Stuart Mill, for example, argued that the law of wealth production was an eternal and non-arbitrary natural truth. On the other hand, the law of wealth distribution was decided by social laws and customs that would change with history. Alfred Marshall wrote in his Fundamentals of Economics that ‘the ideal society is capitalism, and the policy of laissez-faire and non-intervention of government is the best policy for the economy’. Some even claimed that ‘the government with minimum intervention is the best government’. In the 1930s, the Depression and the resulting unemployment in the United Kingdom and the rest of the capitalist world became increasingly grave and, as a result, the traditional vulgar economics which favored the equilibrium between economic development and employment by means of market regulation came under scrutiny. The role of government was again the focus of attention. The representative work was The General Theory of Employment, Interest and Money by John Maynard Keynes, published in 1936, which started the ‘Keynesian Revolution’. Keynes stressed the necessity of wise management in the economy and shifted from the traditional concept of laissez-faire to favoring government intervention. He defined the effective demand and advocated reinforcing government intervention in the economy, increasing effective demand, and realizing full employment through fiscal and financial means, such as increasing public expenditure, reducing interest, and stimulating private investment and consumption. Since then Keynesianism has dominated Western economics. As a consequence, the role of government was exaggerated and the size and functions of government expanded rapidly. World Bank statistics show that government expenses in the old industrialized countries account for nearly 50 per cent of their GDP, as compared to 25 per cent in developing countries. Changes in recent years have brought people back to rational thinking about the role of government. With the globalization of the world economy, the fast development of science and technology, and an increase in cultural and material needs, it is unrealistic for the government to be seen as a savior. A government needs to be aware of its limitations and to concentrate on its responsibilities,

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such as building the legal infrastructure, maintaining the stability of policies, investing in infrastructure, guarding social equality, and protecting the natural environment. The responsibility of management scientists is to research, with the help of systems science, policy science, and emerging complexity science, the ‘dos and don’ts’ of government, and to support the reform of government institutions.

Free Enterprise System: The Basis of a Market Economy Economists of different schools have different views of the nature and operation of the market economy and of the ability of the market to be the essential means of resource allocation. It is beyond the scope of this chapter to comment on the various schools of theory. Instead, we will apply the theory of the open complex megasystem advocated by the eminent scientist Qian Xuesen and start our discussion from a different perspective – management science. In general the market, or open complex megasystem, is a collection of places where buyers and sellers can exchange goods freely. It comprises millions of producers and buyers who are interrelated and form various levels (e.g. rural markets, urban markets, regional markets, domestic markets, and world markets) and structures (e.g. primary product markets, industrial product markets, capital markets, labor markets, technology markets, and information markets). It is related to the outside through exchanges of materials, energy, and information. The market economy system includes the economic system and economic activities built upon the market. Before the 1930s, many economists tended to study individual behavior and the inherent laws of individual businesses in isolation. These studies fall into the category of microeconomics. Keynes, on the other hand, tried to study the overall behavior and inherent laws of the market economy, which obviously belong to the study of macroeconomics. Since then, both microeconomics and macroeconomics have shown marked developments such as theory of firm, input-output analysis, economic cybernetic, institutional economics, transaction cost theory, and option pricing theory. However no theory has been able to integrate the microeconomic activities of enterprises with the macroeconomic operation. In addition, the macro-economic theories often fall behind or even deviate from the realities of economic development. A number of economists have begun to explore a new way. The development of systems science provides an applicable theory (i.e. self-organizing theory) that can be used to solve the above predicament. The interaction between the different units of a system promotes its development in the direction of more powerful and more adaptable systems, similar to the evolution of species, technological progress, and social development. This

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process is often referred to as the self-organization of a system. As Qian Xuesen argues, ‘When a system develops into an orderly structure, it goes through a process of self-organization’. Firms are cells of the market, and are both producers and buyers. Millions of firms are playing an active role in the market through their autonomous operations and are boosting economic development through self-organization. From the perspective of management science, a free enterprise system is the prerequisite for a market economy. However, the freedom is always relative rather than absolute, because the decisions of an individual firm are invariably influenced by other firms and constrained by external environments. As systems science suggests, the disorderly movements of millions of firms at the microeconomic level can promote economic development in a more reasonable direction. In 1984, at the initiation of such Nobel Prize winners as Murray GellMann, Philip Anderson, and Kenneth Arrow, a group of researchers in physics, economics, theoretical biology, and computer science set up the Santa Fe Institute (SFI) in an attempt to find a solution, through an integration of sciences, for such complex problems as the origin of life, biological evolution, economic development, and technological progress. Remarkable achievements have been made to date, especially in economics, including the discovery of the positive feedback phenomenon, chaos phenomenon, and law of competition.

Government Intervention: A Necessity In a market economy system, the market is the most important means for resource allocation and economic regulation, requiring all individual firms to provide products for consumers in the most economical way. However, government intervention and regulation in the national economy is necessary to deal with ‘market failure’, meet the basic human needs of low-income groups, prevent the pursuit of individual interests at the cost of social interests, protect national economic safety, and alleviate the impact of changes in international economic environments on national economic development. Paul A. Samuelson sums up in his Economics the threefold role of government in the economy: improving efficiency, maintaining equality, and guarding stability. ‘Government failure’ should be avoided, as government intervention can sometimes reduce efficiency and increase the complexity of problems. From the perspective of systems engineering, developments can be changed by external environment and speeded up or slowed down by man-made factors. This process is the ‘allo-organization’ of a system. The role of government in the market is also the allo-organization of the market system, influencing the development of the system by changing external conditions.

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Balance between the Two ‘Hands’ The ‘invisible hand’ – the market – plays an important role in guiding the operations of enterprises and promoting economic development whereas the ‘visible hand’ – the government – is important in macro-control. The crux is to balance the force between the two. Three prerequisites need to be observed in the government’s macro-control:

(1) Follow the basic law of the market economy The basic characteristics of a market economy are the exchange of commodities (based on the law of value), balance between supply and demand (based on the law of supply and demand), and competitive development (based on the law of competition). Macro-control must be based on these three laws and recognize the leading role of the ‘invisible hand’. Any subjective intervention in economic development as happened during the planned economy system should be avoided. In pricing, for example, the government can seek to maintain the price stability of a few important commodities by means of price ceilings and subsidies, but in the long run consumer demand and the initiatives of producers can only be stimulated by the price changes, which in mm helps maintain the balance between supply and demand.

(2) Delegate decision-making at the micro level to the management of enterprises Enterprises in the market economy system are economic entities that are independent in management and assume sole responsibility for their profits and losses. They have to compete in the market for their survival and development. The management of enterprises needs to have full decision-making power over the economic activities at the micro level, including over planning, organization, finance, personnel, sales, production, and technology. The macro-control of government must never be allowed to infringe upon the micro decision-making power of the management. The government should not take the place of the management; instead, it can influence management decisions by exercising the power of restriction, such as negating or increasing the possibility of alternatives for an action and changing the objective and conditions of a decision.

(3) Create favorable environments for the set up of the market economy system China is experiencing a transition from a planned economy to a market economy. Such a transition will be long, arduous, and even painful. Governmental macro-control should facilitate the process and shorten the

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transition to the market economy. To this end, the measures of macro-control must change in line with new realities. In foreign exchange, for example, the restriction on individuals in exchange settlements and quotas should be lifted after the free exchange of current items. Limited exchange of capital items should be encouraged when the time is ripe. The final objective is to deregulate and to develop the RMB as a free currency.

GOVERNMENT INVOLVEMENT IN ENTERPRISE MANAGEMENT: FUNCTIONS AND MEASURES Based on the above theoretical framework, we can proceed with such questions as how and to what extent the government should be involved in enterprise management. What is management? It seems that no consensus has to date been reached on its definition. Some have taken the word literally and interpreted it as control and treatment; some have understood it as the completion of work through others; some have explained it as decision-making; and still others have viewed it as organization. To economists, management is an economic resource; to scholars of political science, it is a system of power; to sociologists, it is a system of class and status; and to psychologists, it is a process which facilitates organization. In fact, opinions are so widely divided that no unanimous conclusion can be drawn. To us, management comprises the various activities and the whole process by which managers attempt to make use of resources and to achieve set objectives in a changing environment. If we are right, government involvement in enterprise management can then be interpreted as the activities and process by which the government attempts to influence the operations of firms by making use of all resources and realizing the objectives in macro socioeconomic development. No single model of government involvement in enterprise management can be found, as size, ethnic composition, culture, tradition, level of development, and political system differ from country to country. But there is still some regularity to be found. We believe that government involvement has a universality and, in terms of extent, several models can be identified. The extent of government involvement, however, differs from country to country. Government involvement falls into two categories: indirect management and direct management. Through indirect management, the government tries to influence enterprises by regulating the market but does not interfere with their internal management. Through direct management, the government becomes directly involved in the internal management of enterprises according to laws

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or regulations. In addition, the government can also involve itself in enterprise management through non-official intermediaries, and create a favorable environment for their development by providing infrastructure and public services.

Indirect Government Management (1) Market set up When the capitalist system was still in embryonic form, the market developed spontaneously out of the need to exchange commodities. As an economy develops, the need arises naturally to set up a market of different levels and of different functions. In many countries, government approval is necessary for the setup of a new market. The modern options exchange, for example, originated at the Chicago Board Options Exchange, approved by the US government on 26 April 1973. China is experiencing a transition from the planned economy to the socialist market economy, during which the government must play an active role in setting up the market. Since its opening up and reforms, the Chinese government has approved the setup of securities, futures, real estate, and talents markets, which have contributed significantly to the country’s economic development. This is not enough, however, and markets in future the government needs to set up more to address new changes.

(2) Formulation of laws The market needs a set of rules because of random elements and chaos, which provide a legal basis for government intervention. The market economy is, in a sense, the law-governed economy. The legal system of the market economy should be complete and fall into three levels: ♦ Laws standardizing the basic relations of the market. Civil law and commercial law are used to standardize the market’s basic relations in the early period of the market economy. A set of new laws are formulated with the development of the market economy, including the budget law, social security law, investment law, and banking law, which further the standardization of the market’s basic relations. ♦ Laws standardizing the behavior of market subjects. These laws are mainly used to standardize the behavior of enterprises, and include company law, contract law, cost law, real estate law, securities law, and futures trading law. ♦ Laws standardizing the order of competition in the market. Such laws include antiunfair competition law, anti-monopoly law, and anti-dumping law.

(3) Supervision and control In line with the law, the government can exercise supervision over the market and its subjects through judicial bodies or administrative organizations.

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The United States, for example, set up an anti-monopoly bureau under the Department of Justice after such anti-monopoly laws as the Sherman Bill and Clayton Bill were passed by the US Congress. The bureau is in charge of investigating such illegal acts as price fixing agreements, monopoly mergers, price discrimination, and tie-in sales, and taking legal proceedings to the Federal Court. The Federal Trading Commission was set up based on the Federal Trading Commission Law to guard against unfair competition and unfair and fraudulent behavior in commerce. By control, the government uses mandatory power through administrative bodies and regulations to intervene in the market, and to remedy market failure and improve economic efficiency. The US, for example, has established a number of control organizations through legislation, which mainly fall into two kinds: economic control organizations and social control organizations. The former is responsible for the control of market entry, price, and services in special industries, and the latter is in charge of the regulation of factors that affect society as environmental protection and labor security. Some economists are negative about the role of government control, saying that it will reduce the efficiency of the market economy. For example the 1982 Nobel Prize winner in economics, George J. Stigler, was strongly against the equation of the objective and the effect of government control. He argued that the cost of government control was high and that it would discourage competition. In the past few years, the US government has been reforming its control practices, and has tried to introduce an incentive system. As a result, command control in the United States has become more flexible and intelligent. According to one report, deregulation in five industries (aviation, railway, truck transportation, telecommunications, and cable television) created over US$ 40 billion in returns in 1990 alone.

(4) Macro guidance Through macro guidance, the government applies such macro measures as policies, planning, taxation, and information to guide the market and influence the behavior of enterprises. The most important measures are as follows: ♦ Industry policies. These include policies in industry, agriculture, and energy, and aim to guide enterprises to allocate resources to more promising and more efficient fields, thus improving their overall economic efficiency. For example Japan, after World War II, guided firms from rebuilding capital-intensive industries to developing capitalintensive industries and finally to developing technology-intensive industries. In 1980, the Industrial Structure Review Commission published a report, ‘The Prospects of Industry Policies of the Ministry of Economics in the 1980s’, which successfully guided firms towards developing knowledge-intensive industries and applying

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electronics information technology, energy conservation technology, and new materials technology. As some scholars have pointed out, however, the improper use of industry policies can also lead to disaster. ♦ Economic planning. France, Germany, Japan, South Korea, and Singapore are using economic planning, although people have divergent views on its role in the market economy system. These countries might have different models, but they have in common guiding rather than mandatory plans, with a focus on macro development rather than on micro projects. In addition, their plans have integrated comments from all sides and been reviewed and approved by their congresses. ♦ Fiscal regulation. It is common practice to use fiscal measures and taxation to provide guidance for enterprises. In France, for example, the government provides subsidies or tax incentives to privileged industries or enterprises and a guarantee for their exports. In the United States, the government encourages businesses to increase their research and development expenses by a tax deduction of 20 per cent on the increased expenditure. In Japan, the government uses credit policies to promote the adjustment of its industrial structure. ♦ Information guidance. Companies need a vast amount of external information in decision making; by providing such information, the government can guide their behavior. For example, the US government provides the public with information through government publications, and the French government has set up an ad hoc organization, the Foreign Trade Center, to provide information service for export companies.

Government Direct Management The government’s direct management in many countries is limited to enterprises with investment from or contracts with the government. In enterprises with government investment, the purpose of direct management by the government is to protect the owners’ equities. Such direct management includes:

(1) Organizational control There are many forms of organizational control by the government, including: ♦ Set up of the board of directors. The board of directors is the bridge between the government and a company, and the government can send its representatives to be members of the board. In the Federal Deposit Insurance Corporation in the United States, for example, one director is an official from the Department of Finance while the other two are nominated by the US president and ratified by the Senate for a term of six years. In the UK, the chairman, vice chairman, and directors of SOEs are appointed by a competent authority for a term of five years. In German SOEs, the board of directors is set up by a supervisory board on which half are representatives of shareholders and another half are representatives of employees and the trade unions. The representatives of shareholders are appointed by the minister of finance; the representatives of employees are recommended by the company but need to be reviewed by the Ministry of Finance; the chairman of the supervisory board is

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appointed by the Ministry of Finance; and the vice chairmanship is assumed by the representative of employees. In France SOEs, the board of directors comprises, in equal thirds, representatives of the government, employees, and outsiders (including customers, clients, technology and management experts, and people with an in-depth understanding of the company or of the regional economy). The representatives of the government are appointed by the government, the external representatives are selected on the basis of their expertise, and the representatives of employees are elected by ballot. The candidates should have a minimum of five years of service in the company, and a guarantee of either one or two trade unions or a guarantee of employee trust and united production committee. The size of the board varies in France, with a maximum of 18 members. Each term is five years, up to a maximum of three terms. ♦ Appointment of CEOs. In some countries it is the board of directors that appoints the CEOs of SOEs, but in others it is the government. In France, for example, the CEOs of companies with 90 per cent of shares controlled by the state are nominated by the relevant minister, approved by the cabinet, and then appointed. In South Korea, the CEOs of companies with exclusive government investment or controlled by the government are recommended by the board of directors and appointed by the government.

(2) Financial supervision Many countries have tight supervision over the finances of SOEs, including their budgets, investments, prices, and salaries. In general, the budgets of SOEs need to be approved by the congress or government. In France, any investment over Fr l0 million needs to be approved by the Department of Finance. Management in price and salary is limited to SOEs with a monopoly. In France, for example, the government’s overriding principle in the price control of the products or services of SOEs is to cover the marginal cost. A commission has also been set up to propose a framework for salary increases based on such factors as economic growth and inflation. In some countries, the government even sends its permanent representatives to the companies for financial supervision. In the United States, for example, the government sends its supervisors or a supervisory team to ensure its decision-making power in profit distribution and loss subsidies in SOEs. In France, the Department of Finance sends its ‘national inspectors’ to make sure that the companies are observing the related financial systems and the major items are in line with state regulations. They are also responsible for providing information for the government and advice for the companies. They can attend the board meeting and have the right to speak (but not the right to vote). The inspectors can examine any documents and materials and report directly to the minister of finance. The examination of accounts by the inspectors happens during the operation of SOEs, and the national audit

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institution will perform an after-event audit. Based on the audit, it will submit a report on the accounts of SOEs, accompanied by an analysis of their financial management and performance.

(3) Guidance in operation The government does not in principle interfere with the internal management of enterprises, but can have a certain impact on their operations. The measures used by the government are as follows: ♦ Planning contracts. The government should in principle avoid direct involvement in the operations of enterprises, but can exert an influence through planning contracts. The French government, for example, attempts to achieve a balance between the pursuit of profit and the objective of national policies by signing planning contracts with key SOEs. Bringing SOEs in line with the overall planning system of the country, such a practice ensures not only an integration of the development strategy of SOEs with the objectives in national planning, but also a maximum freedom of SOEs within the planning framework. The planning contract prescribes both government obligations in fiscal investment and profit distribution and enterprises’ obligations in profitability, financing, employment, and technological development. It also has provisions for returns, service quality, productivity, and price hikes, against which the government exercises control over enterprises. Within the matrix, enterprises select the optimal model of operation. In general, such a contract has a term of three to five years. ♦ Purchasing contracts. As their customer, the government can influence enterprises through purchasing contracts. The US government, for example, is the largest buyer in the market and ofien selects the seller by bidding before the conclusion of a purchasing contract. A number of US companies, the producers of military supplies in particular, rely heavily on government purchase and, as a result, the government has a significant impact on their production. Subcontracts. For services that cannot compete in the market, the government can subcontract to enterprises through competitive bidding in the form of service contracts, management contracts, leasing, and long-term contracting. The Brazilian government, for example, subcontracted road maintenance to a private company, which contributed to a reduction of the cost by 20 per cent. The government can influence enterprises through supervision over the contract implementation. ♦ Administrative guidance. This is a unique form of government involvement in enterprise management in East Asia. The administrative guidance is an indirect means of intervention based on negotiation between the government and enterprises, and often takes the form of appointments and removals, procedure controls, evaluation and appraisal, persuasion and bargaining, command, information disclosure, and publicity. These measures, however, do not have any legal validity, and businesses might refuse to accept them if they think them inappropriate. There were several cases in Japan during its adjustment of industrial policies after World War II.

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In countries with a greater percentage of SOEs, the government can use direct management to guide the development of the national economy in a set direction.

Involvement Through Non-Official Intermediaries In some countries, the government exercises control and management of enterprises through non-official intermediaries, such as trade organizations in Japan and statutory institutions in Singapore. In Japan, each industry has its own trade organization and the most famous ones are the Steel Association of Japan, the Automobile Industry Association of Japan, and the Fiber Industry Association. These organizations have different levels of structure and some of them have countless attached smaller organizations. Their key responsibilities are to provide information, consulting, and training services for companies within the industry; to coordinate the interests among companies within the industry; to strengthen relations with the specialized bureau of the government on behalf of companies within the industry; to lobby the specialized bureau to develop policies favorable to the industry; to provide information on the industry to the government; and to assist the government in administrative guidance. A trade organization is, in a sense, not only a useful tool for the government to interfere with the industry and even the business activities of enterprises, but also an effective medium to maintain relations between the government and enterprises. As a basic channel between the government and the industry or enterprises, trade organizations can both reduce the number of businesses that the Japanese government is involved in, which in turn helps the government concentrate on strategic guidance, and increase the bargaining power of enterprises in negotiation with the government, which ensures that the final result will be a win-win situation.

Providing Infrastructure and Public Services By providing infrastructure and public services, the government can not only create a favorable environment for the development of companies, but also exercise an indirect influence on them. In many countries, the infrastructure and public services are managed by SOEs. In the United States, for example, the Federal Government provides infrastructure and public services unfit for private investment, such as roads, airports, urban sewage systems, electric power, post, education, security, fire control, and social security and welfare. In France, public services are wholly controlled by the state, including transportation, post, and telecommunications. The German government is

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effective and efficient in providing social security and on-the-job training for employees of enterprises.

MODELS OF GOVERNMENT INVOLVEMENT IN FOREIGN ENTERPRISE MANAGEMENT No consensus has been reached in the academic community on the models of government involvement in enterprise management. Some tend to think that no regular models can be identified, since government involvement has contingent elements and depends on the values held by the party in power. Others, however, argue that each country has its own model. To us, government involvement in enterprise management relies more on such factors as traditions, culture, political systems, and levels of development of each country, though there are contingencies. Despite the divergent means of involvement and organizations in each country, some inherent law can be followed through social and technological development. Research on management models will help us go beyond the surface and develop a better understanding of the practices in each country. Our research shows that there are three management models abroad, and the major difference among them lies in the degree of involvement or the balance of force between the ‘invisible hand’ of the market and the ‘visible hand’ of government.

Government Regulation – The US and UK Models This government regulation model is also referred to as the Anglo-Saxon model, and the typical examples are the United States and the United Kingdom. In this model, the ‘invisible hand’ plays the key role in the market while the role of government is limited to the regulation and standardization of the market and areas where the market mechanism fails. Its key features are as follows:

(1) In favor of free competition To maintain the order of market competition is the basic function of the US government, whose guiding principle in managing competition is to protect the external environment rather than to become directly involved in competition. In practice, orderly competition in the United States has contributed significantly to the healthy development of its economy and its improved efficiency. Opposition to monopoly by large companies through legal measures is the major policy of the Federal Government in competition management. The anti-monopoly policy consists of a set of legal standards, restricting

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such behaviors of companies as market monopoly and unfair competition. It prescribes the form and content of contracts between companies and between companies and customers, including alliance, merging, and pricing. The anti-monopoly policy embodies a series of social objectives: protecting the interests of the public and small-sized companies, restricting the size of large companies, encouraging competition, and improving economic efficiency. These objectives are a reflection of the likes and dislikes of different interest groups and their influence on the government in decision-making. The Anti-Monopoly Bureau under the Department of Justice is an organization responsible for developing and implementing the anti-monopoly policy. Proceedings against large companies are often taken by the government or other companies, and can last for years. Free competition is helpful in improving economic efficiency, but the government should also pay attention to social equality. Despite their great efforts, the United States and the United Kingdom have fallen far behind Western Europe in social welfare and social security.

(2) Regulation and control by fiscal and monetary policies The primary means of regulation and control by the US government are fiscal and monetary policies. The major tools of fiscal policy are government revenue and government expenditure, and those of monetary policy are the discount rates of the Federal Reserve System, the statutory reserve rate of banks, open market operations, and credit policies. In general, the US government takes two approaches in its regulation and control. In economic regression and depression it adopts loose fiscal and monetary policies, including reducing tax and increasing government expenditure, lowering the discount rate and statutory reserve rate, purchasing government bonds in the market, and lifting restrictions on credit. During times of economic boom or inflation, it adopts tight fiscal and monetary policies, including increasing tax and reducing government expenditure, increasing the discount rate or statutory reserve rate, selling government bonds, and tightening credit. In many cases, the government has to integrate the two approaches in light of the economic situation and implement an appropriate fiscal and monetary policy. The British government has favored Keynesianism since World War II, and relied on fiscal policies for economic control. When the aggregate demand becomes too large, it increases revenue and reduces investment depreciation; when the economy is stagnant, it reduces revenue and increases investment depreciation. With a package of fiscal measures, a flexible tax rate, selected

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taxation, increase of public expenditure and investment, and subsidies and loans, the British government regulates the aggregate demand and stimulates the aggregate supply. Beginning in the mid-1960s, the UK government was influenced by the monetary school in developing fiscal and monetary policies. The devices used are tight control of fiscal expenditure, tax reduction, change of statutory reserve, adjustment of the discount rate, taking advantage of open market operations, and indirect regulation of economic operation through the control of the speed of increase of the money supply. By changing the credit system, monetary system, banking credit system, and interest rate, the government exercises its influence on the reproduction process.

(3) Absence of national economic plan or systematic industry policy In general, the US government does not develop any national economic plan or industry policy. Instead, it makes public its views on economic development and economic priorities through presidential speeches and reports to Congress, such as Franklin D. Roosevelt’s ‘New Deal’ speech when he became president in 1933, and Ronald Reagan’s ‘Economic Renaissance Plans’ delivered to the Congress and Senate on 18 February 1981. In addition, the US government develops special plans for key projects sponsored by the government and exercises a tight control. Examples are the Apollo and the Star Wars plans. The British government attempted to develop and implement a national economic plan from 1945 to 1975, but with little effect. It began to give up its efforts in the following years and only formulated the second year or mid-term economic objectives in its annual national budget. The US government has never developed any industry policy but, in practice, it provides strong support to the key industries. For example, it has developed a number of policies favorable to the development of agriculture, national defense, and the high-tech industry, and provided support for transportation, energy, and telecommunications. The British government has also formulated a number of preferential policies to encourage the development of the high-tech industries and the old industrial zones, but no systematic industry polices have ever been developed.

(4) Essential and tight control in line with the law The United States and United Kingdom have exercised tight control over enterprises, but such control is limited to what is essential. Control is diminishing, and the tendency is often referred to as ‘deregulation’ in the academic community. In the United States, the control of government over industry and commerce has

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been softening, and even in the tightly controlled industries, such as finance, the restrictions have been loosening. In 1980, for example, the US Congress passed the Deposit Institutions’ Deregulation and Monetary Control Act (DIDMCA). In addition, the interest ceiling was lifted and the control over regional entry and scope of operations was softened. In 1994, the US Congress put an end to the single banking system through legislation, allowing banks to set up branches throughout the country and to manage cross-state branch networks from 1997. In November 1997, the American Currency Control Office promulgated a new regulation allowing banks to set up subsidiaries to manage any businesses attached to banks or activities within the scope of operation. This new regulation has provided a legal basis for banks to trade securities, sell insurance, and enter new business areas. In May 1995, the Senate Banking Commission passed a bill to abolish the Grass-Stigler Act enacted in 1933, allowing large banks to merge with large securities companies to form new financial groups and to compete with the large banks of Japan and Germany. The government-regulation model has its origin in history and culture. The United Kingdom was the birthplace of the Industrial Revolution, and was also the first country to set up a capitalist system and have complete industrialization. As a traditional economy, and as the home of classical economics and vulgar economics, it has traditionally adopted a laissez-faire policy in economics and encouraged fair competition. Most British people favor free trade and economic individualism, and oppose monopoly and government intervention. This explains why the British government failed after World War II when it attempted to tighten its control over the economy. In the end, it had to go back to privatization and deregulation. As a result, the percentage of SOEs in the national economy has dropped from 15 per cent to 5 per cent. Economic liberalism and individualism in the United Kingdom has been dimmed by its tradition of social hierarchy. In a new country like the United States, however, the ideological obstacles to free competition were destroyed. It is clearly written in the US Constitution that ‘private property is sacred and inviolable’. Private ownership and contracts are well protected by the law. The public demands that the government should take effective measures to fight against monopoly and protect competition with minimum intervention in the economy. As a result, the United States has established a complete system and numerous organizations in government regulation, and its economy has been widely accepted as the model of the modern market economy.

Government Guidance – The European Model This model is also referred to as the ‘Rhine Model’, represented by Germany,

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France, and certain northern European countries, such as Sweden. In this model, the government controls the infrastructure, public services, and key industries, and provides guidance for the development of enterprises through regulations, policies, and plans. The objective of the government is to increase economic efficiency, to improve the social security system, and to ensure social equality. Its key features are as follows:

(1) Co-existence of free competition and government regulation In Germany, France, and Sweden, the primary tool for government intervention in the economy is the market. These countries encourage free competition and have a standard legal framework. Germany, for example, formulated an Anti Unfair Competition Act in 1896, which developed into a complete system after years of improvement. In 1957, West Germany enacted the Act Against Restraint of Competition, with anti-Cartel as its focus. The purpose of this act is to punish those companies attempting to set up market-entry barriers and avoid competition through concerted action, and to stop them from controlling the market through mergers and acquisitions. The Cartel bureaus of the federal and state governments are responsible for implementing the act. In France, no anti-monopoly act has been formulated to date, but there are prescriptions in the related laws on protecting competition and prohibiting monopoly. In the Commercial Law, for example, it is clearly stated that any monopoly attempting to restrict market competition is prohibited. In addition, the French Department of Economy has set up the General Administration of Competition, Consumption, and Anti-Smuggling and the Competition Commission which is responsible for collecting views from all sides and passing a verdict upon unfair competition. Sweden has a similar competition act and a national administration of market competition. In the meantime, the government exercises a tight control over infrastructure, public services and key industries. In Germany, for example, the percentage of SOEs in energy, transportation, and public utilities is very high. Statistics indicate that it is as high as 100 per cent in production or supply of electric power, gas, and urban water; 99 per cent in post and telecommunications and railway transportation; 95 per cent in other means of transportation, such as ports, inner river transportation, and urban transportation; and 50 per cent in the credit business of the financial sector. French SOEs are spread across a number of sectors, such as energy, transportation, telecommunications, raw materials, process manufacturing, banking, and insurance. As a result of several nationalization campaigns, the SOEs in these sectors have grown significantly in size and strength. They are so highly centralized as to dominate the whole

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industry. In energy, the product of SOEs accounts for 69 per cent of the total (95 percent in electrical power), 78.3 per cent in the number of employees, and 84.5 per cent in investment. In transportation and telecommunications five SOEs, including the national rail company and Air France, control the whole industry. In raw materials and process manufacturing, SOEs dominate the steel and uranium industries, and control most of the glass, chemicals, and electronics industries and electricity-generating facilities and public engineering. In finance and insurance, the state-owned financial institutions control 90 per cent of savings, 84.8 per cent of loans, 97.2 per cent of international financial businesses, and all the activities of the financial and insurance systems. In Sweden, the SOEs are spread over forestry, mining, electric power, transportation, monopoly trades (e.g. exclusive sales of wines and drugs), and welfare for the disabled.

(2) Simultaneous use of economic levers and government guidance The governments of Germany, France, and Sweden are cautious in developing fiscal and financial policies and use economic levers such as government expenditure, credit, price, investment, and taxation to regulate the market and planning, budget, and industry policies to guide the market. In Germany, fiscal policy is featured by adjustment of demand through government expenditure, and control of private demand through taxation. As public finance accounts for a high proportion of GDP, the government can harmonize it with the development of the national economy through an appropriate budget, as well as directly influence gross consumption and investment and balance the aggregate demand with the aggregate supply through policies of fiscal revenue and expenditure. The budget surplus and deficit can contribute to the stability and development of the national economy by increasing or reducing expenditure and revenue. During economic booms, the budget surplus can reduce the demand and control overheating; in economic depressions, the budget deficit can increase the demand and promote economic development. In addition, the government can boost economic growth and stability by encouraging investment, adjusting depreciation rates, and influencing private investment and consumption through the change of individual and legal person income tax rates. The objective of monetary policy is to maintain the stability of the currency. To this end, the Federal Bank of Germany attempts to influence financial markets indirectly through its impact on market behavior by, for example, restricting loans and enforcing a prescribed interest rate. Its primary tools are discount and mortgage loan policies, minimum reserve policies, and open market policies. Because of its effectiveness, the European Treaty of 1992 prescribed that the European Central

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Bank, set up in 1999, should be based on the model of the Federal Bank of Germany. But the governments of these countries also use planning, budget, and industry policies to guide the market. For example, an important feature of the economic development of France after World War H has been government regulation through planning. Its economic planning includes an overall plan for economic development, development of agriculture, development of commerce and industry, priorities of development, and growth targets of macroeconomic aggregate. The purpose of the planning is to influence the decisions of enterprises, especially in investment and marketing, by directing the development of the market, controlling the source of capital for enterprises, and providing favored policies. These practices help put state planning into action, and guide enterprises to make decisions and operate in line with planning objectives. The German government does not formulate any plans for economic development, but it attempts to regulate the economy through mid- term fiscal programs and annual budgets. In terms of industry policies, Germany promulgated the Economic Stability and Growth Promotion Act in 1967, prescribing government guidance in adjusting the industrial structure. The objectives were to support such key industries as electronics, telecommunications, space technology, and nuclear power; help modernize the petroleum and textile industries and increase their competitiveness; and maintain the strength of agriculture and the mining industry. France has a similar industry policy.

(3) Similar influence on economic growth and social welfare Countries like Germany, France, and Sweden attach great importance to improving social security and social welfare while stressing economic growth. Social security in Germany and France, for example, is highly developed and accounts for over one third of GDP. The overriding principle of the German government in providing social security for employees of enterprises is that the country should continue to ensure their social and economic status when they are facing labor and personal risks that could endanger their economic survival. Social insurance in Germany includes social unemployment insurance (the unemployed can receive 70 per cent of the net income of their last job); unemployment compensation (about 60 per cent of their last salary for employees who are not covered by unemployment insurance); pensions (about 70 per cent of the average net income for people over 65 years old); medical insurance (in 1995 the average insurance rate was 13.2 per cent of total income in Western Germany and 12.8 per cent in Eastern Germany); and accident

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insurance. In 1995, the expenditure on pensions, medical insurance, and unemployment insurance were DM 335 billion, DM 228 billion, and DM 127 billion, respectively. The sum of these three items accounts for 68 per cent of the total expenditure on social security. Northern European countries like Sweden are often referred to as welfare states because of their great efforts in improving social welfare. In Sweden, for example, the welfare system was set up as early as 1932, and all employers and employees paid tax directly to the government to cover the costs of social welfare. The country imposes a social security tax which requires the employer to pay about 33 per cent of an individual’s salary. The social welfare of the unemployed is entrusted to trade unions, and the main source funds are union dues, employer contributions, and government subsidies. The government-guidance model also has its origin in history and culture. France, Germany, and Sweden were among the first countries in Europe to develop market economies and to espouse such dynamic concepts as economic liberalism, utopian socialism, social democracy, Marxism, and Keynesianism. The Socialist parties in France, Germany, and Sweden are politically powerful. They favor social democracy and argue for an eclectic combination of traditional capitalism and socialism and a balance between economic efficiency and social equality. Some countries have gone through many economic changes. (Germany, for example, has in the past century successively adopted the free market economy, central control economy, and social market economy). Coupled with the lessons from the two World Wars and economic crises, they have acquired rich experience in dealing with government intervention and market regulation. Many people believe that government intervention can make up the deficiencies of market regulation. However the working classes in these countries have a tradition of fighting for their rights and, as a result, trade unions are becoming increasingly p o w e r f u l . A s n e w p ro b l e m s a n d c o n f l i c t s c ro p u p d u r i n g e c o n o m i c development, the operation of enterprises and social stability are endangered, which in turn demands government intervention and regulation. Through the establishment of a social security system and the legal rights of employees, the government is able to alleviate social conflicts and maintain social justice.

Government Leading – The East Asian Model The representatives of the East Asian model are Japan, South Korea, and Singapore. In this model, the government not only takes the same measures as in the above two models, but also makes use of its intimate relations with enterprises to provide them with administrative guidance. The model has the following features:

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(1) Compelling enterprises to observe market rules Among East Asian countries, Japan has the most advanced legal framework in the market economy. It comprises the laws of economic order, economic organization, and economic activities. The legal infrastructure in Japan matures with the development of its capitalism. Economic legislation after World War II, such as the Anti-monopoly Act, and the Enterprise Rationalization Act, contributed significantly to the transition in Japan from a controlled economy to a market economy. During economic booms, the government also formulated a number of acts, such as the Interim Provisions for the Revitalization of Machinery Industry Act, the Interim Provisions for the Revitalization of Electronics Industry Act, and the Basic Law of Small- and Middle-sized Enterprises, which have played an active role in rationalizing the industrial structure and modernizing enterprises. A number of provisions are concerned with specific industries and products, and most of them are favorable policies. For example, any company that imports state-of-the-art machinery will get a subsidy from the government of as much as 50 per cent of the total cost. In addition, the Japanese legal framework is so comprehensive that laws complement and restrain one another, stipulating that both the government and enterprises act in line with laws and regulations. However, as the government is responsible for developing, interpreting, complementing, amending, and implementing laws, it is able to compel enterprises to observe market rules through rigid regulations and systems. In other countries, where the legal infrastructure of the market economy is far from perfect, the government will meet with great difficulties in regulating enterprises through the law.

(2) Inducing the behavior of enterprises through a benefits system As in other market economies, the Japanese government uses fiscal and financial policies, as well as various economic levers, to guide enterprises. In addition, it tries to stimulate their behavior through a benefits system, in which the most effective means is credit control. It can on the one hand promote the development of the whole industry, and on the other hand have a direct impact on the behavior of enterprises. Since World War II, the Japanese government has implemented a preferential credit policy to meet the needs of economic development and the adjustment of industrial structure. In the early period after the war, most government credit went to such key industries as coal and steel as a result of the ‘preferential production policy’. In the meantime, credit control was exercised over other industries (i.e. silk, cosmetics, housing, and services). With the economy on a fast growth track, the priority of credit was placed on the building of highways, railways, ports, and telecommunications

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to resolve an infrastructure bottleneck. From the mid 1950s to the mid 1960s, the Japanese economy began to take off and the government encouraged stateowned financial institutions as well as the private sector to extend credit to heavy chemical industries and later to technology-intensive industries with better energy-conservation and less pollution. In the late 1980s, the focus shifted to knowledge-intensive industries. Through direct and indirect means of credit, the Japanese government increased its investment in emerging industries and businesses and reduced its support for backward industries, which in turn provided a guarantee of capital for the change of industrial structure. Thanks to a tight control of the financial market, the Japanese government is efficient in using credit to influence the behavior of enterprises. The twotier structure between the government and financial institutions and between financial institutions and enterprises has provided a channel for the government to intervene in enterprise management. This is reflected in three aspects. The first aspect is the government’s guidance and control of the financial market, which has been set up as a result of government intervention. As early as the 1940s, the Japanese government transformed direct financing into indirect financing out of military need, forcing enterprises to secure loans from banks controlled by the government. After the war, Japan imposed the Act of Special Provisions for Company Accounts and the Act of Company Reconstruction Management, which further strengthened the direct financing of enterprises. The second aspect of intervention is the government’s direct loans to enterprises through its affiliated banks, such as the Bank of Japan and a number of ‘treasuries’. The third aspect of intervention is window guidance (a form of administrative guidance) for commercial banks through the Bank of Japan. By this means, the Japanese government is able to adjust the rediscount rate of the central bank, change the rate of reserve against deposit in commercial banks, operate in the open market, and regulate the money supply. As a result, it exercises indirect macro-management and satisfies the capital needs of enterprises in general and of conglomerates in particular. In addition, the Japanese government has also implemented a low interest rate policy through tight control by the central bank, which makes enterprises more reliant on banks for capital and reinforces the relations between banks and enterprises. In the meantime, the cost of investment and operation of enterprises can be reduced substantially while their competitiveness is greatly increased.

(3) Guiding enterprises on a predetermined track of development through plans and industry policies Most countries in East Asia use planning as a means of economic regulation.

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South Korea, for example, bases its economic planning on the Five-year Plan of Economic and Social Development, coupled with a development plan for each sector, an annual economic plan, and specific plans for key projects. All plans are meant to provide guidance, but with clear objectives which can be adjusted in light of the new realities. Economic planning in South Korea focuses on longterm objectives, while the short-term behaviors of enterprises are decided by the market. The planning is often market-oriented, and through the market it provides feedback for enterprises, so that ‘the market integrates the planning and the planning reflects the market’. In practice, the orientation of planning is reflected in industry policies. For example, the past seven ‘five-year plans’ in South Korea have all had a bias towards a certain industry: the first was towards fundamental industry, the second towards the light textile industry, the third and fourth towards heavy chemical industry, and the last towards microelectronics, biological engineering, and new materials. In the early 1960s, the Korean government implemented the ‘improvement method’ to create an entry barrier to certain industries. Companies with an entry, license were granted a monopoly over operations within the industry. In each period, the government would decide one or more key areas, with a priority on loans, tax, and market information, to promote the development of the related industry and national economy. Singapore began to implement five-year plans in 1961, and to date has completed two five-year plans and two ten-year plans. In the first five-year plan (1961–1965), the government developed a strategy focusing on imports to help develop industry. In the second five-year plan (1966–1970), the focus was shifted from economic development to exports. The first ten-year plan (1971–1980) witnessed fast economic growth, and the strategic focus was on new and hightech industries in order to speed up the shift from labor-intensive to technologyintensive manufacturing. To this end, the government of Singapore amended the Act of Incentives for Economic Development and formulated the Amendment to the Act of Incentives for Economic Development. In the second ten-year plan (1980–1990), the government implemented a major economic restructuring to upgrade its science and technology, which is now often referred to as the ‘second Industrial Revolution’. Beginning in the 1990s, Singapore developed an overseas expansion strategy to increase its investment in international markets and cooperation with countries in South-East Asia. The objective was to build Singapore into a global centre of commerce and finance.

(4) Persuading enterprises to follow the ideas of the government through administrative guidance Administrative guidance is a unique form of government involvement in

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enterprise management in South-East Asia. Administrative guidance in Japan usually includes ‘persuasion and negotiation’, ‘information-sharing and communication’, and ‘publicity and education’. Through ‘persuasion and negotiation’, the Japanese government allows related industries or businesses to take action in conformity with its intentions. In economic depressions, for example, the government persuades companies to reduce their production or the price of their products. Through ‘information-sharing and communication’, the government keeps in regular contact with industries and businesses, and works with them in developing, amending, and implementing related policies, measures, and plans. Such communication helps establish a dialogue between the government and enterprises. Through ‘publicity and education’, government officials elabourate their views on policies or the economic situation through lectures or speeches to increase the understanding of enterprises and to influence their behavior. It is through this approach that the Japanese government manages to lead enterprises to act in conformity with government objectives. In general, administrative guidance in Japan is built on the mutual trust between the government and enterprises, and implemented in the context of reasonable economic planning and industrial policy. Through administrative guidance, the micro-economic activities of enterprises are aligned with the macro-economic activities of the country. The administrative guidance for enterprises in Japan focuses on the development of industry policies. For example, the government attempted to promote the merging of sunset industries by formulating a development strategy for emerging industries and to play an active role in coordinating the needs for capital, personnel, and technology. As many ministries (e.g. the Ministry of Trade and the Ministry of Finance) are very powerful, they can either reward or punish enterprises. However, since the administrative guidance of the government does not have any legal validity, enterprises are able to reject it when they feel uncomfortable. When an influential company raises objections or when a number of enterprises unite in opposition, the government will make concessions. The government-leading model has a complex historical and cultural background. It has been influenced by the feudal system, Confucianism, and Western culture. As the government, represented by the emperor in a feudal society, had supreme authority, and as orthodox thoughts were predominant in Confucianism, people today have a high respect for modem government, which helps the government play a leading role. Western civilization has contributed concepts of democracy, rule by law, and science, and as a result a unique social culture is formed in East Asian countries.

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The social culture in Japan is a mix of East and West. It not only retains a quintessence of Confucianism (the emphasis on interpersonal relations, advocacy of collectivism and loyalty, subordination of individual interests to collective interests, harmonization, diligence and thriftiness, and regulation of behavior through ethics and morals) but also absorbs the positive aspects of Western civilization (the emphasis on efficiency, competition, and democracy). Coupled with the spirit of Bushido, a unique social culture is formed in Japan. Japanese nationalism is in fact an expression of the collectivism advocated by Confucianism, which requests that individuals be ‘loyal’ to their organizations and that organizations be ‘kind’ to the individuals. Between enterprises and the government, ‘loyalty’ means that enterprises need to respect the advice and management of the government and their interests must be subordinate to national interests. ‘Kindness’ means that the government needs to develop a development strategy and an industry policy that cater to the interests of enterprises and people. Under the influence of Western individualism, however, the relations between the government and enterprises are often a hotbed of corruption. South Korea is a Confucian country in which hierarchy and authority are highly respected. Even when President Kim Yongsam began to carry out the reform of democracy, malay people reminisced about the ‘good old days’ during the period of power politics and lamented the coming of an age without authority’. Such a social mentality helps implement the policy of strong government and weak enterprises’. In Singapore, Chinese traditional culture and Confucian values have played a critical role in the development of the economy and enterprises. The leaders of Singapore believe that a stable social environment is essential to modem construction. All individuals need to have a strong sense of responsibility. To prevent ‘pseudo-Westernization’, the government advocates two core values: society is higher than individuals and family is the core of society. In February 1990, it published the ‘White Paper on Shared Values’, which stipulated that people put the national interest above everything else; take the family as the basis and society as the core; give care to others and share their troubles as well as joys; seek common ground while reserving differences and trying to reach a consensus on the basis of consultation; and advocate racial equality and religious tolerance. These five values have laid a solid cultural foundation for the government’s macro-control of the economy and for company behavior on the basis of free competition. The above is a rough description of the three key models of government involvement in enterprise management. As the former Soviet Union and Eastern Europe have been experiencing a transition in economic structure, and as

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many developing countries have been experimenting with the market economy system, none of them have yet been able to develop a reliable model. For this reason, they are not covered in this chapter.

TARGET MODEL OF GOVERNMENT INVOLVEMENT IN ENTERPRISE MANAGEMENT IN CHINA After many trials and experiments in the past two decades, China has decided to adopt the socialist market economy system. To accomplish the objective to set up a relatively perfect socialist market economy system by 2010, the government needs to implement a corresponding reform of enterprise management. As one of the cradles of the world’s ancient civilizations, China has a brilliant record in philosophy, literature, and technology and has made a great contribution to the development of human civilization. However, as China had long been a feudal society closed to the outside world, it missed the opportunity to learn from the West’s science, technology, and culture that evolved after the Renaissance. After the First Opium War (1839–42), China began to learn from the West but failed to carry out comprehensive, systematic, and in-depth research because of external aggression and internal turmoil. In the years following 1949, China basically modeled its enterprise management on that of the former Soviet Union, which was obviously unfit for the development of the socialist market economy. China has the world’s largest population, but resources are scarce, regional development is unbalanced, and education is poor. The market is immature, and the mentality of the socialist ‘big pot’ prevails. All these problems have increased the difficulty of the reform of enterprises. Reform needs us on the one hand to work in a down-to-earth manner, advance step by step, and make bold experiments, and on the other hand to take a long-term perspective, develop an overall plan, and set clear objectives. Based on my own research, I propose the following target model of government involvement in enterprise management in China.

Effective Government Effectiveness is the ability to accomplish set objectives and realize desired outcomes, and government effectiveness is the ability to set reasonable objectives and get desired results. Unfortunately, no consensus has been reached to date in the academic community on the definition of an effective government. To us, an effective government must at least have the following distinctive features in terms of its involvement in enterprise management:

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(1) Authority As an integral part of the state apparatus, the government naturally has great power. China has a long tradition of feudalism and people are accustomed to acknowledging and respecting the authority of the government. Therefore, the government can rely on its authority to formulate and implement policies and involve itself hi enterprise management according to the law. But the government needs to make constant efforts to maintain its authority, especially to keep its promises and to ensure equality.

(2) A lean structure In general, the more powerful the government is, the more aggressive it becomes. As a result, its organization gets increasingly swollen. This might account for the vicious circle of ‘streamlining, swelling, re-streamlining, and re-swelling’ despite several structural reforms in government organizations. To get rid of this predicament, the government has been determined to change its function and streamline its structure. It should focus on building its legal infrastructure, maintaining the stability of the macro-economic environment, providing infrastructure and public services, creating a social security system, protecting the environment, and properly managing SOEs. Anything that can be regulated by the market should be done through the market, and anything that needs macro coordination should count on public institutions and nongovernmental organizations. In the meantime, training should be provided for government officials in order to create a team of public servants with better ideological and professional qualities.

(3) Active role Within its function, the government should play an active role. It should be able to guide enterprises with such indirect means of management as plans and policies. Prior to developing plans and policies, it should seek advice from businesses, non-governmental organizations, and experts in related fields, and encourage enterprises to closely follow administrative guidance and preferential policies. Particular attention should be given to avert the negative effect of government policies and to provide compensation for the affected groups. In addition, precautions should be taken against government officials’ myopia to the detriment of its long-term and overall objectives. To minimize mistakes in decision-making, the government should become as scientific, democratic, and systematic as possible, which demands the reform of the decision-making structure and the separation between the power of decision making and the power of restraint. On the other hand, the government should also capitalize

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on research and consulting organizations and bring into full play their support function in decision-making.

(4) Honest and clean This is critical to presenting a good image and reputation to the public, to whom the abuse of power for personal interests is most hateful. For a long time, however, the government administration has been integrated with enterprise management and the legal infrastructure has been incomplete. As a result, corruption has been a grave and persistent problem in China. To reverse the situation, the government administration must be separated from enterprise management; the relations between the government officials and business leaders must be under rigorous supervision; and any illegal behavior offering, asking for, or taking a bribe must be severely punished. The government needs to offer its officials a reasonable level of income and administrative expenses and to prevent extravagance and waste of government resources. It should take the initiative to accept the legal supervision of the National People’s Congress, the democratic supervision of the Political Consultative Conference and related parties, and the supervision of the public.

Dynamic Enterprises Without a great number of dynamic enterprises with independent operations, independent decision-making, and vitality, the market will not be able to self-organize, let alone to emerge as a market economy in a real sense. Such businesses should have the following distinctive features:

(1) Independence Enterprises should have an independent legal status in a real sense. They should enjoy civil rights and assume civil obligations. They should be independent in organization, property, and legal status. On the one hand, the government should fully respect the independent status of businesses, and on the other hand, as the owner of state-owned assets, it can restructure the SOEs through legal procedures.

(2) Autonomy Enterprises should be able to operate and make decisions on their own. They should have full autonomy in formulating development strategies, making business plans, setting up regulations, recruiting management staff, and signing economic contracts. In general, the government should not be involved in the internal management of businesses but, in order to protect the interests of the public, should exercise control over SOEs with monopolies over price and wages.

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(3) Observation of the law On the one hand, enterprises should operate by the law and pay taxes, abide by various norms of behavior, and assume social responsibilities. On the other hand, the government should protect the interests of all types of businesses in line with the law and provide incentives for law-abiding high-performers.

(4) Innovation Businesses can only gain vitality through innovation. They should be innovative and have the capacity to develop new products, new processes, and new markets, and to use new materials and new management skills. The government should encourage businesses to innovate by means of policies, such as providing tax credit for R & D and tax exemption or even subsidies for the purchase of new equipment.

A Standardized Market The creation of a standardized market is the primary function of the government in enterprise management: it needs to not only provide the ‘playground’ but also set the ‘rules of the game’. However, it will be an arduous task to create a standardized market, given the long history of a semi-feudal, semi-colonial society before liberation and a planned economy system after the founding of the PRC in 1949. In addition, the market is far from mature, and the public has little knowledge of it. To us, a standardized market should have the following features:

(l) A complete system The market is a system with different levels and different functions. The elements of the system are interrelated and will influence one another. Therefore, such a system will not function properly until it is complete and comprehensive. The system should include a commodities market and other factor markets such as capital, labor, technology, and information markets. The system should include rural, urban, regional, domestic, and international markets. Prior to setting up a specific market, the government should research into foreign markets, analyze its advantages and disadvantages, and formulate related supervision methods.

(2) Strict laws and regulations Standardization relies mainly on laws and regulations that need to be strict and complementary. In addition to a number of laws regulating the basic relations of the market, the behavior of the subject, and the order of competition, we

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need various regulations to supplement and make the laws more operational. In the legislation process, the government should make sure that the laws will be not only systematic and supplementary to one another, but also practical. They need to be technically feasible, economically rational, legally valid, feasible in operation, realizable in process, and politically acceptable. Such laws will meet with the least resistance in implementation. In addition, the legislation should be timely and concise from the beginning.

(3) Free competition One important task for the government is to protect the freedom, equality, and fairness of competition, and to fight against the market monopoly and other unfair competition. Monopolies are the largest obstacle to the development of the socialist market economy. The government should step up the legislation to standardize the market and get rid of sectoral monopoly, local protectionism, and any national monopoly. In addition, ad hoc organizations should be set up to develop and implement anti-monopoly policies.

(3) Adequate information I n a m a r k e t e c o n o m y, t h e d e c i s i o n s o f b u s i n e s s e s r e l y m a i n l y o n information. In the past, when the planned economy prevailed, the value of information was underestimated. In recent years, a few government organizations have attempted to block public information for personal interests. Given this situation, the government should do its best in legislation to make sure that businesses will get not only public information, but also market information.

Strict Control The market economy is based on law, and the government should exercise strict control over businesses by law. Such control should have the following features:

(1) Proper supervision Businesses are increasing their activities and their internal and external relations are getting more complex, which makes government supervision increasingly difficult. Therefore, a proper supervision system should be established, with a focus on financial supervision. It will include a consistent accounting system, a set of auditing methods, a range procedure, and a reward and punishment system. A common practice abroad is to send expediters to key SOEs. This might also be a good idea for China, but the responsibilities of expediters should be made clear and special training should be provided.

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(2) Legal verdict With the increasing complexity of economic litigation, a clear verdict by law is getting more difficult. Precedent cases might be invoked for reference.

(3) Strong enforcement Enforcement is the key to effective control. Any verdict, if not executed, is merely a scrap of paper, which will in turn damage the reputation of the government. Like social order, economic order should be maintained, and any illegal racketing or debt dodging should be cracked down on.

(3) Good coordination Control should be supplemented with coordination in dealing with exceptional cases between enterprises. However, the government should never be partial to one side, and the result of coordination should be in line with the law and accepted by all related parties.

A Complete Social Security System This is not only essential to social stability and a sound business environment, but also as a reflection of our socialist system. On the one hand, we need to distribute the quantity and quality of work, to maintain a reasonable gap in income between different classes, and to allow some people to get rich first through honest labor and legal operation. On the other hand, we need also to maintain social equality, to protect the interests of low-income classes, and to establish a complete social security system. Such a system should include:

(1) Unemployment relief Unemployment is inevitable with the change of economic structure and optimization of labor resources under the market economy system. Therefore, an unemployment relief system should first of all be in place to guarantee the minimum needs of the unemployed. Unemployment pensions should be covered by the government, and handed out through the auditing institutions against registration. The second step is to set up an unemployment insurance system, with the expenses shared between employers and employees. If it is allowed in finance, the government can provide a subsidy. All employees can get the money when they are out of job. To encourage reemployment, however, the government should also prescribe that the unemployed receiving benefits must take jobs or should offer reemployment training.

(2) Pensions insurance A pensions insurance system must be set up to guarantee the welfare of the

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retired. The expenses should be shared, between employers and employees. For employees who began to work before the establishment of the system, the government and employers should provide a reasonable amount as the base. Employees can get the money when they retire or leave their jobs.

(3) Medical insurance Free medical care should be replaced by the medical insurance system. The expenses should be shared between employers and employees. Original free medical care can be included in the salary in cash.

(4) Accident insurance This is a special insurance against on-the-job injury or car accidents. The expenses should be shared between the government and businesses in proportion. To make the above target model happen, we need to make a detailed plan, to seize the right time, and to implement it step by step. We firmly believe that, with increasing care and attention from people with a vision, China’s reforms will finally succeed. Completed on 5 April 1998

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Chapter

Establishing an Adequate, Equal, and Effective Social Security System for China

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While ‘social security’ has been a household term in China for the past few years, no consensus has yet been reached on its definition and scope. Some Western scholars argue that it is basically security for the retired. In the United States, for example, social security is considered as part of social welfare. It originated in the Social Security Act passed by the US Congress in August 1935. As an integral part of President Roosevelt’s ‘New Deal’, the American government levied an income tax on employers and employees and used social security solely for pensions. However, other scholars maintain that social security should include social insurance, social assistance, and social welfare. A few scholars even believe that social security is a broad concept, including social insurance plans, health care, welfare, and other plans to ensure individual and family income. As an important part of the market economy system, social security is an indispensable means of maintaining social stability and economic development and is basic medium through which the government can ensure social equality. It is also a policy instrument to influence consumption and employment. In the process of developing the socialist market economy, social security in China should reflect the nature of socialism. It is of practical importance to set up an appropriate social security system, given the increase in redundancies and the cost of transformation. In this chapter, I will elaborate on the evolution and development trends of social security and the importance of setting up a social security system in China. Integrating management science, economics, and sociology, I will also explore a target model and a reasonable structure for a social security system appropriate to China. I will also discuss the difficulties and solutions in setting up a social security system with Chinese characteristics.

THE HISTORICAL DEVELOPMENT AND FUTURE TRENDS OF SOCIAL SECURITY The idea of social security can be traced far back in China’s history. As early as 500 BC, Confucius remarked: ‘When great rule is in effect, everything belongs to the public. The old are taken care of. The strongest laborers are put to good use. The young are cared for and all the widowed, the orphaned, the handicapped, and the sick are attended to.’ In Mencius’s view, widows, widowers, orphans, and the homeless are the ‘four types of poor people who have no one to turn to for help and when benevolent rule was implemented by Emperor Wen, these people would be taken care of first.’ Many officials in successive dynasties expressed their ideas of ‘fraternity’. Qu Yuan (339–278 BC) said, ‘I sigh and

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weep for the hard life poor people live’. Liu Xiang (79–8 BC) said, ‘The good ruler loves the people as a father loves his son and an elder brother loves his younger brother’. Yang Jiong (b. AD 650) said, ‘He who can save the world must make the world a peaceful place, and he who can rid the world of worries will enjoy the joys of the world’. Su Shi (AD 1037–1101) said, ‘Those who shoulder the responsibilities of the world will benefit from the world, and those who share the woes of the world will enjoy the joys of the world’. These sayings, among many others, can be taken to be the origins of the modern concept of social security. However, limited by the class exploitation and low productivity in feudal societies, these ideals could hardly be put into practice. In general, they were limited to reductions of taxes and alms given out in times of natural disasters, or to public property, free land, emergency granaries, homes for the aged, and orphanages. The first Western social security law was the Elizabeth Relief Act drawn up in 1601 by Queen Elizabeth I of England. The law was designed to provide help and build shelters for the elderly, the blind, and the disabled; to help the poor and children to learn crafts; and to collect taxes from the wealthy areas to aid those in the poor areas. In the first half of the nineteenth century, a new relief act was passed in England, making it clear that social assistance was the legal right of every citizen and the new norm of social obligation, and that the government and society as a whole had an obligation to protect citizens. The modern social security system was first set up in Germany in the 1880s under Bismarck’s rule. Between 1881 and 1889, under the banner of social reforms’, the German Parliament passed a series of acts, including social insurance for illnesses, workers’ injury protection, and social insurance for the elderly and handicapped. In 1927 an unemployment insurance act was adopted and, as a result, a roughly complete social security system was set up. Since the end of the nineteenth century, social security systems have been set up in Denmark, Norway, Finland, Italy, the UK, France, Austria, Switzerland, Belgium, and Holland. But it was not until 1935, when the Social Security Act was passed in the US, that the modern social security system came into being. After World War II, social security entered a new phase. In 1946, the UK introduced a raft of welfare legislation including the National Insurance Act, National Medical Care Act, Housing Act, and Housing Management Act. In 1948, the National Relief Act was passed. With these acts, England set up a complete social security system ‘from the cradle to the grave’. Since then, developed countries in Europe, North America, and Asia have implemented universal welfare policies. ‘Welfare states’ have appeared and social security has further developed. In 1952, the International Labour Organization drafted and

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passed the Conventions on Minimum Standards for Social Security, indicating that social security had become an international concern. Between the 1950s and 1960s, the prevailing welfare state social security model in Europe was characterized by high taxation and universal high-level social security, with the state playing a principal role. For example, the national security system entitled all national and foreign residents to medical insurance, free medical care, and free medicine provided by state medical organizations. Insurance was provided for the elderly and various unemployment systems were set up. However, a social security system based on ‘universal welfare’ has its problems, too. When the standard of social welfare is increasingly high and exceeds a nation’s economic power, social security funds will be overdrawn and there will be a national deficit. High-level welfare and high social relief will also encourage ‘voluntary’ unemployment and hamper economic development. Given these problems, many countries have begun to reevaluate their social security policies and to start a new round of reforms. The UK first made it clear that social security should not be monopolized by the state. The public and private sectors should cooperate and individuals should be encouraged to get welfare through employment. Reforms in other countries took a similar direction, designed to increase income and reduce the expense of social security. Since the 1990s, the Western social security system has faced greater challenges. Due to the increase of life expectancy, the number of the elderly, and the expenses of medical insurance and pensions, the balance between the revenues and expenses of social security funds has been destroyed. The only way out is to increase tax on employees or to lower existing social security standards. But tax increase is strongly opposed by the younger generation who, feeling unfairly treated, are becoming increasingly anxious about the social security system. Lowering social security standards is opposed by the retired and those reaching retirement age, which can bring about political risks. In the United States, for example, people over 65 have grown from 8 per cent of the total population in 1980 to 13 per cent in 1999 and are expected to reach 20 per cent by 2030. According to a survey by the Social Security Bureau, the number of retired people over 65 will double between 1990 and 2030, while the working population between 20 and 65 will only increase by 25 per cent. The US Economic Development Committee has estimated that the total assets of the social security fund are around US$ 1,000 billion, with annual net earnings of US$ 65 billion. If the existing social security system is not reformed, there will not be enough revenues to cover expenses by 2018 and the funds will be completely exhausted by 2028. Obviously, future social security should not

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rely on continued increase of taxation or reduced benefits but should proceed through basic structural readjustment and policy reforms. At the Twenty-Fifth Annual Conference of the ISSO (International Safety Standards Organization) held in 1996, many visionary participants realized that social security had come to a crossroads in many countries. The view that many social security problems could be solved naturally through economic development was seriously challenged. Two prominent questions received worldwide attention in the academic study of social security: the financing of social security and structural adjustment, and the solution of increasing social risks through privatization. The financial diversification of social security has been the main trend in recent years, characterized by the change from government monopoly through to a sharing of responsibilities among the state, society, employers, and employees. This will inevitably lead to a redistribution of existing interests, and perhaps grow into a sensitive political issue which must be carefully studied and implemented. Some scholars advocate privatization as the solution to the social security problem. They suggest that all or most salary taxes be transferred to the employees’ private retirement plans so that more individual savings can be used for investment and the earnings generated can be used as a source of security. But this proposal has caused controversy with some arguing that privatization provides sufficient security for only a small number of high-income employees. The government still needs to provide relief to those with low incomes and, as a result, reducing public expenditure cannot really be achieved. In addition, private investment will have to face risks ranging from inflation to bankruptcy, making it hard to meet the goal of providing security for investors. Apart from this, in the transition to privatization, the younger generation will feel overburdened, because they will not only have to support the welfare of the older generation by paying income tax but will also be forced to save for their own personal accounts. Some scholars point out that privatization must be supplemented by adequate and complete regulations set up and implemented by public sectors. Even in developed countries, the development of regulations is a major public policy problem. It is more challenging in developing nations where the overall level of public service is low and the integrity and competitiveness of public servants are still a problem. To this end, several scholars have proposed a combination of public and private investment to provide reliable, sufficient, and equal security against social contingencies. .

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THE SIGNIFICANCE AND ROLE IN SETTING UP THE SOCIAL SECURITY SYSTEM As an integral part of the market economy system, the social security system has three functions:

1. An Indispensable Means of Maintaining Social Stability and Economic Development It is true that the Relief Act and New Relief Act in the United Kingdom and the social insurance system in Germany were adopted to maintain social stability and ease labor tensions. However, social security was not taken as a necessary means of maintaining social stability and economic development until the Social Security Act, based on the theories of Keynes, was drafted in the Unites States in 1935. In The End of Liberalism , published in 1926, Keynes argued that the government should actively intervene in economic development. Later, he proposed a policy to get rid of unemployment and depression through government intervention. In his view, it was the shortage of effective demands (including investment and consumption demands) that had led to the grave problem of production surplus and unemployment in the capitalist world in around 1930. Therefore, the government should try every means possible to stimulate private investment and consumption. Keynes explicitly related social security to economic development, suggesting that economic crises could be suppressed if the government greatly raised social welfare through legislation or even deficit policies,’ including raising wage standards and social welfare and increasing income. He then proposed the abolition of slums and the implementation of progressive taxation and bottom wage systems. Keynes’s government intervention theory served as the theoretical basis for the social security system in President Roosevelt’s administration (1933–45). Keynes’s meeting with Roosevelt in Washington in 1934 led to the birth of the Social Security Act. In Keynes’s view, government should take on such social responsibilities as old age relief and unemployment security, which the private sector and market were incapable of doing. This could overcome market failure and crisis and was one of the efficient ‘economic stabilizers’. Under the influence of Keynesianism, the United States, the United Kingdom, and other capitalist countries began to develop economic policies with ‘full employment’ after World War II, which promoted the development and improvement of their social security systems. These policies relieved the inherent contradictions within capitalist society, and helped maintain the stability and economic development of Western countries. In a sense, social

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security is one of the important factors in the ‘self-improvement’ of the capitalist system and the extension of its life cycle.

2. A Basic Device for the State to Fulfill its Function of Maintaining Social Equality The functions of the state embody the nature of the state and involve the solution of basic social problems. With the increasing gap between the rich and the poor after World War I, social welfare became the focus of attention for economists. It was under these circumstances that the British economist A. C. Pigou put forward his welfare economics. Based on the marginal utility theory, he argued that the greater the aggregate national income and the more balanced its distribution, the greater the social welfare. On the one hand, the universal welfare brought by the increase of national income depended on the increase of social output, which required the optimal allocation of resources of social production. On the other hand, as the monetary marginal utility of the high income earners was smaller than that of the low income earners, an increase of universal welfare could be achieved through the redistribution of national income. In other words, income balance could be achieved and overall social welfare could be increased by levying progressive income tax and heritage tax on the rich and increasing unemployment subsidies for workers and social relief for the poor. In 1941, the concept of the welfare state came into being based on welfare economics. A welfare state is a state that is responsible for the welfare of all its nationals. Although people differ in their responsibilities, they all acknowledge that the state has a greater role in ensuring social equality than market forces. The state-managed social security system can act as a means of social reallocation and can, to a certain degree, reduce the gap between rich and poor, ease social tensions, and help the state perform the function of ensuring social equality. The reallocation function of the social security system is not only embodied between the poor and the rich, but also between men and women, racial minorities and white people, well-educated and poorly educated. However, this kind of reallocation is not absolutely fair. For example, since the rich live a better life and enjoy better medical care, they generally have a lower mortality rate and a higher life expectancy and therefore they enjoy longer social security benefits than the poor. Again, in a country where all consumers are taxed, with social security at the same level for all poor people, the poorest receive the least benefit.

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3. A Policy Instrument to Influence Such Behaviors as Consumption and Employment Many studies indicate that the social security system can act as a policy instrument to influence such behaviors as consumption and employment, and economic development as a whole. The effect of social security on consumer behavior can be analyzed with the Overlapping Generations Model, which divides an individual’s life into three phases: childhood; adulthood; and old age. If a man begins to work and receives income when he becomes an adult, he has to divide his income into three parts during his working period: one for current self-consumption, one as savings for retirement, and one for raising the next generation. The ratio of these three parts depends on his consumption choices as well as the influence of the environment (including the social security system). For example, when the government raises social security funds through taxation, it will make individuals and social groups who prefer immediate consumption reduce savings, thus producing a crowding-out effect. For those with a preference for future consumption, it will make them increase their savings so as to retire earlier and have enough savings for consumption while enjoying their retirement pensions. But if the government raises social security funds through compulsory savings, it will force consumers with a preference for immediate consumption to save for the future. For those preferring future consumption, compulsory savings plus voluntary savings will be no less than the previous level. Therefore, it will generally boost savings. The effect of the social security system on employment can be seen from people’s propensity for leisure, choice of career, and retirement age. The better the social security system, the more people will be tempted to opt for unemployment. Of those who prefer to work, some would prefer voluntary unemployment to taking certain jobs. High retirement benefits and comfortable conditions will induce earlier retirement, thereby increasing the burden on social security. It must also be noted that too many social security expenses will make employers reduce the number of employees and job opportunities, further aggravating social security expenses. It is obvious that when social security is ‘overdone’, it will produce negative effects on employment and economic development.

THE CHOICE OF TARGET MODEL FOR CHINA’S SOCIAL SECURITY SYSTEM China’s social security system was set up in the early 1950s, and consisted of social insurance, social welfare, social relief, and special allowances. Of these,

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social insurance was the priority, and its development falls into three periods: the initial founding period (1949–1965), the chaotic period (1966–1978), and the reforming period (1979 to the present).

The Initial Founding Period During this time, the emphasis was on setting up, standardizing, and legalizing a national social security system. Among the social security acts promulgated during this period were: the Interim Regulations for Unemployment Relief (1950); Regulations on Labor Insurance of the People’s Republic of China (1951); Regulations on Protecting Female Laborers of the People’s Republic of China (Draft) (1956); and Regulations for the Scope and Treatment of Occupational Diseases (1957). These acts and regulations were started by urban state-owned enterprise (SOE) employees, and then spread to employees in collectivelyowned enterprises above the county level. Social security regulations for government organizations and institutions included: the Interim Regulations on Special Allowances for Injuries or Death of Revolutionary Workers (1950); Instructions of Free Medical Care for State Personnel in People’s Governments, Parties, Organizations, and Institutions (1952); Interim Regulations on Treatment During Illness for Personnel of Governments at All Levels (1952); Circular on Maternity Leave for Female Workers (1955); Regulations on Medical Care for Children of State Personnel (1955); Interim Methods for Retirement of State Personnel (1955); and Interim Methods on Dismissing State Personnel (1955). These regulations prescribed guidelines for allowances for illness, old age, maternity leave, and death of state personnel. By the end of 1957, China’s social security system had completed its initial stage and its basic legislation in security items, standards, and management methods. A unified system of social insurance funds was set up in fund raising, management, and distribution, and enterprises were entrusted with the withdrawal and allocation of labor insurance funds in proportion to the total amount of wages. The number of employees in SOEs and collectively owned enterprises reached 24.5 million and 6.5 million respectively. The annual payment in welfare insurance was up to RMB 2.8 billion, taking up 17.9 per cent of the total amount of wages. In the following years, social security provisions increased and its management was strengthened. More detailed regulations were made regarding the retirement and redundancy of officials and workers, including the Interim Regulations of the State Council on the Retirement of Workers and Employees (Draft) and the Interim Regulations of the State Council on the Layoff of Workers and Employees (Draft) published in 1958, and the Regulations on

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Placement of Layoffs published in 1962. Improvements were also made to the free medical care system, and the cooperative medical care system was beginning to be implemented in the countryside.

The Chaotic Period During the chaotic Cultural Revolution (1966–1978), the young social security system was severely hampered and damaged, and the method of fund raising, in particular, experienced a regression. The Proposals for Reforms of Several Financial Rules in SOEs (Draft) promulgated by the Ministry of Finance prescribed that all SOEs should stop the withdrawal of labor insurance funds, and that wages for the retired and workers on long sick-leave and other labor protection expenses should be paid from outside the business account. This practically put an end to the accumulation and unified regulation of social security funds, shifting the burden to the enterprises, turning them into selfsufficient ‘mini-societies’, and making the workers more dependent on them. This antisocial trend brought far-reaching negative drawbacks to China’s social security work and the development of SOEs. After the turmoil of the Cultural Revolution, the local restoration and complementation of the existing social security system began immediately. In 1978, the Interim Regulations on the Placement of the Old, Sick, and Handicapped Cadres and the Interim Methods for the Retirement and Layoff of Workers were promulgated. By the end of 1978, annual insurance benefit expenses reached RMB 7.8 billion, accounting for 13.7 per cent of the workers’ total wages. The number of retired and laid off workers reached 3.14 million, and RMB 1.73 million was paid in retirement and redundancy fees.

The Reforming Period After the Third Plenum of the Eleventh CPC Central Committee, China’s social security system entered a new phase of reform, incorporating the system model, operating mechanism, project composition, management devices, and management system. In the Proposal for Developing the Seventh Fiveyear Plan for the National Economy and Social Development by the CPC Central Committee passed in September 1985, the concept of social security was unambiguously put forward. In the Outlines for the Ten year plan and the Eighth Five-year Plan for the National Economy and Social Development of the People’s Republic of China passed in December 1990, the general guidelines and principles for social security reform were made clear. They included promoting the social security system with a focus on the reform and establishment of pensions insurance and unemployment insurance; gradually setting up an old-

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age insurance system for employees of various types of enterprises; improving the means of unemployment insurance and implementing a multi-level insurance framework; striving to reform medical insurance and work injury insurance; and continuing with the promotion of the cooperative medical care system. The documents of the Fourteenth National Congress of the CPC held in 1992 made it clear that the basic objective of China’s economic reforms was the establishment of a socialist market economy. This has pushed forward the reforms of China’s social security system. At the Fifteenth National Congress of the CPC held in 1997, General Secretary Jiang Zemin called for ‘the establishment of the social security system; implementation of a pensions and medical insurance system combining social redistribution and individual accounts; and improvement of unemployment insurance and social relief system providing basic social security’. He also urged that the government should ‘increase public and social welfare facilities; improve the level of education and medical care; and implement a policy of providing basic needs to city residents in great need’. This has further clarified the objective of China’s social security system. On 5 March 1999, Premier Zhu Rongji proposed for the first time the ‘three security lines’ in the Government Report delivered at the Second Plenary Session of the Ninth National People’s Congress. The three lines are the security of basic living for laid-off employees of SOEs, unemployment insurance, and security for the poorest urban dwellers. Despite a few flaws in their implementation, the three security lines have undoubtedly contributed to the social stability. On 14 January 1999, the Interim Provisions for Raising Social Security Funds were promulgated (Order No. 259 of the State Council), prescribing new regulations on the financial management of social insurance funds. According to the new regulations, the collection of funds for basic pensions insurance, basic medical insurance, and unemployment insurance should be entrusted to a unified tax bureau or social insurance organization. As a result, social security coverage was further extended. Obligatory contribution to pension funds would include SOEs; collectively-owned enterprises; foreign-invested companies; private enterprises; other township enterprises and their employees; and public institutions operating as businesses and their employees. Obligatory contribution to basic medical insurance would include: SOEs; collectivelyowned enterprises; foreign-invested companies; private enterprises; other township enterprises and their employees; government organizations and their employees; institutional units and their employees; private non-business organizations and their employees; social organizations; and professionals.

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Obligatory contribution to unemployment insurance would include: SOEs; collectively-owned enterprises; foreign-invested companies; private enterprises; township enterprises and their employees; and institutional units and their employees. On 19 March 1999, the Ministry of Labor and Social Security issued Orders No. 1, 2, and 3, and promulgated the Interim Methods for the Registration of Social Security, Methods for the Supervision over the Collection of Social Security Funds, and Interim Methods for the Management of Declaration and Payment of Social Security Funds. These methods have provided directions for the standardization of the running of enterprises and the government’s management of social security. Over the years, the relevant government authorities and many scholars have done a great deal of research and made many useful suggestions for the reform and improvement of China’s social security system. However, further efforts need to be made to develop an overall target model and optimal structure for China’s social security system so that by 2010, a unified and multi-level social security system with Chinese characteristics can be established that is compatible with the socialist market economy. Such a system should cover all laborers, and cater to the differences between urban and rural areas. It should be standardized with a high degree of social management. Its features should include the following:

Embodying social equality in a socialist country As stated above, ensuring social fairness is a basic function of the state. China is a socialist country with a people’s democratic dictatorship, with public ownership of means of production. Since class exploitation has been abolished in China, there is all the more reason for social equality to be guaranteed. According to Article 45 of the Chinese Constitution, a citizen of China is entitled to material help from the state and society when he or she is old, sick, or has lost his or her ability to work. The state should develop social insurance, social relief, and medical care to be enjoyed by everybody.

Matching the development level of the country Practices have shown that the level of security provided by a country’s social security system should be on a par with its level of economic development. As its socio-economic development enters a certain stage, a social security system that matches its economic power is called for. Meanwhile, there needs to be a balance between equality and competition, and attention should be paid to whether its overall national strength can continue to support its security

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level. In developing China’s social security system, we have to make sure that it appropriately matches the country’s economic development. High levels of social security will push the cost of social security from national income higher and higher, decreasing reserves and thereby causing damage to the foundations of economic development. At the same time, over-high security will discourage labor and private savings and weaken the dynamics of economic growth. We therefore should not borrow the Western welfare state model nor copy Western experiences.

Ensuring practical equality of citizen rights Social security should cover all the citizens of the country. Every citizen, whether in the city or countryside or working in a public-owned or non-publicowned enterprise, is entitled to the same level of social security. Besides, in developing policies and plans of taxation and collection, attention needs to be paid to intragenerational equality and intergenerational equality (i.e. workers of the same generation and in the same situation should enjoy the same level of social security and the common funds of one generation should not be carried over to another generation).

Carrying on the fine traditions of the Chinese nation From a sociological point of view, traditional culture is a means of social control. The fact that China has sustained such a long history and fine culture has, to a large extent, to do with the emphasis on the family and family relations. The Chinese tradition insists on the mutual obligations between generations. As far as two immediate generations are concerned, the first generation should raise and educate the second generation, and the second generation should support the first generation. In many Western cultural traditions, however, parents are responsible for children while children are not required to be responsible to their parents. Therefore, in setting up China’s social security system, we should carry on our fine tradition of providing for the elderly and develop the relationship of mutual help between family members and relatives, making family security a useful and necessary complement to the social security system.

OPTIMAL STRUCTURE OF OUR SOCIAL SECURITY SYSTEM In my view, social security is a means legally provided by the state and government of solving non-security risks faced by members of society. Nonsecurity risks are those that can overpower almost anyone and which, according to the ILO (International Labour Organization) definition, include old age, illness, unemployment, work injuries, occupational diseases, family overburden,

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the loss of professional ability, and the death of sponsors. Generally speaking, the following are some of the policy issues that need to be carefully considered in establishing China’s social security system: ♦ The basic objective of social security is to guarantee the basic living standards for each social member, excluding such social benefits as free education, free medical care, etc. ♦ Social security needs to be supported and complemented by the self-provided security of individuals, and members of society should be encouraged to strengthen self security through voluntary savings, the purchase of commercial insurance, family pension plans, etc. ♦ Social security is obligatory and requires legislation to force concerned parties to assume corresponding obligations. ♦ Social security should be dominated by the government, which should mobilize all social forces in the establishment of the social security system and provide necessary financial support.

China’s social security system should be a three-dimensional structure in a broad sense, and include four levels (social relief, social services, social insurance, and commercial insurance); four parties (state, society, enterprises, and individuals); and four aspects (unemployment, old age, medical care, and accident insurance). The variables within these three dimensions are all qualitative (nominal or ordinal variables), and their interconnections help form a relatively stable and dynamic social security system with Chinese characteristics.

Four Levels (1) Social relief Social relief refers to the support extended by the government and society to a citizen who is unable to maintain his basic standard of living. In general, the government mainly provides subsidies to families without income or whose per capita income is below the minimum living standard. The subsidy usually takes the form of cash and sometimes is given as coupons (like US food stamps) or in kind (food, clothes, etc.).

(2) Social services Social services refer to the various services provided by the government and society to ensure that citizens enjoy a certain standard of living. Social services in a developed country have a wide spectrum, including: medical care; psychological services; handicapped rehabilitation; culture and education;

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employment; caring for the elderly, sick, handicapped, and orphaned; crime correction; and public welfare. But for a country like China, which will be in its primary stage of socialism for a long time, social services coverage will have to match the level of economic development, including services for the elderly; seriously ill; those with physiological and psychological handicaps; those who have lost the ability to work; and reemployment services for citizens who have difficulty in adapting to technological progress and industrial restructuring because of lack of knowledge and skills.

(3) Social insurance Social insurance is a social system in which the government organizes fundraising from employers and employees and provides compensation for those who have been paying for insurance but have temporarily or permanently lost the ability to work or have lost or reduced their sources of income because of old age, illness, unemployment, or other problems. There is a certain relationship between the contributions and earnings of social insurance, but anyone, as long as he is qualified, can claim insurance money, regardless of the wealth and living standard of the beneficiary.

(4) Commercial insurance Commercial insurance is a social means of economic compensation for property loss or personal injury or death because of natural disasters or accidents. It is also a means of solving non-security risks. In the market economy system, insurance is operated by insurance companies and citizens can choose to buy insurance policies on a voluntary basis. Therefore, commercial insurance is not considered a part of social security. However I believe that commercial insurance can complement social security, as it is an effective and low-cost means of dealing with low probability events such as work injuries, accidents, and serious illness. In special circumstances, commercial insurance bought by enterprises, trade unions, or collectives for their employees should be counted as a part of the social security system. Each of the above four levels of social security should play different but synergistic roles and should not be confused with other levels when related policies are being made or implemented.

Four Parties (1) State As described above, social security is the basic measure the state takes to

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ensure social equality. Therefore, the state should play a leading role in the establishment of the social security system and act as its mainstay. Generally speaking, financial allocations should be the major source of social relief and social services. In some countries, the government also provides financial subsidies for social insurance.

(2) Society One of the essential functions of society is the organization of a great number of individuals to form a force to solve various problems, conflicts, and confrontations. Society, as a result, should play an important role in social security, chiefly through official or non-official organizations based on geographical, professional, or blood ties (e.g. social communities, trade unions, charity organizations, and relatives).

(3) Work units Work units here refer to the employers, including enterprises, institutions, and government departments, who function in social security terms like the employers in Western countries. Work units, because they have signed a labor contract with their employees, are required by law to take on some of the responsibilities of social security, chiefly by submitting social insurance funds to both socially regulated accounts and their employees’ individual accounts.

(4) Individuals An individual should have a sense of social security through his or her own efforts, and try to receive intragenerational reallocations of individual income with voluntary savings. Individuals should be forced by law to save and contribute to the social security system through taxation or donation in order to be entitled to social reallocations of income. Among the four parties, there should be clear responsibilities and obligations for each party. The government should be responsible for its citizens, enterprises for their employees, social communities for their respective members, and individuals for themselves and for society as a whole. Meanwhile, each party should pay social security expenses in accordance with its responsibilities and financial situation.

Four Aspects (1) Unemployment security Unemployment refers to a situation in which citizens with working abilities have lost their working opportunities, including structural unemployment as a

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result of industrial readjustment, seasonal unemployment as a result of seasonal changes in the demands for labor, and ‘voluntary unemployment’ because the workers refuse to accept the working conditions offered. Unemployment security refers to security provided to unemployed citizens in the form of unemployment insurance and/or government unemployment relief for a certain period of time, and efforts to get them re-employed with the help of social services. If the unemployed fail to get reemployed after a certain period of time, they will be treated as citizens having difficulty meeting their basic needs and will receive basic living subsidies from the government.

(2) Old age security Old age security is provided by the government and society to old age workers who have passed the working age to maintain their living standards on a certain level. In China, we should combine the socialization of old age security with our fine tradition of adult children caring for elderly parents. Ordinary retired workers can be paid monthly retirement allowances through their individual accounts and receive the necessary social services provided by society. Widowed or childless old people should be provided with sufficient social services so that they can enjoy their retired life in a relatively better condition. The government should provide those on low retirement allowances with subsidies commensurate with minimum living standards.

(3) Medical care Medical care is provided by the government and society for the prevention and treatment of illness, injuries, and handicaps. It is mainly designed to resolve financial risks in times of serious illness. Medical care therefore takes the form of social insurance and is funded mainly through social financing. Individuals who are sick should be responsible for paying a certain amount of their medical care expenses. Sometimes work units can buy commercial insurance for their employees.

(4) Accident security Accident security is provided to workers when they are affected by work injuries, traffic accidents, etc. Work injuries should be mainly compensated by work units, through temporary relief or the purchase of commercial insurance. Protection against other types of accidents is usually done through the purchase of commercial insurance by work units or by the employees collectively. For the above aspects, we should adhere to the principle of ‘treating them differently while trying to achieve an overall balance’. Since the four kinds of

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security differ in terms of their requirements and frequency, proper institutional arrangements should be made for the sources of funds and the degree of security. Meanwhile, an overall balance should be sought among them so as to make best use of limited funds.

ANALYSIS OF THE DIFFICULTIES IN IMPROVING CHINA’S SOCIAL SECURITY PROBLEM After the target model has been determined, we need to identify the difficulties in the transition from the present situation to the target model and the procedures and methods needed to overcome the difficulties. The following problems need our particular attention during the transition period between the present and 2010.

How Should We Raise the Funds? The financing of the social security system will affect not only its effectiveness and stability, but also the development of the national economy. Different countries might have different practices, but in general they combine taxation and forced savings. Taxation is normally on a cash basis, which means that employers and sometimes employees pay a certain percentage of the total salary (rate of social financing) as a salary tax (or insurance premium), and the government manages the money and uses it for short-term redistribution. This fund-raising model is based on the principle of short-term horizontal balance of income and expense. It is very popular in Sweden, the United Kingdom, and other European countries, and is a traditional method for raising funds for pensions, medical care, unemployment benefit, and other types of social insurance in many countries. Its strengths lie in its flexibility to adjust the percentage of taxation according to changing needs, its strong social nature, ease of operation, minimum need for personal information, and low management cost. However, this model will cause inter-generation redistribution (i.e. the benefits for one generation will have to be paid for by contributions from the next). The balance of income and expense and payment capabilities will vary with the structure and demands of the participants, thus making it difficult to adapt to the fluctuations of economy and an aging population. This fundraising method can also discourage the workers’ initiatives for employment and can have negative effects on labor supply. Forced saving is also known as the long-term accumulation method. The day the workers start their work, the employers and employees regularly pay a certain percentage of their total salary as insurance premium into employees’

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individual accounts, which will work as long-term accumulation funds that can increase in value. The ownership of the funds belongs to individuals and can be claimed as a lump sum or monthly as circumstances demand. This is a fund raising method for social security based on the principle of balance of longterm longitudinal income and expense. This model has been adopted mainly in Singapore and some other countries. It is characterized by its high motivation and transparency and stable withdrawal rate. In addition, it is easy to supervise and collected funds can enter the capital market without difficulty. With the increase of its value as a result of long-term accumulation, it can ensure future payment without causing any inter-generation transfer of burden. But its management cost is higher as it has a higher demand for personal information and a complex information processing system. Since there is a long interval between contribution and earnings, the funds may lose their value when uncontrollable risks (such as inflation, natural disaster, and war) occur. Almost every country in the world is trying to seek an optimal combination of the above two models to form a two-level social security system, not only to ensure the current need of expenses, but also to meet the growing needs of the future. In general, while maintaining the framework of social financing on a cash basis, individual accounts are introduced for long-term accumulation, with the first model used to ensure the basic life needs of the whole nation and the second model used to meet the future needs of the individual. This model is highly flexible. The percentage of contribution can be adjusted according to reserves and necessity, which can help avoid the risk of uncertainty of the longterm accumulation method and solve the problem of insufficient reserves and the imbalance of inter-generation burden. As we have pointed out above, the US social security system has faced serious challenges because of the aging population and other problems. Therefore, a US think-tank, the Committee for Economic Development (CED), has put forward a proposal to set up a two-tier social security system. They suggest that while maintaining the existing retirement plan supported by government taxation, measures should be taken to ensure its solvency, including slowing down the growth rate of earnings of high and middle-level income earners; gradually putting off the retirement age from the present 65 to 70; keeping 62 as the age of early retirement but increasing the discount of retirement benefits; and levying a federal tax on welfare benefits above the amount of contribution by the workers. At the same time, improvements should be made to the equality and economic efficiency of the participants, including: gradually decreasing the benefit level of the non-working spouse; putting an end to the income test for beneficiaries so as to increase the initiative of the

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elderly to work; and extending the coverage by requiring the new employees of the central and local governments to participate in the plan while giving freedom of choice to the employees who have already participated in the retirement plan. On the other hand, to restore confidence in the social security system and compensate for the loss resulting from the slowing down of the growth of present planned welfare, individual private retirement accounts should be set up. Employers and employees are required to contribute 1.5 per cent of the employee’s wages (self-employed workers need to contribute 3 per cent). This kind of forced savings account should attract tax exemptions but needs to abide by related trust regulations, including the stipulation that the fund is not to be used until the individuals have retired. As can be seen from the above, this plan will create a two-tier social security system. The first level is basic welfare, which slows down the growth of the existing ‘defined benefits’ plan to achieve the balance of income and expense, and the second level is the new ‘defined contributions’ plan, which transfers contributions to the individual’s retirement accounts. If the two-tier system is well incorporated, the economic safety network provided by social security at present can survive without causing too much extra burden to future workers. As the reductions of welfare in the existing system are limited mostly to those with a high or middle-level income, the economic benefits of retirees with low incomes will be guaranteed. Individual retirement accounts can provide an additional source of income for all retirees, which is especially valuable to those whose benefits have been reduced in the defined benefits plan. Intergenerational equality will be improved by increasing the proportion of benefits produced within the system and providing investment returns for the contribution of young workers. Some Chinese scholars and government officials are interested in the central public fund system practiced in Singapore. They are of the opinion that at a time when the Chinese economy is not highly developed, the government is not in a position to provide high level social security and therefore should follow Singapore’s example and implement the policy of self-saving for selfuse and self-security. The government can only provide preferential policies. Public funds are in fact an accumulation of social security funds in the form of forced savings, which also provide an important financial source for economic development. According to the Singapore Central Public Fund Management Bureau, current central public funds are managing housing, medical care, old age security, and 16 related plans. People are encouraged to support themselves in old age through required savings; people who cannot afford the contributions

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for old age security must rely on the contributions of their family members; and individual contribution accounts cannot be redistributed, which is only a mechanism to encourage individual savings through work. Forty per cent of employees’ wages in Singapore are contributed to public funds, the contribution being divided between employers and employees equally. The part paid by employers can be entered under production costs and the part paid by employees is deducted from their salaries. The maximum monthly wage payable to public funds is S$ 6,000, which means that the maximum amount paid to the public funds by employers and employees is S$ 1,200 each. This 40 per cent enters three accounts: 30 per cent goes into a general account which can be used for housing and investment; 6 per cent goes into a health savings account which is used to pay for expenses of hospitalization and medicine; and the remaining 4 per cent goes into a special account which is used as old age security. In 1995, the aggregate national savings of Singapore were 51 per cent of its GNP, and 93 per cent of the savings were public funds, which indicates that public funds savings have become important for supporting national construction and development plans. Despite an effective incentive system, the public funds system has its weaknesses. It is not a social security system with a social insurance nature, but a forced savings plan which does not redistribute social resources. It is merely a forced redistribution of income for the same person at different ages and different times. Besides, this practice does not cover the self-employed (over 20 per cent of the country’s population), women without contributions, or the unemployed or disabled. For those with low incomes, the Singapore experience shows that forced savings are not sufficient for old age security. Government support is favorable only to those with high or middle-level incomes. It is obvious that there are inherent defects in the operating principles of a public funds system based on forced savings. The social goal of social security is to provide everyone with security needed for basic living. However, people with low incomes cannot receive the necessary old age security, even though they need social security the most. High-income earners benefit most from the Singapore model, which violates the principle of equality emphasized in most social security systems. In 1986, the Chinese government began the social financing system for pensions insurance in SOEs at the county level. In 1991, it was required that individual pension accounts be set up and that the social financing system be raised to the provincial level. At the Third Plenum of the Fourteenth CPC Central Committee, the principle

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of ‘combining social financing and individual accounts’ was put forward for the first time. In March 1995, the State Council issued the Circular on Deepening the Reform of Pensions Insurance System in Enterprise, which demanded the establishment of a basic old age security system combining social financing and individual accounts. The final objective was to set up a multi-level pensions insurance system which needed to be supplemented with enterprise insurance and personal savings. In 1997, the standard of socially financed pensions was set, the proportion to be paid by individuals was standardized, and the management of pension funds was centralized. In January 1999, the Interim Provisions for Social Insurance Collection were issued, requiring businesses to pay for their employees’ basic pensions insurance, basic medical insurance, unemployment insurance, and work injury insurance, totaling 29 per cent of the average wage. Employees are required to pay just 7 per cent of their wages. Of the total contributions, which account for 36 per cent of a worker’s wages, 21.2 per cent goes into the social financing fund and the remaining 14.8 per cent goes into the employee’s personal account. China’s social security is thus established mainly through forced contributions from enterprises and personal savings. The government takes only limited responsibility. According to the regulations, the central and local funds are responsible for one third of the three security lines, but in fact the proportion that the government pays is even higher. For example, in 1999, a total of RMB 19.5 billion was raised as a basic living security fund for redundant workers, out of which 50.8 per cent was contributed by the government, 20.5 per cent by society, and 28.7 per cent by enterprises. We can use the CGE (Computable General Equilibrium) model to find an optimal combination of cash basis and long-term accumulation. The simulated calculations indicate that these two methods both similarly affect nominal GDP, real GDP, total social investment, and the demand for labor. However, forced savings have a greater impact than social security taxation, and the impact becomes stronger with the increase of savings and taxation. Therefore, raising social security funds through the collection of social security taxes not only saves social costs, but also facilitates management. This is in line with the direction of the ‘shift from fees to taxes’. As the beneficiary of social security is the individual, social security taxes should be related to personal income. Therefore, all taxes related to personal income (e.g. personal income tax, savings interest tax, and inheritance tax), in my view, should be combined into a social security tax and the tax rate should be adjusted. The collected money should be used specifically for social security. At the same time, the proportion to be paid by businesses and individuals, and the proportion of social financing and individual accounts, should also be

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adjusted. For example, the total percentage of contribution can be lowered from the original 36 per cent to 32 per cent, of which 24 per cent should be paid by businesses and 8 per cent by individuals. Half of the collected money should go into social financing funds and half into individual accounts. With the increase of life expectancy and the aging population, there appears to be a tendency to raise the retirement age in pensions insurance reforms in many countries. Studies by the ILO show that by raising the retirement age from 60 to 65, pension costs can be reduced by 50 per cent. Therefore, some Chinese scholars also suggest extending the age for retirement, which, however, runs counter to the present lack of jobs in China. We propose that after 2005, the retirement age for intellectuals be raised to 65 for males and 60 for females. The extension of social security coverage is another important source of social security funds. Theoretically, the social security system should cover all laborers and citizens. At the moment, China’s social security coverage is far from extensive, insurance contributions have not been standardized, and social security funds are still inadequate. Therefore, we need to include all laborers in the social security system as soon as possible, which will not only increase sources of funding for social security but also promote social stability and economic development. The CGE model shows that if we include all the employees from collectively owned and other types of enterprises in the social security system, and adopt a uniform system and contribution percentage, social security income will increase by 6.6 per cent. Keeping compensation (salary plus social security contributions) constant, salaries for the employees of collectively owned enterprises and other types of enterprises will decrease by 5.5 per cent and 14.4 per cent respectively. Evaluated against all parameters, the impact on the overall economic system is very small. It is therefore feasible to include all the workers in the social security system. If we then try to include urban employees of private enterprises, the selfemployed, or other types of employees in the social security system, social security income will increase by 26 per cent, while the GNP and government deficit will remain more or less the same. Although there will be some negative impact on the income of these people, it will be beneficial to the economic system as a whole. In addition, as these people are relatively young and have higher incomes, the pensions insurance will not be a big burden for them. If they are included in the social security system, there will be more funds available for the social insurance of the workers, thus relieving the pressure of insufficient funds to pay for insurance expenses. And if we go still further and include farmers, who make up 70 per cent

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of the country’s population, into the social security system, and separate the social insurance for urban and rural residents, the simulated results show that the impact on the economic system is still acceptable. Holding compensation constant, the extension of social security coverage and reasonable readjustment of the proportions of contribution will make it feasible to include all laborers, including farmers, and increase the percentage of social insurance in GNP from 2.8 per cent to 10 per cent. However, there would be many problems if we included farmers in the overall social security system. Firstly, as farmers have a low income, it is difficult to fix the income base for social security contribution. Secondly, farmers generally have a poor sense of social security and are more inclined to depend on family security. Thirdly, as farmer live in scattered areas and have poor transport and communication facilities, and as social security networks have not been properly set up in the countryside, it would be difficult to collect social security contributions from farmers. Fourthly, as the corresponding taxation and banking systems are incomplete in the countryside, the management of security funds would be a problem. It would, therefore, be difficult to include all rural laborers in the social security system within a short period of time. We propose that experiments be conducted in areas of the countryside where the local economy is developed and farmers have a higher income, and where there are better taxation, banking, and information facilities. On this basis, by 2010 we can gradually try to include all rural laborers into a social security system commensurate with rural development levels. Further research is needed on this issue.

Who is Responsible for the Management of the Funds? After World War II, western European governments took up the responsibility of improving the common welfare of all their citizens and played a great role in promoting the development of the social security system. However, too much governmental intervention can bring about negative effects. The government has too great a share of resources, which weakens the market mechanism. If the government covers all security items, it encourages some people to be dependent upon the state and on social security. The extension and growth of social security and social welfare inflates management and gives rise to waste, inefficiency, and bureaucracy. Therefore, the socialization of social security management has become the concern of all nations. Chile is a good example of the reform of pensions insurance. In 1980, its government decided to hand over the management of pensions funds, originally controlled by 32 government departments, to 20 private pension

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fund management companies licensed by the government. Each company was allowed to manage just one fund and was responsible for its operation. The revenues generated were distributed and transferred to individual accounts. Additional items were added to the pensions insurance (e.g. work injury insurance and family member insurance, but with additional contracts to be signed). Management expenses (cost plus profit) of these companies would depend on the competition among them. Workers could choose to join any of the pension fund management companies and could transfer between companies. The labor department was responsible, on behalf of the government, for supervising the companies, including their loans, investments, and the issuing of various bonds, so as to minimize the risks of fund operation and protect the rights of laborers. Since its reform and opening up, China’s management of social security funds has been on its way to socialization. Based on the principle of the separation of administration and business, the labor administration departments under the State Council are responsible for the collection and supervision of social security funds throughout the country and the local labor departments at all levels are responsible for the collection of social security funds within their jurisdictions, while the actual management of social security funds is handed over to professional social security institutions. These institutions are set up by the government for the operation and management of social security. They differ from the government’s administrative departments for social security but are nonetheless closely related, as they are entrusted by the government to do the work. Such a practice easily gives rise to ‘non-separation of administration and business’, embezzlement, and corruption. Some funds are even in the red. Further research is therefore needed on how the government should exercise effective supervision over social security agencies and ensure the increase of value of social security funds, while at the same time minimizing its intervention in the daily operation of these agencies. In order to maintain and add value to social security funds, the government has set strict restrictions on their investment: they can only invest in government bonds and deposit in banks but are not allowed to invest in the stock market; employees in social security institutions are to be paid by the government; and social security institutions are not allowed to claim compensation from social security funds. This, on the one hand, ensures the safety of social security funds and prevents social security institutions from abusing their power by illegally using funds. On the other hand, it restricts the autonomy and initiatives of social security institutions. Therefore, I suggest that on the basis of the establishment of a strict supervision mechanism, social institutions should be

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allowed gradually to invest some security funds in the stock market and use most of the generated profits to add value to the funds. To prevent social financing funds from occupying individual accounts and increasing potential risks, I suggest that the two accounts be managed separately. Social financing funds can still be managed by designated institutions, but their operations must be closely supervised and management transparency should be improved. Management of individual accounts can be entrusted by collectives or individuals to commercial banks or trust and investment companies licensed by the government.

Who Should Pay for the Transformation Costs? The transformation of the social security system will naturally raise the unavoidable problem of the payment of debts inherited from the old social security system. Social security debts should be dealt with carefully and should not be allowed to devaluate in any way. Social security reforms affect the interest of three groups: retired workers (‘old’ people), workers who began to work in the old system but who have not retired (‘middle’ people), and those who have not yet entered the labor market (‘new’ people). No cost is involved for ‘new’ people. But for old and middle people, there will be the problem of whether the pension equities from the old system should be acknowledged and how they should be compensated. In the cash-basis system in many countries, the social security system does not have an independent budget and, as a result, social security debts are often implicit. In the academic community, they are referred to as Implicit Pension Debt (IPD). However, during the transition from the cash-basis to the long-term accumulation system, these implicit debts will become visible and turn into transformation costs. In 1981, Chile carried out a thorough reform of its cash basis system and set up a new pension system under which the individual contributions of employees and individual account accumulations were combined and the funds were managed by private management companies. Major changes included implementing forced savings, setting up individual accounts, privatizing the function of forced savings, and turning savings accumulations into pensions in accordance with the indexed annuity market. The government required all employees in every publicly and privately owned enterprise to participate in pensions insurance, transferring 10 per cent from their wages into each employee’s account as the source of their pension funds. Employees had the freedom to entrust the management of the pension fund to any of the pension fund management companies. If employees did not contribute the minimum

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by retirement age (65 for males and 60 for females), so long as they had been insured by the pensions organizations for 20 years, the government would bridge the gap. When an employee retired and became the beneficiary of the pension plan, he could choose to use the accumulation in his individual account at different times or in the form of an annuity. In the process of transition, Chile adopted the practice of the ‘old system for old people’ and the ‘new system for new people’. The middle people could choose to join the old or new system. The new Pensions Act in Chile stipulates that those who entered the labor market before December 1982 could have five years to decide whether to join the new system, but after that time everybody would have to participate in the new system. Retirees would generally use the old system. As the returns on investment reached 11 per cent in the first year of the new system, people were very active in participating in tile new system. By the end of 1981, over 1.4 million people (40 per cent of the labor population) had transferred to the new system. The government first of all clarified that social security debts would consist of three parts: the pension equities of the employees who had retired before the new system was set up; the future pension equities of the employees who had not retired but decided to stay in the old system; and the accumulated equities of the employees who had decided to transfer to the new system. For the first two categories, the government paid directly from ordinary financial revenues, and for the third category, the government paid by issuing ‘registered bonds’, the amount of which was based on the contributions of the employees in their working years. In this way the government paid off its debts and put the bonds in the pension fund management companies chosen by the employees. The annual interest rate of the registered bonds was 4 per cent, but these bonds could only be redeemed after their owners had retired or had become disabled. Chile’s social security reform has seen remarkable achievements. By 1994, over five million people (about 95 per cent of the total working population) had participated in the social security system and the accumulated savings had increased from US$ 300 million (0.9 per cent of its GDP) in 1981 to US$ 22.4 billion (42.2 per cent of its GDP). The substitution rate of pensions (the ratio between pension and salary in the last year before retirement) increased from 50 per cent in 1980 to 70 per cent, while the actual income of employees increased by 10 per cent with the decrease of the contribution rate. The success of the reform can be attributed to a number of factors, such as the corresponding reform of the macro economic system, a strict legal system, and close supervision over the operation of pension funds by the government. But the major reason was that the government had succeeded in solving the problem of the transformation cost.

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As China has long practiced a low-income distribution policy, workers’ wages had six deductions before distribution, including one for pensions insurance. However, the deducted part did not accumulate in the form of pension funds, but was used by the government directly as production funds in investing in SOEs. As a result, employees’ pension equities were directly expressed as government debts. From the early 1950s to 1978, the annual increase of the average salary was below 0.38 per cent, and by 1978, workers’ wages were only RMB 615, even lower than in 1957. In 1978, per capita savings were only RMB 22, but the accumulation rate had increased from 21.4 per cent in 1952 to 43.8 per cent in 1978. Employee pension equities were included (it is estimated that China’s implicit pension debts were about RMB 1,000– 2,000 billion), for which the government had to be responsible during the transformation. In a transition from the enterprise pensions insurance system to the new system combining social financing and individual accounts (hereafter referred to as ‘unified accounts’), the debts generated in the old system became the transformation cost. The Chinese government chose to use the premium earnings generated by social financing in the ‘unified accounts’ to compensate for the transformation costs. When the premium earnings of the social financing were not sufficient to pay for the current pensions, the premium earnings of individual accounts were cashed. As a result, the ‘unified accounts’ system which was supposed to have the function of accumulation was in fact turned into the cash basis system. The practice of using unified accounts to cover the transformation cost was one of the major factors contributing to the imbalance of current income and expense. In recent years, governments at all levels have tried hard to ensure that pensions were paid in full and on time. According to a report, in 1999 a total of RMB 188 billion was paid in pensions throughout the country, with a payment rate of up to 98 per cent. In addition, RMB 13.3 billion was paid as historical debts to old age pensioners, out of which RMB 5 billion was raised by local governments and RMB 8.3 billion was paid by the central government. But the problem of current balance of pensions remains unsolved. Since we expect the working generation to pay for the retired generation and prepare for their own retirement at the same time, this will inevitably lead to a high rate of contribution and a low rate of actual payment. In the principle of ‘determining the contribution by expense with a little surplus’, ‘expense’ refers to the cost of supporting the retired generation and ‘surplus’ refers to the accumulation for the working generation. It is impractical to rely on employees to support two generations.

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As the revenues of the ‘unified accounts’ are used to cover the transformation costs, there is nothing left in individual accounts. However, the nominal compound amount in individual accounts is owned by individuals, and as result there will be enormous ‘hard debts’ in the future. The assets in individual accounts generated by the principle and interest will create a gap in the ‘unified account’ system, which will grow bigger as time goes on. According to old-age social insurance regulations, the individual accounts of employees should take up 14.8 per cent of their total wages at the same interest rate as banks in the same period. With the increase of wages, the assets (principal plus compound interest) in the individual accounts will increase rapidly. In addition, as employees own the assets in the individual accounts and the payment of pensions is obligatory, the sustainability of the unified accounts’ will be seriously challenged. Experience shows that the problem of ‘empty accounts’ cannot be solved through ‘unified accounts’. The only choice is for government to cover the transformation cost. The final responsibility for the social insurance system rests with the government. Instead of ‘covertly paying back the explicit debts’, the government can define the responsibilities and ‘overtly pay back the explicit debts’ so as to ensure the future balance of income and expense of the unified accounts. However, as the cost of the transformation is enormous and the process is going to last a long time, it is essential to solve the problem through various measures. In some areas, the problem of transformation costs was solved through a lump-sum compensation or the ‘purchase of working years’, but its effectiveness remains to be seen. Owing to the limitation of state funds and lack of scientific methods of inspection, it is likely that the problem of transformation cost might not really be solved. It might be wise for China to follow Chile’s example and try to solve the problem over a relatively long period. First of all, ways should be found to calculate scientifically and reasonably the individual equities of employees in line with their years of service, rank, and gender. After confirmation, the government can issue and distribute ‘registered bonds’ to the employees of SOEs. These bonds can be put into the individual account with an annual interest, and all employees can withdraw annually after retirement over a period of 15 years. This will allow the government to absorb the transformation cost over a long period and avoid being overburdened. As employees are ensured of future security, it will also be more conducive to social stability and economic development. The money needed to cover the transformation cost can be listed as an item in the central and local annual budgets, and can be complemented by selling some of the state-owned assets, issuing short-term bonds, or using part of the social financing funds without affecting the current balance.

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Where Can Those Made Redundant Go? As a result of the interaction between the traditional ‘low wages and high employment’ policy and the narrow coverage of the social security system, SOEs have been the main channel of employment, resulting in overstaffing and inefficiency. Workers’ wages, bonuses, and other benefits such as housing, pension, and medical care were all covered by the enterprises, resulting in the so-called ‘iron bowl’. In addition, due to a lack of incentive and supervision systems, many people were not motivated to learn or innovate, but instead grew more and more dependent on the enterprises and the state. The survival and development of enterprises were further endangered by structural readjustment and technological progress. Therefore, ‘reducing the number of employees to improve efficiency’ has become inevitable in the reform of SOEs and the placement of those made redundant has posed a big challenge to China’s social security system. The employees in SOEs have been made redundant for a number of reasons: SOEs have shut down because of sluggish sales; production has changed as a result of structural adjustment; there are too few job opportunities for too many people; there has been a lack of adaptability to technological advances; and, streamlining has occurred. As the market has long been sluggish while competition has become increasingly intense, the economic efficiency of many enterprises has decreased sharply, and some of them cannot even afford to pay their employees. Given this grave situation, the only choice for these enterprises is to lay off some of their employees. However, as China’s old social’ security system was built mainly on enterprises with a very low level of socialization, serious problems crop up as soon as these enterprises get into trouble. To protect the interests of people made redundant, the related government departments set up a reemployment project as early as the end of 1993 and began experiments in Shanghai, Shenyang, Qingdao, Chengdu, Hangzhou, and other cities in early 1994. In March 1995, after being approved by the General Office of the State Council, the project began to be implemented throughout the country. In 1997, the State Council was called on to integrate the reemployment project with the economic structural adjustment and the deepening of the reforms in SOEs. Throughout the country, leading groups and ad hoc agencies were set up for the reemployment project. The central and local governments also issued a series of preferential policies to encourage reemployment. For example, the Ministry of Labour Security and the State Administration of Taxation have recently announced that business registration procedures should be simplified for unemployed workers who want to be involved in community services,

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and there will be a three-year exemption of operations tax, income tax, and administrative charges. For those who want to start private businesses or family handicraft businesses, departments of commerce and industry administration and urban construction should complete the approval procedures as soon as possible and grant one-year exemptions of administrative charges. A t t h e h e a r t o f t h e re e m p l o y m e n t p ro j e c t i s t h e e s t a b l i s h m e n t o f reemployment service centers, whose function is to take care of laid-off workers, provide them with job training, help them find new employment, distribute basic living and medical care expenses, and pay their pension and other social security expenses. But if someone fails to be reemployed within three years, their labor contract with their former enterprise will expire. In the past few years, the reemployment centers have played important roles in improving labor quality and protecting the basic living security of people made redundant. According to reports, by the end of 1999, out of 6.5 million redundancies, 4.9 million had found new jobs. Ninety-three per cent of those who were unable to find new employment had entered reemployment centers and 97 per cent had received basic living expenses. It was estimated that by 2000, the number of the unemployed in SOEs would reach 12 million, only 5 million of whom could find new employment. The problem of reemployment remains. People made redundant from SOEs can enjoy as much as three years’ security when they enter reemployment service centers, which is obviously conducive to social stability. However, as the increase of job opportunities lags far behind the growth of the labor force, and most of the laid-off workers are not qualified for positions provided by the high-tech and foreign-invested companies, it becomes very difficult to get most people re-employed. It therefore requires efforts from all sides to open new channels of employment and create favorable conditions for SOEs to get rid of redundancy and increase efficiency. As far as enterprises are concerned, they should first concentrate their ‘major forces’ on developing their major businesses. They should separate the major from the minor businesses, and give autonomy of operation to the supplementary workshops or branches or even allow them to merge with businesses in the same industry to achieve the economy of scale. But in the meantime, they can maintain business relations with these branches. They should separate social functions, handing over the attached schools, hospitals, and other social service institutions to the local government for unified management. They can develop the labor export business by seeking overseas project contracts. They can encourage those made redundant to start small service businesses. They should terminate, as soon as possible, labor contracts with those who have been implicitly employed or have left the reemployment

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centers. Finally, they should allow those who meet the standards to have early retirement. In a word, enterprises should try to reduce the number of people who enter the reemployment centers, in order to relieve burdens on the government and themselves and so that the ‘reduction of employees’ can really result in an ‘increase of efficiency’. Besides continuing to help laid-off workers to find new jobs with preferential policies and organizing social forces to support the reemployment project, the government should adopt different measures to help them according to their respective conditions. For example, young workers under 35 can go to vocational schools and enjoy the same treatment from the reemployment center, but should leave the centre and terminate their labor contracts with the enterprises upon graduation. Some can try to find jobs by themselves. Their labor contracts with the enterprise can be kept for three years, during which the enterprise will pay for their pensions insurance and unemployment insurance but will not pay for their basic living expenses. Males between 35 and 50, and females between 35 and 45, should be the priority of the reemployment service centers. Those who wish to find jobs themselves can keep labor contracts with their former employers. For those who have been in the reemployment centers for three years but still have not found jobs, their labor contracts with the enterprises can be terminated in accordance with the regulations and they can receive compensation as their past pension benefits. What is most difficult is to change the mindset of those made redundant from SOEs. According to a survey, as the employees of SOEs have long been accustomed to the ‘big pot’ under the planned economy system, what they are most concerned about is not the decrease of their incomes but maintaining a sense of stability, safety, and belonging. They prefer to keep their previous benefits, positions, privileges, and working environments, and as they get older this tendency becomes even more pronounced. Most workers realize that it is necessary to reduce the number of employees to improve efficiency, but most of them want to keep their jobs and insist that business leaders should be careful, fair, just, and open in deciding who is going to be laid off. Those who have already been put on the list to be laid off still wish to receive various benefits from the state and the enterprises. Some would rather stay at home than leave the enterprises to find new jobs, even when, the enterprises have already been closed and are unable to pay their basic salaries. Some of them, fearing that they will have to terminate labor contracts with their former employers after three years, even refuse to enter the reemployment service centers. This phenomenon is referred to by some scholars as the ‘attachment’ to the enterprises by the laidoff workers.

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There are some laid-off workers who hold biased views regarding the choice of jobs. Some are unwilling to take up service jobs. Some are even unwilling to work in township enterprises or non-public enterprises. Many workers know little about government regulations and rules regarding reemployment. A few of them still have doubts, thinking that entering the reemployment centers is just a temporary measure by the government so as to terminate their labor contracts in three years. The first measure to be taken to solve the above problem is to provide policy education and psychological counseling, helping workers made redundant to change their mindset towards employment. Meanwhile, China should step up in setting up a socialized social security system and reduce the worries and anxieties of laid-off workers. We believe that being laid off is a special unemployment phenomenon in China, and with the development of the country’s economy and the improvement of the social security system, laid-off workers should be put into the unemployment security system. It is reported that the government in Jiangsu has announced that by the end of 2002, enterprise reemployment centers will be completely closed and that laid-off workers will be considered as unemployed and will be directly pushed towards the labor market for reemployment.

CONCLUSION The social security system is an integral part of the market economy system, a necessary means of maintaining social stability and economic development, a basic tool for the government to ensure social equality, and a policy tool in influencing people’s consumption and employment behaviors. In the process of establishing the socialist market economy, social security should be the embodiment of socialism. At a time when the number of SOE lay-offs and the cost of transformation have increased, the setting up of a social security system in line with China’s realities is of great significance. By 2010, we should have set up a social security system with Chinese characteristics that agrees with the socialist market economy and covers all laborers with differences between the rural and urban areas. It should be standardized in regulations, reasonable in cost and benefits, and highly socialized in management. It should also be unified, orderly, and multi-leveled. In addition, the system should embody the nature of socialism to ensure social equality and fairness, meet China’s level of development, and ensure the actual equality of civil rights while maintaining the fine traditions of the Chinese nation.

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The optimal structure of China’s social security system should be threedimensional in a broad sense, including four levels (social relief, social services, social insurance, and commercial insurance); four parties (government, society, work units, and individuals); and four aspects (unemployment, old age security, medical care, and accident insurance). The variables in the three dimensions are all qualitative (nominal variables or ordinal variables) in accordance with the principles of clarifying the scopes and complementing each other; sharing reasonable responsibilities, and achieving overall balance while retaining differences’, constitute the optimal structure of our country. The interaction and mutual influence between these variables contribute to a relatively stable and dynamic social security system with Chinese characteristics. In raising funds for China’s social security system, we should seek an optimal combination of the cash-basis system and long-term accumulation system. It is suggested that taxes that relate to personal income be expanded into social security tax, the rate of contribution and proportion to be shared be adjusted, and the coverage of the social security system be expanded to all employees. We should also study carefully and implement the social security system for laborers in the countryside. After 2005, the retirement age for intellectuals can be postponed to 65 for males and 60 for females. To prevent social financing funds from using the accumulations in individual accounts and resulting in ‘empty accounts’, it is suggested that the two accounts be separated in management. The former can be managed by institutions designated by the government, but their supervision and management transparency should be improved. The latter can be entrusted by enterprises or workers themselves to commercial banks or trust and investment companies licensed by the government. After the establishment of a strict supervision mechanism, social security institutions should be allowed to put some of the social security funds into the stock market and use most of the generated profits as added value so that social security funds can be used more effectively. In the transition from the system of enterprise pensions insurance to the new system combining social financing and individual accounts, the pension debts to the workers formed under the old system become the cost of transformation. The practice of using ‘unified accounts’ to cover the transformation cost is one of the important factors contributing to the imbalance in current income and expense, and the empty individual accounts will increase the future risks. We suggest that the government make clear the responsibilities of respective parties for the cost of transformation. However, as the cost is enormous and longlasting, various measures should be adopted to solve the problem. While continuing to ensure that basic living expenses are paid to laid-

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off workers, giving preferential policies to help them to get reemployed, and organizing social forces to support the reemployment project, the government should adopt different measures in line with the different conditions of laidoff workers. Enterprises should try to reduce the number of people entering reemployment service centers so as to reduce the burden on the government on the one hand and achieve the effect of ‘reducing the number of workers to improve efficiency’ on the other. With the development of the national economy and the improvement of the social security system, the laid-off workers should be gradually incorporated into the unemployment insurance system. Completed on 26 March 2000

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7

Chapter

A Systematic Analysis of the Housing Reform in China’s Urban Areas

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A REFORM OF GREAT SIGNIFICANCE Housing systems comprise a wide range of laws, regulations, and policies in construction, distribution, exchange, and management. The establishment and improvement of housing systems are related not only to the existence and progress of mankind, but also to social stability and economic development. With the development of science and technology and the progress of society, people have increased their demands for housing. Housing, therefore, has become a priority of social and economic development in many countries. As early as in 1933, the Athens Charter endowed a city with three functions: residence, work, and pleasure. The second United Nations Conference on Shelter held in June 1996 in Istanbul defined ‘a proper shelter for everyone’ and ‘the sustainable development of human residence in an urbanized world’ as a ‘subject of global significance’. The Istanbul Manifesto (hereafter referred to as the Manifesto) stressed that the challenge facing human housing is global, and cooperation needs to be developed among international, national, and local governments to solve the world’s housing problem and to improve the living environment of human beings. International communities need to strengthen their financial assistance and technological transfer among countries. According to the Manifesto, the number of residents in urban and rural areas should grow in a balanced way. If housing construction in rural areas is neglected, a large number of the rural population will flow into the cities and make the urban housing problem even worse. The United Nations (UN) designated 1987 as the ‘International Year of Shelter’. China, among 130 other countries, registered and participated in the activities held by the United Nations. The 1982 UN resolution, in which the year 1987 was designated as the ‘International Year of Shelter’, proposed ‘to provide the homeless, by the year 2000, with a shelter with tap water and drainage pipes and proper public transportation, improve the urban infrastructure, and prevent the overexpansion of cities’. The objective was ambitious. According to one report, over one billion people around the world are still in need of shelter, among whom 500 million city dwellers are living in extremely poor conditions and 100 million people are homeless. Half of the population in certain large African, Latin American, and Asian cities are living in ghettoes or simple sheds. Moreover, with the rapid increase of the world’s population, the housing problem will become even more acute. In 1997, the sixteenth session of the United Nations Population and Residence Commission passed a resolution demanding that governments lose no time in developing or implementing their own housing strategies and policies.

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China is also facing a serious housing problem. As a result of the longpracticed policy of high accumulation, low consumption, high employment, and low salary under the planned economy system, housing construction has been planned in accordance with the state infrastructure investment plan. Governments at all levels and state-owned enterprises (SOEs) and institutions secured over 90 per cent of the government’s construction funds, financing only a small part of projects themselves. All funds had to be brought under the control of the state infrastructure scale. The state distributed homes to employees, via government organizations, at low rents (only RMB 0.1 per m2 per month). As a result, housing became a sort of welfare benefit, and the state was even responsible for its maintenance. From 1958 to 1977, under the guidance of the leftist principles of ‘production first, life second’ and ‘work first, house next’, investment in housing construction declined. By 1978, the per capita living area for urban residents had declined from 4.5 m2 in 1949 to 3.6 m2. Many families were in desperate need of shelter, and the insufficient housing supply had become a serious social problem. After China’s reform and opening up, the weaknesses of such a housing system became increasingly prominent. National finances were no longer able to meet the increasing demand of employees for housing and the huge expenses of maintenance and renovation. The housing construction funds obtained by each enterprise varied so much that their employees enjoyed widely different levels of housing. Employees regarded the state-assigned residences as their own property, and refused to return them when they went abroad or found a high-paying job in a foreign-invested company. Some leaders, by abusing power for their own interests, occupied more houses than allowed and even occupied state-owned houses by force for their children, grandchildren, and other family members. As early as in September 1978, Deng Xiaoping pointed out that the solution to the housing problem could include a variety of means, such as allowing individuals to build houses with government support to be reimbursed in installments. The construction materials could be provided by the government and there were also many potential sources of private funding. Deng emphasized that the building industry was an important sector for increasing public revenue and accumulation, and should be given priority in long-term planning. On 5 April 1980, in a talk with relevant central leaders, he said: ♦ With regard to the housing issue, a series of policies should be developed on urban housing construction and distribution. Urban citizens can purchase or build a residence on their own. Not only can the new buildings be sold, but also the old ones.

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♦ Houses can be purchased at a lump sum, or by installment in 10 or 15 years. When the residence is sold, the rent should be adjusted so that people will feel it profitable to buy a residence. If the rent is too low, nobody will buy a residence. In deciding the rent, a number of factors need to be taken into account: location (downtown or remote areas, urban or rural areas) and transportation (convenient or difficult). When the rent is raised in the future, the low-income earners shall be given a subsidy. All these policies shall be consistent. In housing construction, joint investment or private investment with government support should be encouraged. Even an individual can be allowed to find a way out on his own. In the rural areas, new designs should be developed. Instead of the old-fashioned four-walled courtyard house, multi-storied buildings can be built. This can help save the arable land. The type of multi-storied buildings should cater to the needs of different regions and different residents.

These far-reaching words laid the framework for China’s housing system reform, and with them the reform started both theoretically and practically. The significance of the reform of the urban housing system can be summarized by the following four principles: ♦ Reflecting the principle of distribution according to labor and ensuring social fairness. As China will stay in the primary stage of socialism for a long time, a variety of allocation forms, with distribution according to labor at their core, should be adhered to and improved. If residence is still to be allocated in kind as a sort of welfare benefit, the principle of distribution according to labor can hardly be represented. As long as a person works for the same enterprise, he has the same right to ask for a home, regardless of his own contribution, performance, or educational background. The increasingly shrinking gap in salaries and the practice of allocating housing in an egalitarian way is quite contrary to the communist principle of distribution – each according to his ability and to his work. This is obviously detrimental to the employee’s socialist initiatives. Because of the difference in the construction funds secured by different enterprises and the resulting difference in distribution standards, employees with similar backgrounds may differ greatly in their housing conditions, which contributes to the unfairness in housing distribution. By way of housing reform, the distribution of housing will be carried out in the form of cash and become part of the employee’s income. ♦ Meeting changing consumer needs. With social, economic, and technological development, increased income, and changes in family population and structure as well as in the workplace and nature of work, consumers will have new needs concerning the space, location, size, and interior decoration of their homes. Under the old system, residence was distributed as a form of welfare in kind, and new needs would not be taken into consideration until the next allocation. Very often, such needs would not be met, and every round of distribution would present great trouble. By way of housing reform, the distribution of residence can be implemented in the form of currency and the changing needs of consumers can be met through market exchange. Thus, the quality of people’s lives will be improved. ♦ Promoting the development of the national economy. Domestic and international experience has showed that housing construction is an industry with good

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consumption potential and a high industrial correlation, but with a low technology barrier. It can promote the development of dozens of industries such as construction, building materials, light industry, and electronics. In addition, it can create a great number of job opportunities and boost economic growth. It is estimated that in China every RMB 100 investment in housing will create RMB 170–220 of demand for related industries and that every RMB 100 in sales of residences will promote RMB 130–150 in sales of other commodities. Therefore, an increase of 10 per cent in housing construction will increase GDP by 1 per cent. Every 100 job opportunities in the housing industry will create another 200 job opportunities in related industries. Through the reform of the housing system, the demand of employees for new homes will be stimulated, which will in turn promote housing construction and the development of the national economy. ♦ Preventing corruption. Under the old system, in which housing was regarded as welfare and distributed in kind, government officials and business leaders were inclined to abuse their power for their own benefits, such as using public funds to build or decorate their own houses; securing public housing for their children, grandchildren, and relatives; being partial to their friends and relations in the course of housing allocation; or illegally selling or renting public housing. Such corruption has since roused great indignation among the public. Through the reform of the housing system, leaders are no longer granted the power of allocating residences, which effectively prevents corruption in residence allocation.

In summary, the reform of the housing system is of great significance in China. It will be a long and arduous process, with obstacles from many sides. In developing a target pattern for reform, we need to combine international experience with China’s realities. We need to apply the theories of system engineering, economics, and behavioural science, and study various cases to identify and solve the difficulties in implementing the reform. Strategies and measures should also be developed to help realize a transition from the present system to the target pattern.

The Difficulty of China’s Housing Reforms Since 1979, China’s housing reform has experienced many hardships. Despite a number of achievements, the overall progress has been far from satisfactory. The idea of the reform is admittedly correct, but its implementation met with all kinds of resistance. There are two obvious reasons behind this resistance: it is very difficult to raise rent and employees are not motivated to buy a home.

(1) Diffculty in raising rent According to economic theories, most Chinese employees are not motivated to buy a home since monthly rent is far lower than the monthly interest on a mortgage. Therefore, raising rent has become one of the basic tenets of the housing reform.

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In 1986, Yantai, Changzhou, Bengbu, and Tangshan were selected as experimental cities for the housing reform. In August 1987, Yantai’s housing reform scheme was approved by the State Council. It was characterized by ‘raising the rent and issuing coupons, and placing empty residences on the market’. In October, Bengbu developed a housing reform plan that featured ‘raising funds and rents to sell houses by one step’. At the beginning of 1988, the State Council called the first National Work Meeting on the Reform of the Housing System. In February of that year, Proposals for Implementing the Reform of the Housing System in the Urban Areas across the Country by Stages and in Groups (State Council Issue [1988] No. 11) was printed and distributed, signaling the official launch of the housing reform in both central and local governmental plans. The first step of the reform was to raise overall rents to cover maintenance costs and boost enthusiasm for purchasing residences. The second step was to sort out residence distribution (housing allowance was to be included in salaries and accounted as the cost of the related enterprise) and increase the employees’ ability to bear the expenses. The aim was to realize the commercialization, socialization, and specialization of residences. This was the first overall plan concerning housing reform in China and was also known as the plan of ‘raising rents and providing housing allowances’. This reform, first practiced in Yantai, Bengbu, and Tangshan and later in Shenzhen and Chengdu, met with success. Not only were the maintenance expenses and depreciation of existing buildings guaranteed, but unreasonable demands for residences were effectively curbed. In Yantai, Tangshan, and other cities, some people willingly submitted residences that were illegally occupied, which would never have taken place under the traditional housing system. In the first system the price has played its regulatory function in residence distribution. At the same time, the increase of rent reduced the unreasonable ratio between rent and selling price, promoted the sale of public residences, and opened new financing channels for housing construction. Regrettably, no sooner had the housing reform started than serious inflation took place in China. At the beginning of 1988, retail prices spiraled upwards. Consumption indexes for city residents increased by 20.7 per cent as compared with the year before, and prices for life essentials such as vegetables, meats, poultry, eggs, and seafood went up by over 30 per cent. Serious inflation led to a degree of economic panic. The whole country was thrown into panic buying and there were bank runs. If the plan of ‘raising rents and providing housing allowances’ had continued, inflation would have been aggravated, which would in turn have speeded up the deterioration of the national economy. Meanwhile, as the ‘rent raising’ plan threatened the interests of those in power, it met with

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great resistance from those with vested interests. The whole plan, which was to have been completed in three to five years, was dismantled before it spread on a large scale. In June 1991, the State Council printed and issued the Circular on Continuing the Reform of the Housing System in Urban Areas in an Active and Stable Manner (State Council issue [1991] No. 30, hereafter referred to as the Circular). According to the Circular, current rents would be adjusted and public residences would be sold, while new policies would be developed for new residences. This indicated that the policy orientation was beginning to change. It is hoped that by the new policy for new residences, the obstacles in raising the rent of inventory residences can be removed, and incremental reform in the peripheral areas will be possible. The final objective is to realize a qualitative change through accumulation of quantitative changes. On 17 October 1991, the State Council approved and distributed the Proposal for Deepening the Reform of the Housing System in Urban Areas, drafted by the State Council’s housing reform team. The Proposal defined the overall objectives and the phased goals of the reform. The overall objectives stressed the importance of the housing reform as an integral part of the overall economic reform, and reiterated the main ideas of the Circular . It proposed to start from the reform of low-rent public housing in line with the planned socialist commodity economy, and to shift from the existing distribution system of welfare in kind to a distribution system of cash wages. In the phased goals, it proposed to increase the rent of public housing to cover the expenses of the three factors of simple reproduction (maintenance expenses, overhead costs, and depreciation) by the Eighth Five-year Plan (1990–1995), and the cost of the five factors that account for the cost of rent (maintenance expenses, overhead costs, depreciation, investment interest, and real estate tax) by 2000. The longterm objective was to increase the rent up to the level of market rent rate, which consists of eight factors (land use cost, insurance cost, and profit in addition to the five factors). Through the reform of the housing system, residences would finally be commercialized and socialized. In July 1994, the Decision by the State Council on the Deepening of Reform of Housing System in Urban Areas (State Council issue [1994] No. 43) was promulgated, proposing to deepen the housing reform within the reasonable family expense of employees, to develop and implement new rent policies, and to increase the rent by 2000 to 15 per cent of the average income of a two-job family. These plans have met with great difficulties in implementation. By 1997, the average rent of public residences in 35 large and medium-sized cities across

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the country was RMB 1.29 per m2, which was only 20 per cent of the actual cost of rent (RMB 6.25/m2) and 12 per cent of the market rent rate (RMB 11.09/m2). Only in a few cities, like Shenzhen, did the rent paid reach the actual cost of rent.

(2) Reluctance of employees to purchase residences Another main idea of the reform is to encourage employees to buy their residences. It has long been emphasized in traditional Chinese culture that ‘everyone shall have a residence’ and ‘one can enjoy his job only when he has a secure residence’, but employees were very reluctant to buy a house of their own under the traditional housing system in which residences were regarded as welfare in kind. Another important factor was very low average incomes. At the 1978 National City Housing Work Conference, the instructions of central leaders were communicated to all participants: individual initiatives should be encouraged in solving housing problems. After that, the State Council issued policies allowing individuals to build or buy houses. In 1979, the state allocated funds to Liuzhou, Wuzhou, Nanning, and Xi’an, requiring the local governments to build residences collectively and sell them at the civil construction cost. In 1980, the experiment was implemented throughout the country. At the end of the same year, the National Construction Administration and the All-China Trade Union organized an ad hoc meeting, sharing their experiences of building and selling residences. It was put forward that negative leftist influences should be eliminated, and that employees and citizens should be supported in the building of their residences. It was also suggested that the selling price of residences should be based on the basic construction costs (the cost of civil construction and interior equipment), while the cost of land acquisition, dismantling, and civil facilities should be resolved by governments at all levels. The payment could be made in a lump-sum or by installment, although the latter was preferred. The installments could range from five to 20 years, with the annual interest less than 2 per cent. For the lump-sum payment, a preferential discount of 20 per cent should be given. In April 1981, the General Office of the State Council distributed the report of the meeting throughout China, asking all localities to follow the experiment. After the issuing of the notice, the experiment was extended to 60 cities and a number of towns at the county level. Old residences were also put on sale. The price for the newly built residences was typically RMB 120–150 per m 2 of construction area. The total cost of an ordinary apartment with two bedrooms equaled almost five times a family’s annual income. However, the experiment was not successful. According to incomplete statistics, by the end of 1981 a total of only 3,000 apartments were

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sold in the experimental cities and towns across the country. Not long after this, the experiment was brought to an end. In 1982, according to the instructions from the State Council that ‘a breakthrough needs to be made and new experience must be acquired in a few cities’, the State Construction Commission and the National Construction Administration decided to select Zhengzhou, Shashi, Changzhou, and Siping as four experimental cities, where newly built residences were sold with subsidies. When an employee bought a residence, the total cost would be shared between the individual, the local government, and the employer, with each party covering one-third (often called the three–three system). The cost of a residence included the construction cost of the building; the construction costs for water supply, drainage, roads, heating, gas supply, and electricity; and the compensation fee for land acquisition and dismantling. The cost of other public facilities was not included. A discount was considered for any lump sum payment. Thirty per cent of the total cost was required as a down payment, and the rest of the cost had to be paid off within a maximum of 15 years with annual interest. Old residences were sold at different prices according to their quality and, similarly, the cost was shared between the three parties. In general, the total cost of a residence was slightly higher than the price in the former experimental period, but it did not pose a heavy burden to families since the local government and the employer compensated two-thirds of the cost. An ordinary family could buy an apartment with two-year’s income. As a result, the new approach did not meet with much resistance during its implementation. Based on the experience of the four cities, the State Council decided in October 1984 to expand the experiment more widely across the country. By the end of 1985, 160 cities and 300 counties and towns in 27 provinces, municipalities, and autonomous regions were involved in the experiment, with total sales of 10.9 million m 2. However, the practice met with great resistance from enterprises and local governments, since two-thirds of the costs were to be covered by them (the government’s part was often transferred to enterprises). In 1985, subsidized sales were stopped because they were regarded as ‘sales at low prices’. After the failure of the rent increase plan in 1988, the relevant departments proposed to sell public residences at discounted prices and get rid of the heavy burden of maintenance. The idea was not presented in official documents, but its influence spread throughout the whole country, which resulted in a second wave of selling residences at low prices. To stop this practice in some areas, the State Construction Commission issued the Emergent Notice of Prohibiting the Sales of Public Residences at Low Prices on 8 June 1988. The Notice was effective in some ways, but the wave of selling residences at low prices was not

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stopped. According to incomplete statistics, 6.45 million m2 of public residences were sold in 1988 in urban areas across the country, which, if measured in returned capital, was equal to a price of RMB 65.7 per m2. In 1991, when the State Council approved and publicized the Proposal for Deepening the Reform of the Housing System in Urban Areas, local governments began to develop and implement their own plans for housing reform. In January 1991, the Beijing municipal government announced its plans to expand the experiment. The basic idea was to ‘boost the increase of rent with the sale of residences, and provide subsidies for the sale of residences but not for the gradual increase of rent’. In February of that year, the Shanghai municipal government disclosed its plan to raise the rents with subsidies, sell residences at preferential prices, and collect public funds for housing. In developing local plans for housing reform, however, most areas were more interested in selling residences at preferential prices and, as a result, the whole country caught this ‘flu’ within a short time. In general, big cities were more regulated in implementation than medium and small cities. The immediate result was increased discounts and the resurrection of selling residences at low prices. This was the third wave, and in June 1992 a proposal to stop the practice was raised at the housing reform work conference sponsored by the State Council. On 6 February 1995, the General Office of the State Council issued the Circular on Transmitting the Implementation Plan of the Easy Residence Project Stipulated by the Leading Team of the Housing Reform under the State Council. The aim of the project was to bring into play the initiatives of all sides in line with the housing reform, accelerate the process of residence commercialization and socialization, and promote housing construction in urban areas. The principle was to shift the burden to individuals with support from the government and the employer. Through a well-planned procedure with a focus on big and medium-sized cities, the project was meant to set an example for the reform of the housing system. The project started in 1995 and aimed to build 150 million m2 of additional floor space in five years. Forty per cent of the funds were provided through government loans, and the remaining 60 per cent were raised by the relevant cities through specific funds for housing reform. The land was provided by local governments through administrative allocation, and the related costs were reduced or exempted. Upon completion, the residences were sold directly to medium or low-income families at their cost price, and priority was given to those who had no shelter, lived in dangerous buildings, or lived in very poor conditions. High income families were not included in the project.

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Marked progress has been made in recent years, and by 1997 the completed floor space reached 71.6 million m2, which provided shelter for 650,000 urban families in dire need. The planned floor space for the first half of 1998 was 106.9 million m2, far beyond the total space of the initial plan. Achievements have also been made in setting up public housing funds and selling public residences. By the end of 1998, aggregate public housing funds reached RMB 123 billion, which played an important role in increasing the source of housing construction funds and developing policy housing finance. The sale of public residences witnessed a fast growth in 1996 and by 1998, with the exception of Beijing and Tianjin, 50 per cent of public residences permitted to be sold had been bought by employees. In some provinces, the figure was up to 60 per cent. However, it is worth noting that most of the residences were sold to employees during the three waves and after the implementation of the project. Excluding these residences, the proportion of employees with private residences was far below this level at the time of writing. In some big cities, in particular, employees are reluctant to buy their residences as the price is still high. According to a sample survey of 860 families in Beijing in October 1998, 573 families (66.6 per cent) had no plan to buy their residences and only 72 families (8.5 per cent) planned to buy their residences within two years. According to data from the State Economy and Trade Commission, investment by SOEs in residence construction was RMB 131 billion between 1992 and 1994. Together with subsidies for maintenance costs, annual average expenses exceeded RMB 140 billion, or RMB 160 billion including the interest cost. A large number of newly built residences flowed into the traditional housing supply and distribution system, surpassing even the reform speed of the inventory of public residences. In Shanghai, for example, between 1991 and 1997 46 million m2 of new residences entered the old system through allocation, while the aggregate sale of residences was only 34 million m2. Another statistic shows that the countrywide total floor space of newly built residences in 1996 was 301 million m2, of which two-thirds were built by government organizations and enterprises or bought from the market and then assigned to employees. Although some of the residences were sold to the employees at cost price, the nature of welfare distribution in kind remained unchanged. The only difference was that the original monthly ‘low rent’ had been shifted to a once-and-for-all ‘low price’. The covert subsidies from the state and the enterprises had been increasing with the acceleration of housing construction. After the First Session of the Ninth People’s Congress, the government stopped the practice of distributing residences as welfare in kind, which started another round of distributing residences before the deadline and selling public

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residences at low prices. The General Office of the State Council issued an emergency notice on 12 May 1988, demanding an immediate rectification of the practice. Severe punishments would be given for any violations after the promulgation of the notice, and the related authorities would be disciplined. Criminal responsibility would be pursued for serious violations. Looking back at the housing reforms in China, we notice that great progress has been made in spite of all the difficulties and hardships. The main achievements are that investment in residence construction has expanded from investment by the state to diversified investments; the reforms have increased from the simple act of selling public residences and raising rents to an overall plan involving rent, sale, construction, and public funds; the proportion of private residences has increased steadily; and people’s mindset of depending on the government and employers for housing has changed. The residents, as the end users of residences, have to enter into the housing market. Since 1998, when the newly elected government set a deadline for the distribution of residences as welfare in kind, housing reform accelerated. We must realize that the road to reform is long and arduous. For a new level of achievement, we need to focus our research on the following three areas: the definition of a target model for the housing reform; the technical, economic, legal, operational, and political feasibility of each reform policy, focusing on the tradeoff of the interests of all the parties to minimize resistance to the reform; and the development of the reform strategies and procedures with necessary adjustment. Since the reform is path-dependent (i.e. every reform measure is affected by the previous measure), special attention must be paid to the possibility of great cost caused by a careless measure.

THE TARGET MODEL FOR HOUSING REFORM The overall objective of the reform is to set up a housing system in conformity with China’s realities, in other words a housing system suitable for the primary stage of socialism and the socialist market economy system that meets the demands of city and town dwellers. When China started reforming and opening up, Deng Xiaoping made a few important speeches on the reform of the housing system, outlining a target model for China’s housing reform. However, his outline did not crystallize until the end of the 1980s as a result of the strong resistance of the old forces and traditions. In January 1988, the State Council issued their Proposals for Implementing the Reform of the Housing System in the Urban Areas across the Country by

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Stages and in Groups, which made it clear that the objective of the reform was to realize residence commercialization in line with the demands of the socialist planned commodity economy. Beginning with the reform of the low rent system, the existing distribution in kind was to be shifted to distribution in cash and, by means of commodity exchange, residents would acquire the right to own or use their residences and a virtuous investment cycle of input-output would be realized. With the entry of residences into the consumer market, a new road would be found, which would not only be conducive to the solution of housing problems in urban areas, but would also promote the development of the real estate, building, and building materials industries. In 1991, at the second working conference on housing reform, the State Council published the Circular on Continuing the Reform of the Housing System in Urban Areas in an Active and Stable Manner . It pointed out that the reform of the housing system is an integral part of economic structural reform and its fundamental aim is to alleviate people’s residential difficulties, steadily improve housing conditions, lead consumption in a positive direction, realize residence commercialization by steps, and boost the real estate industry. The principle of the reform was to stick to the following: the coexistence of housing rental, sale, and construction; the share of cost among government, employers, and individuals; the decentralization of decision-making in accordance with the local situation under a united policy; and the reform of related systems. At the end of 1993, the Third Plenum of the Fourteenth CPC Central Committee passed the Decision on Several Issues in the Establishment of the Socialist Market Economy System, which proposed that the reform of the housing system in urban areas should be accelerated, the price of housing land should be controlled, and commercialization and development in housing construction should be boosted. Shortly afterwards, at the third national work conference on housing reform, the basic ideas for the reform were proposed. Focusing on the sale of public residences, the practice of residence rental, sale, and construction were to be advocated simultaneously, and the housing industry was to be boosted by developing related policies and markets. Through the commercialization and socialization of residences, a new housing system would be set up in urban areas to meet the demand of the socialist market economy. In July 1994, the Decision by the State Council on the Deepening of Reform of the Housing System in Urban Areas was promulgated and it prescribed the fundamental objective, basic content, and immediate priorities of the reform. It made clear that the objective was to establish the following: a new housing system in urban areas suitable for the socialist market economy; realize

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commercialization and socialization of residences; step up housing construction; improve housing conditions; and meet the increasing demand of urban residents for housing. The contents of the reform can be summarized by ‘three reforms and four establishments’. The ‘three reforms’ included: the reform of the investment system from a full reliance on the state and employers to a reasonable division between the state, employers, and individuals; the reform of the housing construction and management system from full responsibility of the employers for construction, distribution, maintenance, and management of residences to a socialized and professional service; and the reform of the distribution system from the distribution of welfare in kind to the distribution of money in wages. The ‘four establishments’ were: the establishment of a supply system of low-cost residences aiming at medium and low income families and a supply system of commodity residences aiming at high income families; the establishment of public housing funds; the establishment of a policy-oriented and commodity-oriented housing credit system; and the establishment of a standardized real estate exchange market and a socialized housing maintenance and management market in order to realize a virtuous investment cycle of input–output and boost the development of the real estate industry and related industries. The reform was supported by a complete set of measures and implemented in stages. On 3 July 1998, the State Council published and distributed their Circular on Deepening the Reform of the Housing System in Urban Areas and Speeding up the Housing Construction , which defined the goal in the following way: to stop distribution in kind and realize the monetization/of residences; to establish and improve a multi-level supply system in urban areas with a focus on lowcost residences; and to develop housing finance and standardize the real estate exchange market. This symbolized the start of a new phase in the reform. At the Fifteenth National Congress of the CPC, President Jiang Zemin, also the general secretary of the Central Committee, proposed in his report that by the year 2010, China’s GDP should be doubled to further increase living standards and set up a complete socialist market economy system. Based on this strategic goal, we have extensively studied housing system theories. By integrating international experience and China’s realities, I hold a target model for reforming housing by 2010 should at least cover the following eight areas:

1. A Dynamic Balance Between Demand and Supply From the perspective of the supplier, residences are constructed as a basic life necessity to meet the minimum needs of consumers, but lag behind the consumers’ growing effective demands. Therefore, the demand and supply of

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residences is always in a process of dynamic balance. This refers not only to the dynamic balance between the aggregate supply and aggregate demand, but also to the mutual adaptation between the supply structure and the demand structure. Since its reform and opening up, China has increased its input in housing construction to solve the housing difficulties of urban dwellers. From 1979 to 1997, a total of RMB 1,743 billion was invested in urban housing construction. The floor space of newly built residences increased from 38 million m2 in 1978 to 405 million m2 in 1997, with an average growth of 13.3 per cent on a year-toyear basis, much greater that the growth in GDP in the same period. As a result, the housing conditions of urban dwellers have improved significantly. The per capita residence area in cities increased from 3.6 m2 in 1978 to 8.8 m2 in 1997. However, this is far below the level in China’s rural regions (where per capita residence area is up to 22 m2) and below the international average of 11 m2 per capita for countries with similar per capita incomes. According to the results of regression analysis in the period from 1980 to 1996, the relations between the per capita GDP, and the year can be represented in the following formula: Y = 429.0502 E0.1223T According to the formula, the per capita GDP in China in 2000 was RMB 5,598 and will be RMB 11,200 in 2010 if the objective of doubling GDP in ten years can be achieved. International experience shows that the housing conditions of a country or a region are positively correlated with its economic development during a certain period. At the early stage, the former will increase rapidly with the growth of the latter, but will slow down when reaching a certain level. Based on an observation of the samples, the turning point of the change will take place when the per capita GDP reaches RMB 10,000 with a corresponding per capita living space of 15 m2. Therefore, housing conditions in China’s urban areas will experience a rapid growth before 2010. According to data from the State Statistics Bureau, the total population of China’s urban areas amounted to 369.9 million in 1997. If one family consists of 3.19 people, there are altogether 120 million families, with an urbanization rate of 30.1 per cent. The population by 2010 will be over 1.4 billion, with an urbanization rate of 40 per cent. If the per capita living space is 15 m 2, then a total of 8.4 billion m 2 of floor space is needed. Given the existing per capita floor space of 3.6 m2 in 1997 and the annual increase of 2.5 per cent in housing construction, 8 billion m2 in total needs to be built before 2010, which means an

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annual growth of 9.4 per cent. This objective is likely to be achieved if we take into account the momentum in the increase of newly built residences and the average annual incomes of employees in China. According to one report, the floor space of new residences amounted to 350 million m2 in 1998, 9.7 per cent more than that in 1997. There are three segments in China’s real estate market: commodity residences at market price, low-cost residences, and low-rent residences. However, the definition of the three segments has been obscure. In exploring the target model for China’s housing reform, therefore, we might as well start from the perspective of the supply structure and segment the market into three distinct levels: the high, the middle, and the low grade. In studying the demand structure, we can classify employees into five classes in terms of their income: high, upper-middle, middle, lower-middle, and low. The high income class earns above 400 per cent of the average income of local employees. The upper-middle income class earns above 200 per cent of the average income of local employees. The middle income class earns 80 to 200 per cent of the average income of local employees. The lower-middle income class earns 50 to 80 per cent of the average income of local employees. The low income class earns below 50 per cent of the average income of local employees. In general, the high income class will be the chief consumer of high grade residences, while the upper-middle, middle, and lower-middle income classes will mainly buy or rent middle-grade residences and the low income class will mostly rent low-grade residences. Lacking figures of the employees’ actual income and income distribution, it is hard to match quantitatively the demand structure with the supply structure. According to their simple linear relations, high, middle, and low grade residences will account for 20 per cent, 60 per cent, and 20 per cent respectively. As most residences at present are low-grade residences, and the occupancy rate of high-grade residences is extremely low, middle-grade residences should be the priority in housing construction for the time being. As mentioned above, the balance between demand and supply is dynamic. It is inevitable that some households will have housing problems by 2010, while a number of houses will remain unoccupied. However, both should be controlled below 5 per cent.

2. Commercialization of Residences Under the market economy, it has been widely accepted that housing is a commodity. In China, however, there was a hot debate in the late 1970s in the academic community over the property of residences as a commodity. Guided by the theories of Deng Xiaoping, and after years of practice since China’s

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reform and opening up, most scholars are now beginning to accept residences as a commodity. However, some scholars deny this by pointing out that in setting the rents and prices for residences, the law of value is discarded; that low-cost residences are not regarded as commodities; and that barriers are set up for the exchange of residences as commodities. Therefore, we must admit, first of all, that under the socialist market economy, residences are commodities with the properties of utility and value and are able to meet people’s demands for shelter through exchanges. In the meantime, it is insufficient to merely acknowledge the general commodity property of residences. We have to admit that residences are a complicated and special commodity, characterized by the following:

(1) Necessity Residence is a commodity that people must have in order to support their existence and, as a result, its social demand will always exist. Excluding other demands, the demand for residence, or the price elasticity coefficient, is rigid.

(2) Durability The life span of a typical residence at the present time is 50 years, at an annual rate of only 2 per cent in terms of its natural replacement. Therefore, the consumer replaces his residence not because it has completed its life span, but because his income, family population or structure, place of work, nature of work, environment, and aesthetics have changed.

(3) High value Residence is a commodity with a high value, and its price depends mainly on the construction cost and land price, which usually amounts to over four times the annual income of a family. In developed countries, the expense on residence (the mortgage loan or rent, together with cost of water, power, and real estate management) will account for 20 to 35 per cent of a family’s total income.

(4) Immovability Since a residence is immovable, its value will fluctuate with the surrounding environment (for instance, the distance and quality of the school and shops, environmental pollution, security conditions, etc.). People will also have to change their residences when their work place changes. In many countries, people even buy residences as a means of investment to maintain value or mitigate taxes.

3. Exchange Through the Market A market is a place for commodity circulation, or the sum of all commodity

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exchanges. Under the socialist market economy, residences should not only be regarded as commodities, but should also be exchanged on the market. Through market power, residence commodities can adapt to different needs and the dynamic balance between supply and demand can be achieved. The evolution of the world’s housing policies shows that the dominant model in all countries must be ‘market regulation supplemented by government support’. Even in countries like Sweden, where people enjoy a high degree of welfare, the solution to housing problems is still dependent on marketization. Marketization means that the pricing of a residence must be based on the law of value and factors such as scale, quality, location, and environment. It should be subject to adjustment in accordance with supply and demand. Through competition, satisfactory price and transaction terms can be reached between the supplier and the consumer. Marketization of residences depends, first of all, on the establishment of a residence market system. Based on the different market properties, the market system can be classified in the following different ways: ♦ In terms of the sequence in which residential products enter the market, the residence market can be divided into the primary market and the secondary market. The primary market is also known as the incremental market or first-hand residence market, which refers to the exchange market where new residences are traded. The secondary market is also known as the inventory residence market or second-hand residence market, which refers in general to the re-exchange market for residences which have already undergone a first transaction, including the circulation and exchange of the purchased commodity residences and public residences and the transfer of the use of rights of residence. ♦ In terms of the types of residences, the residence market can be divided into the public residence market (i.e. the residence market with direct investment from the government in construction, aiming at low income families) and the commodity residence market (i.e. the private residence market, including the ordinary commodity residence market developed by real estate developers for upper-middle income families, and the house market and high-quality apartment market aimed at high income families). ♦ In terms of location, the residence market can be divided into many regional segments based on cities or even city districts (such as the Zhongguancun residence market of Beijing and the Luohu residence market of Shenzhen). ♦ In terms of the form of transaction, the residence market can be divided into the exchange market, aiming at incremental residences including such sub-markets as sale (pre-sale), rent (pre-rent), and mortgage, and the exchange market aiming at inventory residences, including such sub-markets as rent, transfer, mortgage, and insurance. ♦ In terms of the purpose of the consumers, the residence market can be divided into

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the self-use market and the investment-oriented market. In the self-use residence market, a person buys a residence as a durable consumer good to satisfy his demand for space, and this purchasing behavior is influenced by his personal preferences. In the investment-oriented market, a person buys a residence as a means of investment, with the intention of renting or selling the residence for higher returns, and his purchasing behavior is influenced by the returns on housing investment, the returns on other investment tools, and the demand characteristics, trends, and preferences of the users in the market.

For the sake of analysis, the residence market can also be divided into other types. For instance, it can be divided in terms of ownership features into the complete-ownership exchange market (the exchange of ownership) and partialownership exchange (the exchange of use rights). The above types of market constitute the necessary parts of a residence market system. For example, without the secondary market, it would be difficult for the consumer to sell his existing residence for a new one to satisfy his changing demand. Without an investment-oriented market, it would be hard to attract a large number of individual investors into the residence market, and the dynamic balance between supply and demand could not be achieved. Therefore, the target model for China’s housing system shall include a complete residence market system consisting of the above-mentioned types of markets.

4. Integrating in Wage Distribution Under the traditional planned economy system, housing was regarded as a welfare benefit. Housing cost was not part of the reward for labor in wage distribution. Instead, it was deducted beforehand by the state and used for the redistribution of national revenue. As a result, housing has been beyond the scope of distribution according to labor. Under the socialist market economy, a residence is a type of commodity which is exchanged on the market. Therefore, residence cost must be integrated in wage distribution so that employees are able to rent or buy a residence on the market instead of relying on their employers for the construction, purchase, and distribution of a residence. By separating housing from employers, we can bring residence under the scope of distribution according to labor and eliminate corruption in residence allocation. As the integration of residence cost into wage distribution brings about a fundamental change in consumer behavior, people can buy or rent a residence based on their financial ability and preferences. They can also exchange their residences in line with changes in their family structure, nature and place of work, personal income, and taste. This will surely contribute to the development of all types of residence markets and the housing industry as a whole. The proportion of housing cost in salary depends on many complicated

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factors. It should include housing expenses (rents or the virtual rents of private residences) as well as those of such necessities as fuel, water, and power. In developed economies, housing costs in the 1990s accounted for 15 to 30 per cent of household income. Given the realities of China, the wage income of employees will have been socialized by 2010, and a balance will be achieved among employees working for all kinds of ownership enterprises. By then, residence costs will make up 15 to 20 per cent of household income.

5. Ensuring Social Fairness As the housing problem relates to social stability and economic growth, governments of different countries have paid special attention to the formulation and implementation of housing policies in order to maintain social fairness. Among other measures, housing allowances and other supporting means like finance and taxation are necessary. In most countries, wages include housing expenses, and housing allowance is provided as a means to adjust social distribution and maintain social fairness with a priority on the low income class. Examining the world’s housing allowance policies, we find two types of intervention and regulation in the residence market. The first is the direct involvement of the government in residence supply and the provision of housing allowances, and the second features the government’s financial subsidies for those in need of housing. The usual means include tax deductions for those who buy a residence for their own use and a cash allowance to subsidize the rent. However, the general tendency is a transition from the former to the latter, i.e. from ‘subsidizing the bricks’ to ‘subsidizing the headcount’. By 2010, low income families will account for 10 to 20 per cent of families in urban areas, and the government will still need to provide them with rental allowances and low-rent residences at a rent less than 10 per cent of the household income. To encourage people to buy residences, the government should develop preferential tax policies for residence buyers.

6. Setting Up a Financial Support System Since a residence is a high-value commodity, both the demand and supply sides need support from the financial sector. Therefore, a financial support system for housing will have to be set up. Such a system should include three main parts: housing construction financing, housing purchase financing, and the securitization of housing credit. In a modern economy, the financial sector and real estate industry will interact with each other. Bank credit plays a key role in promoting housing construction, while the high returns and low risks of the real estate industry

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create a favorable business environment for banks. But without strict supervision, bank credit will contribute to the bubble in the real estate industry when the economy is overheated. Banks will incur severe losses as a result of enormous dead debts. For this reason, certain principles should be adhered to in developing housing credit policies. First of all, the developer ’s own funds should make up at least 30 per cent of the total construction cost. In other words, a bank loan cannot exceed 70 per cent of the total cost. Secondly, a construction loan from a bank must be within 20 per cent of its total credit assets. Thirdly, the growth of a construction loan from a bank should not exceed the growth of its total loans by more than 3 per cent. Lastly, banks are not allowed to be directly involved in the real estate business. Housing credit is an important measure to turn people’s demand for residence into effective demand through financial means and promote residence consumption. The target model for housing credit should rely mainly on commercial loans while making policy support subsidiary. The amount of a commercial loan can cover up to 80 per cent of the total expenses of a residence on a mortgage basis. The term of payment can last from 20 to 30 years with a floating interest rate. Policy support should include a deduction from income tax of the expenses to pay back the principal and interests of housing loans, a discount interest for housing loans, a provision of insurance for mortgage loans, and an incentive for housing savings. As housing credit is long-term credit, it will reduce the liquidity of bank assets, create interest risk, and have a negative impact on bank performance. Therefore, securitization of housing credit is needed to increase its liquidity and diversify risks. Securitization means that the bank’s mortgage loan is issued in the primary capital market in the form of bonds and traded in the secondary capital market. This will not only speed up the turnover of bank capital and diversify bank risks, but also provide an effective investment instrument for investors. In the meantime, the interest gap between mortgage loans and bank deposits will be reduced, and housing consumption will be boosted. To realize the securitization of housing credit, it is necessary to set up a financing system, comprising the banks that provide mortgage loans, bonds exchanges, and bonds companies. The insurance industry should also be developed to provide necessary help. One of the effective experiences of Singapore, for example, has been to set up public funds through compulsory savings. As a long-term and mutual fund, the housing fund is important in stepping up housing construction and improving the housing conditions of urban residents. The State Council’s housing reform team published a provisional regulation on 3 July 1996 on the establishment of a

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housing fund system. Achievements have been made in the past few years, and obviously the practice should be integrated into the housing financial system for stronger supervision. However, for a country with such a large population and regional differences in development as China, public housing funds can only be regarded as a subsidiary of the housing finance system.

7. Maintaining the Balance Between Rental and Purchase One feature of an ideal society is that everyone should have his own residence. In reality, however, some people cannot afford or are unwilling to buy a residence for various reasons, while others prefer to sell their own residences and rent a house. This has resulted in the demand and supply of rental service. In addition, the existence of rental residences is conducive to the turnover of residences and thus to the development of the real estate market. Even in developed countries, only 65 per cent of residents have their own houses. In China, it is predicted that by 2010 this figure will be around 70 per cent in urban regions. Apart from the low rent residences provided by the government for the low income class, a key factor in maintaining the balance between rental and purchase is the pricing of rents. An overall balance needs to be maintained between the actual rent and the virtual rent of private residences. The virtual rent should include the interest of the first payment, the interest and principal of the mortgage loan, and the real estate management cost. The government should strengthen its macro-management of the residence rental market, mainly by taxation and subsidies, to maintain a balance between rental and purchase and to protect the rights of residents and owners.

8. Developing the Housing Industry The development and modernization of the housing industry is an important measure to speed up housing construction and increase the supply of low cost, high quality residences. The concept of a ‘housing industry’ was first put forward by Japan’s Department of Industry in the late 1960s. It is the sum of all trades in different industries related to housing. The housing industry has seen rapid growth in the past 30 years. Through a series of reforms such as the standardization of housing components, prefabrication of housing products, mechanization of housing construction, and intensive production, the productivity of the housing industry has been greatly improved and its modernization has been realized. According to a United Nations survey in over 70 countries, investment in housing construction usually accounts for 3–8 per cent of the GNP of a country, or 20–30 per cent of the total value of fixed assets. The development level of

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a country’s housing industry is represented by the following: the per capita completion area (the index of production and construction); the supply of standard parts through socialized production; the material structure of walls; the energy conservation of the construction; the technical service system at the construction site; and the mechanization and rationality of the construction. China’s Ministry of Construction made it clear in 1996 that the housing industry produces and deals with residence as its end product. It involves the planning, design, construction, and real estate management of residences as well as the production of relevant materials and components. The Ministry also made arrangements for the experiment of residence industrialization. In 1998, the national work conference on housing construction proposed to strengthen the management of housing construction and upgrade the industry with modern science and technology. A series of measures was set at the conference to facilitate the shift from extensive to intensive production and the modernization of the housing industry. The general idea was to improve the quality of housing projects, functions, environment, and after-sale service through the establishment and improvement of the technical warranty system, housing construction and components system, quality control system, and housing performance measurement system. It is predicted that by 2010 the initial modernization of the housing industry will have been realized in China.

KEY TO THE HOUSING REFORM – BRINGING INTO PLAY THE INITIATIVES OF FIVE GROUPS In a sense, reform means revolution, which will invariably readjust the existing pattern of interests. To make this happen, efforts should be made to bring into play the initiatives of all sides and minimize any resistance. Housing reform, in particular, is closely related to millions of families, and demands our detailed analysis of the basic attitudes and behavioral characteristics of five groups: employees, developers, employers, banks, and the government. Balance of interests should be maintained among the five parties so that better opportunities can be found for the development of reform measures.

The Characteristics of Employees’ Housing Consumption The majority of China’s urban residents are employees of government organizations and businesses and their families. For years, they have been accustomed to housing distribution as welfare in kind. In the transition to a distribution system of cash wages, their housing consumption will be restrained by such external factors as the economy, policy, law, organization,

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community, and social group to which they belong. Together with such internal factors as household income, family structure, and the status quo of housing consumption, these external factors will generate a compound influence on the attitudes of urban families towards housing reform and housing consumption. These attitudes will solicit their consumption desires and behavior. A national sample survey and focus interview shows that housing consumption in China has the following features:

(1) Inactive approval The result of the survey shows that most employees are in favor of the state’s measures in housing reform. The top three most influential reform slogans are: ‘Stop housing distribution as welfare in kind and provide a housing allowance’; ‘Establish housing funds’; and ‘Sell inhabited public residences’. The least influential one is ‘The new commodity residences are only for sale, not for rent’, followed by ‘Raise the rent of public residences step by step’. However, many employees have little understanding of the state’s policies in housing reform, and doubt the expected returns of the reform. Although they favor reform, they do not do so actively. The survey also shows that the status quo of existing housing consumption is an important factor that influences employees’ attitudes. The families who have already bought the public residences in which they are living are more in favor of the housing reform than those who simply rent public residences. But the least support comes from those with no housing at all. This indicates that the families who are unable to secure a residence as welfare in kind are looking forward to ‘catching the last bus’. This attitude is best exemplified by the sudden increase of marriages in some places just before the deadline for housing distribution as a welfare.

(2) Reasonable and controlled demand for allowance Over 85 per cent of employees expect a housing allowance of up to 40 per cent of their income, and 65 per cent of employees expect a housing allowance with a term of 15 years. This is a reasonable and controlled demand. Noticeably, families of the employees of SOEs demand a smaller allowance than those of government organizations and institutions. This indicates that a vast number of employees are considerate and self-controlled, which should be valued in housing reform.

(3) Lack of desire for housing loans The survey shows that 25 per cent of families have used bank loans in housing purchases. However, most families seem to be immature. Although on average

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the employee families in the survey can afford 47.6 per cent of the total cost of a residence with their savings, they have no wish to borrow more than 30 per cent of the residence cost, with a loan term of less than five to 10 years. This reflects clearly their long-cherished value of avoiding long-term debt. Such a lack of desire for bank loans is in fact deep-rooted in traditional Chinese culture, which sees debt as a risk and burden in business and consumption. This mindset has presented the biggest obstacle to the development of personal housing loans. Another obstacle comes from the over-complicated formalities and overly strict terms in applying for bank loans as well as the high interest rate. As a result, many families borrow money from their friends and relatives rather than from banks.

(4) Immature expectations for housing consumption The average housing expenses of the families in the survey account for 8 per cent of their income, but about 60 per cent of the families expect a percentage below 15 per cent. For most families, ‘the lower, the better’. The survey shows that the employees’ income level has no significant impact on their desire for housing consumption. The longer the service of the head of the household, the stronger the inclination to lower rent, expenses, and consumption. This is an indication that they have not changed their old mentality that ‘residence is welfare’. Their expectation is still immature, as they are unable to look at rent and housing costs from an economic perspective. In summary, it can be concluded that most families, out of their recognition of the reform and opening up program and trust in the Communist Party and government, are in favor of the housing reform while knowing little of its objective and significance. They are reluctant to say goodbye to the old housing distribution system. They have doubts and worries about the reform and its potential burden on their families. Therefore, we need to disseminate the new housing policies and define the target model and policy measures of the reform, so that employees and their families will realize the reform program’s longterm benefits. Besides, we need to be careful in developing policy measures and considering the economic ability and psychology of the employees. For retirees or retiring employees who began working long before China’s reform and opening up, compensation should be provided as housing expenses were not included in their old salaries.

The Expectations of the Real Estate Developers With the deepening of housing reform in urban areas, real estate developers have gradually taken the place of government and enterprises to become

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the chief force in housing construction and the main suppliers of residences. According to statistics, ordinary residences developed by developers have accounted for over 50 per cent of the total construction volume. Thanks to the support of banks and local governments, 1992 saw a boom of real estate development, which offered an unprecedented opportunity for the rise and growth of China’s real estate developers. Many people made tremendous profits in real estate development and transactions. However, the boom did not last long. Regardless of China’s realities, this blind development was doomed to fail from the start. As the government began to strengthen its macro control, the frenzy of real estate development stopped sharply, leaving a great number of empty buildings and unfinished projects. As a result, the banks had large amounts of sunk capital and a number of developers went bankrupt. The increasing standardization of the real estate market in China and the promulgation of the Management Rules for the Urban Real Estate Development and Operation on 24 July 1998 have created a favorable environment for the healthy growth of China’s real estate industry. In the meantime, many developers need to change their mindset to adapt to the deepening reform of the housing system in urban areas. They need to realize four transitions: switching investment focus from high and medium grade residences to medium and low-cost residences; shifting from group consumption to individual consumption in terms of target customers; shifting from scale to the effectiveness of supply in terms of development; and shifting from high profits to reasonable margins in terms of profitability. To motivate real estate developers to build low-cost residences, the government should take into account their interests and allow them to make a reasonable profit by favorable tax policies so long as the quality of residences is guaranteed. The sale of low-cost residences should follow the law of the market while macro-control is exercised over price. Developers should have the freedom to adjust prices in line with location, grade, direction, and height of the residence. The high income class must be prohibited from buying low-cost residences to avoid damaging the commodity residence market and increasing the commodity residence inventory. For the development of commodity residences, early taxes should be reduced to lower the cost of development.

The Special Role of the Employer For many years, government organizations and enterprises have played a key role in developing or purchasing residences. With government allocations or self-raised funds, they either build residences on their own land or directly purchase residences from urban construction departments based on an employee’s years of service, position, marital status, and family size and

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structure. The employees have right of use while the ownership remains with their employers. The end customers’ desires and purchasing power are determined not by the residence market but by the construction funds and the opinions of their employers. Therefore, one of the main objectives of the housing reform is to help government organizations and enterprises get rid of these burdens. However, as these organizations have been the main executors of the old housing system for years, they will continue to play a special role in the process of housing reform. They need to take an active role in raising rent and selling public residences, collecting housing funds, and disseminating to their employees the significance and policies of the housing reform. As compensation for employees will be provided by public finance in the housing reform – that is, the cost of housing reform will be covered by the government – the administrative organs and institutions with full appropriation will not have an economic problem. But enterprises and institutions with balance appropriation will have to pay all or part of the cost. Some leaders of SOEs argue that it is unfair to them, as the housing expenses that should have been included in wages have in fact been paid to the state as profits. With the worsening of their economic performance and increasing redundancies, it would be an even harder blow for them to be responsible for employees’ housing allowances. (The housing standard in enterprises with economic difficulties is often far below the average, and as a result more allowance funds are required). According to investigations, some units are not yet ready to accept the termination of housing distribution as welfare in kind and to realize its commercialization and marketization. One reason is that they are reluctant to give up their innate power of housing distribution. They are afraid that control over their employees will be weakened as soon as their power is removed. Enterprises with poor economic performances expect to retain the old system so that they can seek more welfare for their employees as their performances improve. A number of enterprises and government institutions, therefore, adopt a ‘wait-and-see’ attitude towards the housing reform, as they worry about the potential loss from overactive involvement in its implementation. One company, for example, took immediate action when the policy of establishing public housing funds was developed in 1992. In 1998, however, the government prescribed that the years of service for the discount in purchasing public residences would be up to the date of setting up the housing funds. As a result, all the employees lost six years; the management felt ashamed when they received complaints from their employees.

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Another concern with the reform is that the privatization and the opening up of the secondary market might cause turbulence in residential areas as a result of the intrusion of ‘outsiders’. Enterprises and government institutions would not be motivated unless their interests and equities as the owners of public residences were taken into account in the housing reform. There are abundant examples. In the Provisions on Turning over to the State the Revenues in Selling State-owned Residences, jointly promulgated by the Ministry of Finance, the Leading Team of Housing Reform under the State Council, and the Ministry of Construction on 23 November 1994, it was prescribed that the revenues of the sale of state-owned houses should be turned over according to the following proportion: 85 per cent for housing management departments, the administrative bodies and government institutions with full budget management; 60 per cent for government institutions with balanced budget management; 30 per cent for government institutions with independent budget management; and 10 per cent for enterprises. In the Circular on Collecting the Revenues in Selling State-owned Residences issued by the Ministry of Finance and the People’s Bank of China on 14 June 1995, it was reiterated that sales revenues should be collected on time and in full. These policies dampened the enthusiasm of home owners, and as a result sales of public houses remained stagnant until December 1995, when the national work conference on the housing reform was held in Shanghai. At the conference it was made explicit that sales revenues should be taken as a special fund for housing construction and reform, and that government institutions and enterprises should no longer be required to turn them over to the state. They should be retained by the owners in full. Since then, the initiatives of home owners were brought into play, which in turn promoted sales in public houses. According to the Provisions on Establishing a System of Public Housing Funds promulgated by the leading team of the housing reform under the State Council on 3 July 1996, housing funds for employees tend to include a number of sources. For enterprises, housing funds can be obtained through reserves for house depreciation and other transferred funds, and that deficiency can be listed in the expenses and costs in the audit. For government organizations and institutions with full budgets, housing funds can mainly rely on the transfer of the existing housing funds, and the deficiency can be covered by government appropriations. For government organizations and institutions with a balanced budget, housing funds can be raised by their own funds and government budget in proportion. The burden on public finance should be assumed by central and local financing in line with the financial system and jurisdiction. The same method should be adopted for government institutions with independent budgets. To facilitate

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housing reforms and reduce costs for enterprises, it is well advised to provide a housing allowance in a lump sum for employees who began to work before 1978 and are aged over 50. Also, the residential area of the enterprises should be entrusted to real estate management companies with the objective of socialization.

The Leading Role of the Government Of the five forces of the housing reform, the most active one is the government. Governments at all levels must accept the decision made by the CPC central committee and the State Council to build a macro-control system in line with the operation of the market. Financing at all levels must find a new solution through the housing reform because they are no longer able to meet the increasing demand of the employees for better residences with the old model of housing distribution as welfare in kind. The socialist market economy requires a change of the government’s function and a separation of government administration from enterprise management. The government should transfer operations and management to enterprises, resource allocation to the market, and social supervision and services to social intermediaries. As a result, its function in economic management will be shifted to the development and implementation of macro-economic policies and the creation of a good environment for economic development. Through economic, legal, and administrative means, the government exercises macro control over economic activities. In the process of deepening the housing reform in urban areas, the government will continue to play a key role, but its function will be limited to the development of policies, exercise of macro control, and supervision with minimum direct involvement. Experiences in many countries have shown that direct government intervention will inevitably lead to a decrease in efficiency and a waste of resources. It will not only be detrimental to the establishment and improvement of a demand and supply mechanism in the housing market, but also increase the government’s burden of selling houses at a reduced price. This can be illustrated by the mistakes some local governments have made in carrying out the ‘easy home’ project. International experience has also shown that the solution to the housing problem should rely mainly on the ‘invisible hand’ of the market in resource allocation, while the ‘visible hand’ of the government should maintain social fairness by formulating policies favorable to the low-income class. However, if its coverage is too wide, it will not only increase the burden of the government but also hamper the process of residence commercialization and marketization and thus be detrimental to the establishment of the socialist market economy.

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The Cooperation of Banks Housing reform requires the cooperation of banks, as both housing construction and purchase require large amounts of capital. However, banks will be vulnerable to great loss, given the risks from both the demand and the supply sides. Developers need bank loans to build residences. If the market is not brisk and the completed residences cannot be sold, it will be hard for banks to get back their loans. In the meantime, residents also need loans to buy houses, but their solvency will be reduced in the event of unemployment, decrease of income, and severe illness. Real estate financing in China is still in its infancy, but banks have shown great enthusiasm towards the real estate industry. According to one report, the aggregate current fund loans to developers reached RMB 3 trillion and housing construction bonds for developers reached RMB 200 billion. Meanwhile, the financial sector is also directly involved in the real estate industry by means of establishing its own development companies. It has promoted the expansion of real estate development companies in the direction of conglomerates, which has resulted in an industry bubble and a large inventory of empty residences. In recent years, in the construction of low-cost residences initiated by the government, banks have given great support to developers. However, excessive policy interference has increased the banks’ financial risks. In Beijing, for example, the newly constructed low-cost residences in the 19 districts were put onto the market at almost the same time. This type of action inevitably increases the difficulties of selling residences in some locations. In addition, the room for price reduction is limited. Banks have little chance of having their loans repaid on time when there is an oversupply. Consensus has been reached in the financial community on the role of housing finance in promoting the development of the housing market. The state-owned banks and commercial banks are taking measures to expand their credit businesses. However, individual housing credit is a new business that is often policy-oriented with a large, diversified group of consumers. Many of these consumers know little about housing credit. The development of housing finance is further hampered by potential financial risks and the poor policy environment. The individual credit market requires support from a rigid and complete legal system. Without the protection of the law, banks will have no legal resort and will not be able to exercise their right of disposal towards insolvent families, given an individual credit cycle of 10–20 years. Mortgage and guarantee are two major measures through which the

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financial industry can avoid risk. At present, policies related to mortgages and guarantees for individual housing credit are incomplete and, as a result, mortgages do not help diversify a bank’s risks. In addition, the laws and regulations are immature, which has resulted in the sinking of housing credit in the form of assets in kind. To promote housing reforms, government interference in credit business should be minimized. The government should instead provide macro guidance, allowing construction loans to operate in line with the law of the market. In the meantime, clear and concrete regulations should be developed on individual housing loans and be communicated to consumers more clearly. Last but not least, related laws and regulations must be formulated to provide legal protection for housing finance. For example, an income registration law should be drafted to ensure a bank’s effective analysis of the credit status of the loan receivers, and laws on mortgage registration and disposal should be developed to ensure a bank’s effective recovery of its loans.

STRATEGIES FOR THE TRANSITION FROM THE EXISTING SYSTEM TO THE TARGET MODEL Having defined the target model of the housing reform and analyzed the basic attitudes and behavioral characteristics of the parties concerned, we propose adopting the following four strategies to realize the transition from the existing system to the target model. These strategies have taken into account the announced polices on the housing reform.

1. Providing Reasonable Allowances and Activating Inventory Residences To step up the housing reform and break with the old housing system, the first action is to take back the residence ownership and distribution rights of government organizations and enterprises. At present, the so-called public houses are actually occupied by employees at a low rent. In addition, both the state and employers are spending billions on management and maintenance. Therefore, it is essential to sell most public residences in stock to employees. This requires setting a reasonable price and providing a reasonable allowance to increase the purchasing power of the employees, as well as raising the rent significantly to encourage them to purchase. In pricing, two problems need to be solved. The first is to have one standard for all residences, regardless of their location, height, aspect, and environment. The second is low pricing, as a result of various discounts, creating a chance

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for people to purchase their own homes as much as possible and turning public ownership into private property. Given the realties, I argue that the pricing of public houses should be based on the price of low-cost commodity houses, allowing the deduction of depreciation and the consideration of differences among various factors. This can not only prevent the malpractice of selling public houses at a low price, but also provide a pricing basis for their future exchange on the market. In the meantime, a reasonable allowance should be provided in the sale of public houses. This is because the employees of government organizations and enterprises have long been underpaid. For many, it is a heavy burden to use a large sum of cash to buy a home, and a reasonable allowance will be helpful to their enthusiasm for housing purchase. Another reason is that housing consumption was excluded from wages during the planned economy system. The longer an employee’s years of service is, the higher the deduction will be. Therefore, it is reasonable to provide a housing allowance based on years of service. Such an allowance is similar to social security. Given the various discounts for the public homes that have been sold, it would be unfair to the employees who will eventually buy their public residences if no allowance is provided. According to a sample survey of the National Statistics Bureau, the average housing expenses of urban residents in 1998 constituted only 3 per cent of their income. To stimulate their desire to purchase, rents should be increased drastically. This increase can be carried out in two steps. The first step is to increase rent to the level of cost rent without any allowance, which would account for 7 per cent of a family’s income. The second step is to increase rent to the level of market rent rate in two years, which would account for 15 per cent of a family’s income. Allowances will be provided only to low-income families to maintain their rent at the level of cost rent. Our field study shows that most employees are ready for the increase in their rent, both economically and psychologically. Therefore, we should lose no time in pushing for such a practice. As an example, the experience of Germany can be used for reference. After its unification, the German government invested heavily in housing renovation in the former East Germany, and increased rent significantly in 1991 and 1993. Rent increases played a pivotal role in housing reform. The first increase in October 1991 included all the operating costs in the rent, which went up to DM 3.44 per m 2 per month, four times more than the rent before the reform. The second increase in January 1993 raised the total rent to DM 7.5 per m2 per month, which was 75 per cent of the cost of rent in the former West Germany. These two significant increases not only promoted the

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alignment of the residential economy between the east and the west, but also laid a foundation for the establishment of a state-controlled market rent system. Similar experiences can be found in China. Ten years ago, Shenzhen decided to sell all public homes to employees, and increased rent from RMB 0.14 to RMB 2.06 per m2, with a housing allowance provided at the same time. By the end of 1997, 124,643 apartments had been sold with recovered funds up to RMB 7.45 billion. The aggregate loans provided by the Shenzhen branch of the Bank of Construction reached RMB 2.65 billion, among which the rate of overdue loans was 2.1 per cent and the rate of paid-up interest was 98 per cent. In spite of inflation and income increases since the late 1980s, housing prices have been maintained at the reasonable level of five times a family’s annual income. The sale of public residences will not only help the government and enterprises get rid of their large inventory of residences and pay off old debts, but also activate the inventory assets occupied by the employees and recover enormous capital. It is estimated that 50 per cent of urban residents will have their own residences as a result of the policy of selling public houses with reasonable allowance, which will create a favorable environment for the reform of the housing system.

2. Adapting to Demand and Developing the Market The focus of the housing reform after the solution of the sales of public residences should be on the development of the housing market: providing commodity residences for those who have no shelters and allowing those who have bought public houses to sell them and either buy new ones for improvement or rent. An important objective of the housing reform is to establish a multi-level urban residential supply system with low-cost housing as the priority. The key is to implement different policies for families with different incomes (i.e. highgrade commodity residences for high-income families at market-regulated prices, low-cost commodity residences for middle to low-income families at a policy-guiding price, and low rent residences for low-income families at a price set by the government). In a multi-level housing security system, residences housing people with different levels of income can have different levels of security. ‘Easy-home’ projects and low-cost residences have played an active role in the development of the housing market for the supplier, but problems remain for the demand side. The priority is to allow the market to play its basic function in resource allocation. It is estimated that families with no shelter in a real sense (excluding

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employees who are renting public residences at a low rent as a welfare benefit) account for 10 per cent of the total population of urban families, including employees who have just begun to work for government organizations and institutions, employees who are working for private and foreign-invested companies, and employees who are working for enterprises in financial difficulty. Some of them rent houses and others live temporarily with their parents or relatives. Despite the difference in their incomes, most of them can afford to buy commodity residence with a mortgage. Purchase allowances should be provided to employees working for government organizations and institutions who either have no shelter or live in sub-standard houses. Careful study is needed to determine the amount of the allowance. The present policy is that a housing allowance will be provided for families with a housing cost/income ratio (the ratio between the average cost of a 60 m 2 economy residence and the average annual income of a two-job family) above four, and the amount of the allowance will depend on local housing prices and personal income. Three types of housing allowance are provided in different places. The first type is on a monthly basis within a set term. In Guangzhou, for example, the term is 25 years (300 months). The second type is on a lump sum basis, provided at the time of purchase. A limit (usually 25 years) is set on the years of service of an employee who applies for the lump sum allowance. Below the limit, allowance will be provided according to actual years of service, and the gap is taken as a loan from the employer which will be deducted in future years of service. The third type is the combination of a basic allowance with the lump sum allowance, which means that the basic allowance will be provided on a monthly basis, while the gap positions and years of service will be provided as a lump sum upon purchase. In many places, the second type is preferred by senior employees and the first type by new employees. We believe that the combined approach is more appropriate for China. On the one hand, the housing problems of senior employees can be solved all at once, and on the other hand, part of the installment payment can be covered with the basic allowance which can be included in the wages whenever appropriate. The key consumers in the housing market are the high-income employees of government organizations and enterprises, who make up 60 per cent of urban families in China. Efforts should be made to create favorable conditions for them to improve their housing conditions through the market. They should be encouraged to sell their old residences in the secondary market, and buy new ones with the resulting income plus individual savings, housing fund loans, or bank credit.

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Files on employees’ residences need to be set up and the ownership of the sold public residences should be clarified to prevent malpractice and corruption in the sale of old public residences. Employees who have bought public residences at unreasonably low prices should bridge the gap before they are granted complete ownership. Those who have violated state regulations by occupying more residences than allowed should be severely reprimanded and charged with a rent equivalent to the level of commodity residences. Those who dare to sell or rent their residences without authorization should be heavily fined and any income from such a sale or rental should be confiscated. In the meantime, people who report such offenses should be rewarded to encourage the fight against corruption. The prevailing housing supply system consisting of commodity residences, low-cost residences, and low-rent residences is appropriate in structure, as it caters to the demands of different income classes. However, as the proportion of low-cost residences is as high as 70 per cent, it can be detrimental to the basic function of the market in resource allocation. It also delays the commercialization and marketization of residences, if low-cost residences are defined as residences of social security at a price directed by the government (allowing 3 per cent of margin for the developer). In addition, the government will have to bear the obligation of organizing and providing low-cost residences. I believe that the housing allowance provided in selling public residences has already embodied the function of residence as a form of social security. It is neither possible nor appropriate for the government to take over the responsibility of housing improvement. Therefore, a large proportion of low-cost residences should be allowed to trade in the market as medium-grade commodity residences. During the operation of low-cost residences, the government, developers, and consumers should follow the rules of the market, find their own positions, and assume their own obligations while enjoying corresponding rights. The government is responsible for making directive regulations, providing preferential policies, and supervising the application of the preferential policies by the developers and consumers so that the policies will not be abused. Developers are responsible for selecting development projects, development scales, construction standards, selling prices, and marketing methods according to the directive plans and preferential policies of the government, and at the same time for taking the potential risk of wrong decisions. Consumers can independently choose, based on their own payment ability and preference, suitable residences and take the possible risk of wrong decisions. From the perspective of social and economic development, low-rent and low-cost residences will have to, when developed to a certain extent, gradually

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move in the direction of commodity residences. In South Korea, for example, the Korean Housing Corporation has monopolized around 90 per cent of the housing supply. The Corporation’s focus has shifted from the supply of strictly governmental public residences to the supply of public as well as commodity residences. For low-cost residences in particular, attention should be paid to their different levels to ensure a gradual and smooth transition from low-rent residences to market-priced commodity residences. Priority should be given to the shift of low-cost residences from a near-market price to a full-market price. The government should provide timely advice to lead development trends and formulate long-term policies and strategies conducive to the transition of lowcost residences to commodity residences.

3. Strengthening Macro-control and Disposing of Empty Buildings In developing the housing market, one of the most pressing problems is empty commodity residences. During the development rush in 1992, investment increased by 117 per cent compared with the previous year, and the figure reached 211 per cent in Hainan and 100 per cent in Inner Mongolia, Liaoning, Jiling, Helongjiang, Fujian, Shangdong, Henan, and Guangxi. The investment focused on the coastal provinces, followed by the north-east. Investment in Guangdong alone accounted for 32 per cent of the total. The inflow of capital from the interior of China to the real estate industry in the coastal areas contributed to a price hike in land and housing, which in turn stimulated the speed of inflow of capital from the interior areas. The consequence of this is a serious imbalance of the national economy and great financial disorder, with illegitimate bank loans of over RMB 100 billion. On 24 June 1993, the Central Committee of the CPC and the State Council issued the Opinions on the Current Economic Situation and the Strengthening of Macro Control, which set forth 16 policies to regulate the financial order and strengthen macro control. These measures, though effective in controlling the source of funds and reducing the problem, did not stop turbulent developments in the real estate industry. In 1993, investment in commodity residences reached RMB 113.8 billion, 125 per cent more than the previous year, Mille sales of commodity residences were only 48.7 per cent more than the previous year. There was a huge overstock of commodity residences. In subsequent years, overheating real estate development was brought under macro control. However, the non-occupancy rate was not reduced as a result of the immature housing market, short-term variables, and blindness of the developers. It was reported that by the end of 1997 and 1998, the total areas of empty buildings were 70 million m2 and 80 million m2 respectively. The

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situation deteriorated in 1999, as the developers were over-optimistic about market demand and group consumption (i.e. many government organizations and enterprises wanted to ‘catch the last bus’ of the distribution of residences as welfare in kind before the deadline). From January to July 1999, 101.63 million m 2 were developed as commodity residences throughout the country, a 28.6 per cent increase compared with the same period of the previous year, and the completed area was 42.05 million m2, a 24.3 per cent increase compared with the same period of the previous year. However, the sold area was 35.66 million m2, only 7.1 per cent up compared with the same period of the previous year. Although the overstock of commodity residences resulted from the overheating of real estate development rather than reform of the housing system itself, it had a negative impact on the developers and banks and became a worry to the government. Consumers, when seeing so many empty buildings and ‘unfinished projects’, feel tremendous shame, but at the same time expect a substantial decrease in the price. Therefore, the problem can only be solved through the strengthening of macro-control. It is reported that the Tentative Proposal for the Disposal of the Overstocked Buildings in Hainan Province, which was jointly promulgated by the people’s government of Hainan Province, the Ministry of Construction, the Ministry of Finance, the Ministry of Territory and Resources, and the People’s Bank of China, has been approved by the State Council. Obviously, Hainan Province has been selected as a pilot province for the project. Statistics show that by the end of 1998, the development and construction scales of commodity residences had reached 36.69 million m2 during the ten years since the founding of Hainan Province, and the completed area increased to 16.86 m2. In addition, 1.44 million m2 is now under construction, 11.35 million m2 is suspended, and 7.04 million m2 has been approved but its construction not yet started. Since the founding of Hainan, the aggregate sales of commodity residences have been 9.74 million m2, and 7.03 million m2 of constructed residences remain unsold, of which 5.94 million m2 are not occupied. The overstock of buildings has led to a great deal of stagnant capital, and posed a great threat to the economic development of Hainan. The basic principles in handling the overstocked residences in Hainan approved by the State Council are as follows: to start from the macro economy and minimize the loss of state-owned assets; to standardize the real estate market and improve the quality of financial assets in line with the law and the market; to control the increase of real estate and stimulate effective demand through economic and administrative means; to solve historical problems and realistically adjust the relationship between creditor and debtor; and to make

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an overall plan and progress step by step. Three steps and measures have been suggested for the disposal of the overstocked buildings in Hainan Province: recourse of the debt and definition of the ownership, centralized disposal of the financial assets, and the classified disposal of overstocked buildings. With regard to the ‘unfinished projects’, effective measures have been developed in Guangdong Province, where the interests of owners both at home and abroad are well protected. It is reported that by November 1998, the problem of 102 buildings (over 70 per cent) was solved, covering 13,000 households and RMB 1.6 billion in down payments. The key to the problem is to strengthen macro control and also to look into its root causes and symptoms. For historical problems, governments at all levels should follow the examples of Hainan and Guangdong provinces to develop measures that are flexible, practical, and effective. In the meantime, enterprises should be regulated according to the operation and management provisions for the development of real estate in urban areas to prevent further overstock of empty buildings. Through an effective self-control mechanism, dissemination of industry policies and disclosure of statistics, and market demand and supply information, blind development and over-construction can be avoided.

4. Making a Breakthrough and Progressing in a Coordinated Way Housing reform in urban areas is a complex project. On the one hand, we need to identify certain key problems in order to make a breakthrough. On the other hand, we need to develop a close cooperation between all sides and progress in a synchronous and steady way. After years of experiments, a new distribution system has been recognized as a breakthrough: distribution in currency. Under the old housing system, residences were distributed as welfare in kind, with all the costs of management, maintenance, and renovation covered by the government and employers. Obviously, the housing reform will come to a deadlock if this situation is not reversed. By providing a housing allowance, employees can buy or rent residences through the market. Such a transition from distribution in kind to distribution in currency will not only reduce the employees’ dependence on their employers and prevent the flow of newly built residences into the old system, but also rectify the malpractice and unfairness in housing distribution. In addition, the housing reform will help change the mindset of employees towards housing consumption, and set up a housing system that is based on the commercialization of residences and is in line with the socialist market economy. Two major measures in promoting the new housing distribution in currency are the abolishment of the housing distribution in kind and the increase of rents.

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No compromise should be made in these measures, regardless of the obstacles. Meanwhile, close cooperation should be developed in the following areas to ensure a smooth transition from the existing system to the target model.

1. Establishing a Housing Supply System With the Developers at the Core In developed countries, the supply of residences is shifting increasingly from the government or non-profit organizations to the private sector. The role of government is diminishing. In some European countries, for example, the proportion of residences completed in 1994 which were supplied by developers were as follows: the United Kingdom, 98.5 per cent; Germany, 98.4 per cent; and Holland, 70.3 per cent. However, governments in emerging countries and regions are still playing an important role in the supply of residences. For instance, the proportion of residences constructed by the public sector in 1996 reached 85.2 per cent in Singapore and 78.3 per cent in Hong Kong. However, these countries and regions began to realize the importance of reducing the government’s burden in the supply of residences and motivating private developers to be the major players. In China, the housing supply was wholly dependent on the government and employers under the planned economy system. A transition is taking place from the old to the new system. In Shenzhen, for example, the economy is much more developed than in other parts of the country and has two supply channels: developers (i.e. commodity residences) and the government (i.e. welfare and low-profit residences). In many big cities like Beijing, the key channels are the developers and employers who either construct independently or cooperate with others. With commercialization, the weight of commodity residences will increase. Therefore, a housing supply system should be set up with developers at the core. The government shall only be responsible for the supply of low-profit and low-rent residences, while enterprises shall withdraw from the supply system. Developers, under the guidance of government policies and with the support of financial institutions, should raise funds according to the law and invest in the construction and marketing of commodity residences. They should operate independently and be responsible for their own gains and losses. Through self-development and selfaccumulation, they should become the major players in the housing supply.

2. Establishing a Housing Consumption System With Individuals at the Core With the abolition of the old distribution system, employers are playing an

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increasingly minor role in the housing system, while urban dwellers are becoming the key consumers. One report states that in China’s housing market group consumption has already given way to individual customers. The private purchase of residences has risen to 77 per cent. Investment demand is usually decided by actual customer demand. Therefore, developers have to study their effective demand after individuals have become the key consumers in the housing market. The housing market will remain a buyer’s market for a long time. The characteristics of this demand can be summarized as follows:

(1) Different levels The consumer’s demand for residences can be grouped into five levels: space, function, environment, service, and taste. The first-level demand is represented by basic physiological needs, i.e. a space in which people can have shelter, rest, and procreate. When these needs have been satisfied, people will have a second-level demand for function, such as additional rooms, separate quarters for rest and leisure, and a complete set of interior facilities. This is a milestone in the development towards housing civilization. The third-level demand is for the quality of the internal and external environments, including such features as lighting, ventilation, decoration, and furniture in the rooms; natural and social environments; and public facilities. This is an important part of affluence in housing conditions. The fourth-level demand is for service quality. From housing maintenance to daily family life, people demand quality services. This represents a transition from being well-off to being very well-off. The fifthlevel demand is for personal taste. During a transition from being very welloff to being wealthy, people begin to manifest a personal taste for community, neighborhood, family, and culture and art. Given the realities of China, most cities will experience a transition to a well-off level in the next 5–10 years, and a few coastal cities will experience a transition from a well-off to a wealthy level. During the process, the five-level demands will exist side by side. Among urban dwellers, there exist both people who are in dire need of basic living space and wealthy people who demand quality houses and apartments.

(2) Progressiveness The consumer ’s effective demand is decided by their socio-economic development and purchasing power. In housing consumption, consumers have to first of all obtain the ownership or the actual right of use. They therefore need to make a lump-sum investment in a residence and pay current expenses on decoration, energy, real estate management, and property taxes. Though

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general housing consumption shall conform to the different stages of social development in terms of the whole of society, the quantity and quality of the housing consumption of each family is dependent on its purchasing power. With socio-economic development and the growth of family income, people will invariably increase their demand for residences, which will in turn create an opportunity for the sustainable development of the real estate industry.

(3) Prudence As residences are durable goods of high value, consumers are usually prudent in making a purchase with their own savings and bank loans. They tend to be very selective in terms of the cost-function effectiveness and quality of residences. They might have many requirements and try to get a better deal in the payment terms and contract clauses. This is where group consumption differs and requires meticulous work from the seller. To establish an ethical housing development mechanism that is oriented to effective demand and based on effective supply, developers should, according to the above features, make a careful study of consumer psychology and behavior and try their best to meet consumer demand with quality products. By creating a strong brand, they can win the trust and recognition of the consumers.

3. Establishing a Housing Exchange System with the Intermediary as the Link In house trading, neither the buyer nor the seller is able to get updated information about the market, while trading costs are extremely high. For most buyers, it is very difficult to get access to the latest information about the market and determine purchasing prices according to the location, type, and condition of the building and its affiliated facilities. Therefore, the housing market needs consulting services from such professionals as housing appraisers, agents, and lawyers to improve its efficiency and reduce trading costs. The housing intermediary service, which involves finance, law, consulting, property assessment, and agents, has witnessed a fast growth in recent years. As a whole, however, it is far from mature, and can hardly meet the needs or a buyer’s market with individuals as the main consumers. On the one hand, the laws and regulations are incomplete, and market behavior is not standardized. On the other hand, the quality of practitioners is poor, management is poor, and the means are backward. All these factors have brought about a number of grave problems. Purchasing and renting intermediaries, in particular, have irritated consumers by their fraud, random charges, and poor service.

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4. Establishing a housing control system with the government as the key As the housing market is still immature and many factors have had an impact on housing demand and supply, its balance can hardly be maintained through the price mechanism alone. Thus, government interference is essential in influencing the quantity and price of market supply and demand, leading the main bodies to form reasonable expectations of the housing market and optimizing the market’s resource allocation. Under the market economy system, the macro-control of the government over the housing market includes three measures: increasing the housing supply, boosting the housing demand, and controlling the price of rent. It must be pointed out that the government’s macro-control over the housing market is based on the recognition of the commodity property of residences and the basic laws of the housing market. The main responsibility of the government is to help eliminate the weaknesses of the market. In exercising macro-control over the market, it needs to understand the existing relations between supply and demand, analyze such basic features of the market as housing supply elasticity and demand elasticity, and follow the laws of long-term and shortterm changes in housing supply and demand. The government’s macro-control over the market can provide adequate market information and grant an equal position for both the supply and demand sides in trading, and speed up the formation of a balanced market. It can also promote market competition, and push suppliers to reduce construction costs by improving design, adopting new processes and new materials, and improving the bidding management and quality supervision systems rather than by using inferior materials. On the demand side, the government can help change the mindset of total reliance on the government and employers, and stimti-late the search for new sources of income and increased spending on housing consumption. However, government interference will sometimes produce a negative impact on the market such that the supply side expects a price hike and the demand side expects a price decrease. For example, when the government allows group consumption, the supply side is reluctant to lower the price and increase its input in improving the construction design and effective space of residences. Another example is the low-rent policy which has discouraged housing consumption in urban residents. The above is a preliminary analysis of housing reform in the urban areas of China. Such reform must be a complicated and strenuous process. Over the past decade, a great deal of precious experience has been acquired. It is my belief

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that the reform will be a great success and create a favorable environment for a complete socialist market economy system by 2010, as long as the reformers uphold the theories of Deng Xiaoping, develop an in-depth understanding of the realities of China and a vision for its reform, define the target model, balance the interests of various sides, regulate the timing for policy-making, and work in a down-to-earth way. Completed on 29 August 1999

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Chapter

An Analysis of China’s Rural Consumer Markets

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Since the late 1990s, new problems have begun to crop up in China’s economic development: a surplus of products and a decrease in price levels. With the threat of deflation, the expansion of the rural consumer market has become critical to China’s continued economic growth. As early as 14 October 1998, the Decisions of the CPC Central Committee on Several Important Issues in Agriculture and Agricultural Work was passed at the Third Plenum of the Fifteenth CPC Central Committee. It stated explicitly that facing the impact of the Asian financial crisis and the challenge of economic globalization, we must try every means to improve our agricultural work, boost the agricultural economy, and increase the purchasing power of the farmers. This will help expand the domestic demand, maintain the momentum for economic growth, and increase our space in international cooperation and competition. In developing the overseas markets, we must also focus on the expansion of the domestic markets, and on the rural market in particular. This should be our starting point in economic development. On 11 October 2000, the Proposals of the CPC Central Committee on Developing the Tenth Five-Year Plan of National Economy and Social Development was passed at the Fifth Plenum of the Fifteenth CPC Central Committee. It pointed out that ‘the increase of the farmers’ income concerns not only agriculture and rural development, but also the whole national economy. We must spare no efforts in adjusting the agricultural structure, expanding the sources of income for the farmers, increasing our support and protection for agriculture, reducing the farmers’ burden, and realizing the continual growth of the farmers’ income.’ China boasts a population of over 1.2 billion, of which 900,000 million comprise the rural population. The rural market has almost unlimited potential and can provide great momentum for industrial development. It is of practical importance to improve agriculture, maintain the stable development of the agricultural economy, increase the production and income of farmers, and help farmers to become wealthy within the shortest possible time. In developing international markets, we must also find a foothold in the domestic market and in the rural market in particular. The increase of domestic demand is not only an important measure to meet the challenge of economic globalization and expand our position in international cooperation and competition, but also a major strategy to reduce the threat of deflation and maintain the stable growth of China’s economy. However, it should also be borne in mind that the development of the rural market is a complex, arduous, and long-term task. China has a 70 per cent rural population, featured by limited arable land, a vast population, and unbalanced

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regional development. In such a ‘dual economy’ structure, the development of the rural market is not only related to the development of the national economy and the change of the economic structure, but also concerns the transfer of rural labor and the progress of rural urbanization. In this chapter, I will start from the realities of agriculture and use complexity science and consumer economics to discuss the difficulties and problems in developing the rural consumer market. I will also try to come up with a number of suggestions and proposals. For the sake of brevity, the term ‘farmers’ will be used to cover all rural residents and the term ‘per capita income’ when referring to the net income per capita.

REDUCING RURAL POPULATION AND INCREASING FARMERS’ INCOME: THE ONLY WAY TO MODERNIZATION The importance of agriculture in the national economy is its basis. It not only meets the needs of the country for farm products in quantity and quality, and ensures the food supply and social stability, but also provides labor, capital, and a huge market for industrial development. A close look at the modernization process in many countries reveals that it is in fact a process of proliferation of modem industrial production and modem industrial life, with industrialization at its core. Industrialization is accompanied by the gradual separation of handicrafts from agriculture to become an independent industry, the departure of farmers from the land to become industrial workers, and the development of rural areas into cities and towns. Agriculture has not only provided both markets and resources (including human resources), but has also accumulated capital for industrial development. With industrialization, the weight of agriculture in GDP and the percentage of farmers in the total population have been decreasing, while the productivity and living standards of the farmers have been improving. The United Kingdom was the first industrialized country in the world. In the 100 years from the mid 18th Century, its population tripled and its per capita income doubled. A number of villages were replaced by big cities and towns. The number of non-agricultural residents, supported by the grain produced by each farmer, increased from 1.5 in 1650 to 6 in 1860. The United States is another good example. The rural population in 1790 accounted for 94 per cent, but dropped to 21 per cent in 1930. All these examples have shown that the only way to modernize is to reduce the rural population and increase farmers’ income. According to the latest data on input and output, the actual consumption of every RMB 100 billion by farmers will create a consumer demand of RMB 235.6

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billion, and increase the intermediate input of the industrial sector by RMB 125.3 billion, the agricultural sector by RMB 62 billion, and tertiary industry by RMB 47.8 billion. Rural residents account for 70 per cent of the total population, but they accounted for less than 38.7 per cent of the retail volume of consumer goods in 1999. If we can increase the ratio to 50 per cent, as in the Seventh Five-year Plan, the retail volume of consumer goods will increase by RMB 350 billion, and consumer demand will increase by RMB 800 billion. A study by the National Statistics Bureau shows that the income elasticity of the farmers for industrial consumption is around 1.314, which means that for every 1 per cent increase of farmers’ per capita income, the consumption expenditure will increase by 1.314 per cent. If each farmer increases his or her consumption by RMB 10 each year, the resulting actual purchasing power will be around RMB 9 billion, an increase of the rural retail volume of consumer goods by 0.75 per cent if using 1999’s total retail volume of consumer goods as an example. It is obvious that the development of the consumer market will rely on the huge market in the countryside.

REALITIES AND POTENTIAL IN THE RURAL CONSUMER MARKET In theory, rural consumers have huge potential. Since China’s reforms and opening up, farmers’ per capita net income has experienced a rapid increase, from RMB 134 in 1978 to RMB 2,210 in 1999. Annual growth has reached up to 14.3 per cent, and actual annual growth is 7.7 per cent after inflation. In the meantime, farmers’ consumption has been increasing, from RMB 116 in 1978 to RMB 1,577 in 1999. The net increase amounts to RMB 1,461, at an average of 13 per cent on a year-to-year basis. Taking inflation into account, the actual growth rate is 7 per cent. However, the consumption level of farmers is much lower than that of urban residents. Consumer durables are a good example. The possession rates of washing machines, refrigerators, and televisions per 100 rural households were 24.32, 10.64, and 38.34 sets respectively in 1999, while these rates were 91.44, 77.74, and 111.57 sets respectively for every 100 urban households. According to one optimistic estimate, the possession rates of the 230 million rural households will be up to the 1999 level of urban households in 10 years. This means an annual demand of 15.4 million washing machines, 15.4 million refrigerators, and 168.7 million television sets. Such a vast demand is likely to come true. The average purchasing power of an individual farmer in 1998 was RMB 3,181, which means a total purchasing power of RMB 2.74 trillion for a rural population of 860 million. However, the

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actual consumption of that year was only RMB 1.46 trillion (53 percent). The average balance of the purchasing power of an individual farmer by the end of 1998 was RMB 1,633, of which 53 per cent was cash. Taking into account the huge bank deposits of rural residents (up to RMB 1 trillion at the end of 1998), the potential purchasing power in the countryside is almost unlimited. However, the huge potential of rural purchasing power is hard to turn into actual consumption. The retail volume of consumer goods in the rural market increased from RMB 106 billion to RMB 1,204 billion between 1980 and 1990. However, its proportion in the total retail volume of consumer goods dropped from 65.7 per cent to 38.7 per cent in the same period. Between 1985 and 1999, rural consumer markets increased from 53,300 to 63,600, but their proportion in the total number of consumer markets dropped from 86.9 per cent to 71.8 per cent in the same period. Sales in rural consumer markets increased from RMB 51 billion in 1985 to RMB 938 billion in 1999, but their proportion in total sales dropped from 80.9 per cent to 43.2 per cent in the same period. Obviously, the rural markets are far from being prosperous. The impact of rural consumption on the national economy is diminishing. Farmer consumption before 1987 accounted for 60 per cent of overall consumption. This decreased from 62.1 per cent in 1978 to 43.6 per cent in 1999, despite the fact that the total volume of the farmers’ final consumption grew from RMB 109 billion to RMB 1,719 billion in the same period. The total consumption of the farmers is much lower than that of urban residents. The impact of rural consumer demand on the expansion of the overall consumer market is diminishing. The final consumer demand of the farmers has an increasingly smaller pull effect on the growth of GDP. Since the 1990s, the pull effect has been decreasing, with a high of 56.9 per cent in 1992 and a low of 25 per cent in 1997. The pull effect of the farmers’ final consumption on GDP dropped from 30 per cent in 1992 to 12.4 per cent in 1997. In a word, the position of the countryside in the consumer market has been decreasing. Beginning in 1999, the government developed a series of policies to boost the consumer market, including increasing the income of urban residents, reducing the interest rate, and levying interest tax. These measures have stimulated the urban market, but have had little impact on the growth of the rural market. In fact, they have led to the further decrease of the importance of the countryside in the national consumer market. With the flow of the rural population to cities increasing, the importance of rural consumption has dropped sharply. However, the real problem lies in the unbalanced economic development between urban and rural areas as a result of

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the ‘dual economy’ structure. An inevitable consequence is the increasing gap between the town and the countryside in consumption levels. In terms of micro consumption, farmer consumer demand has undergone fast growth since the reforms. Compared to urban residents, however, there is still an obvious gap, which is the direct result of the difference in income between urban and rural dwellers. Beginning in the 1990s, the growth of farmers’ income has been much slower than that of urban residents in most years. The narrowing gap of the 1980s is now expanding. The ratio of income between urban and rural residents decreased from 2.6:1 in 1978 to 1.7:1 in 1984. Between 1992 and 1998, however, the ratio increased to 2.64:1. In 1999, the per capita incomes of farmers and urban residents were RMB 2,210 and RMB 5,854 respectively. In comparable price, farmers’ incomes in 1998 were RMB 16.6 less than those of urban residents in 1986. In terms of purchasing power, it was the same with the 1987 incomes of rural residents. The 13-year gap in income led to a significant difference in consumption level. Accompanying this gap is the increasing discrepancy in consumption expenditure between urban and rural residents. Between 1990 and 1998, the per capita consumption expenditure of urban residents increased from RMB 1,279 to RMB 4,332, while the per capita consumption expenditure of rural residents increased from RMB 585 to RMB 1,590 in the same period. The ratio of consumption levels between the two was 2.19:1 in 1990, but increased to 2.72:1 in 1998. In terms of consumption structure, farmers have not been able to get rid of the model of survival consumption. Food and housing expenses have taken the largest share of their consumption. In 1998, the Engels coefficient of urban residents was 44.5 per cent, while the same figure was 53.4 per cent for farmers, comparable to the 1983 coefficient for urban residents. In 1990, the Engels coefficient for farmers was up to the level of urban residents before the reforms. Between 1990 and 1998, the Engels coefficient for farmers decreased by only 5.4 per cent while the same figure was 9.7 per cent for urban residents in the same period. Farmers’ housing expenses were kept between 14 per cent and 18 per cent, while the same figure was between 8.2 per cent and 9.6 per cent for rural residents who enjoyed welfare housing and housing allowances. The high proportion of food and housing expenses has kept farmers from other consumption. In 1999, farmers possessed such high-end consumer durables as washing machines, refrigerators, televisions, and cameras, but their possession rates were much lower than those of urban residents. Brands and grades also differed widely different between rural and urban durable goods. The marked difference

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in both materials and branding further suggests a vast gap between rural and urban residents in consumption. The above is an analysis at the macro level. Given the great regional differences at the micro level, the contrast between the potential and the reality of the rural consumer market is much more complex. At the Third Plenum of the Fifteenth CPC Central Committee, President Jiang Zemin stressed that the stability of society would not be possible without the stability of the countryside; the wealth of the whole nation would not be possible without the wealth of the farmers; the modernization of the country would not be possible without the modernization of agriculture. Admittedly, farmers’ lives have been improving since the reforms. However, it is extremely difficult to tap rural consumption potential and develop the rural consumer market. Based on my field study in Jiangxi and Anhui provinces, the problems can be grouped under three categories: ♦ The first problem is the unbalanced distribution that exists despite the potential of the farmers’ overall purchasing power. Most of them do not have the purchasing power for consumer goods, and due to a number of factors, improvement in this respect is hardly possible. ♦ The second problem is the conservatism in the farmers’ consumer behavior. They have a strong sense of self-security, and tend to put all their money in banks. Thrifty as they are, they only spend money on house building and marriages. ♦ The third problem is the degree of maturity of the rural consumer market. The commodity exchange is not standardized, trading costs are high, auxiliary facilities are poor, and credit consumption is not popular. All these factors have a negative impact on rural consumption.

In the following pages, I will try to look at these problems from the perspective of complexity science, analyze the various factors affecting rural consumption, and eventually come up with a number of policy suggestions. In recent years, institutional economists represented by Douglass North, the Nobel laureate, have stressed the importance of social, historical, cultural, and political factors in social and economic development. As formal and informal systems have evolved on the basis of the history and culture of a given society, any analysis of the rural consumer market in China must start from the interaction between the system and the economy. However, due to the high complexity of social changes and economic development, minute differences in the initial conditions and random factors in the process of development will likely produce a significant impact on the present state and development path. These problems demand our further research.

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DISPOSABLE 1NCOME OF THE FARMERS: THE SOURCE OF CONSUMER POWER According to consumer economics, purchasing power is the sum of money put into the market to buy commodities (including means of production and means of subsistence) in a certain period. The part that has been transferred from the form of money to the form of commodity is referred to as the realized purchasing power. The remaining money in the form of deposits and cash in hand is referred to as the unrealized purchasing power. To obtain a full picture of the purchasing power of rural residents, we have used the survey program proposed by the National Statistics Bureau, and computed the indices of their purchasing power as follows: Purchasing power of rural residents = annual cash income - tax payment - part handed over to the collective - collective reserves and apportioned cost - other nonproductive expenses - savings, credit, and cash expenses + balance of deposits at the beginning of the year + cash in hand at the beginning of the year = purchasing power of the current period + balance of purchasing power of the previous year To facilitate the analysis of the rural consumer market, we try to introduce the concept of ‘consumer power ’, which refers to the farmers’ ability to pay in a given period for their means of subsistence and basic services. It reflects the aggregated consumer demand of the farmers to be paid in money. The ability of the farmers to buy goods and services in the market and the process of realization is an important means to determine and realize the purpose of social production, and to meet the material and spiritual needs of the farmers. Therefore, the farmers’ consumer power reveals the energy and capacity provided by the rural consumer market. It is not only related to the prosperity of the rural consumer market, but also has a significant impact on the development of the national economy. The consumer power of the farmers depends mainly on their disposable income, that is, the cash income in the current period, plus the balance of deposits and cash in hand in the previous period, less than tax, cash expenses on production, and other non-productive expenses (such as repayment of debts and gifts). As agricultural production and farmers’ incomes are seasonal, it is more appropriate to calculate the disposable income on an annual basis. It is worth pointing out here that this concept is quite different from the disposable income in the national income account, but much closer to the ‘disposable purchasing power’ suggested by the National Association of Industry. Based on the above definition, we are now in a position to give an in-depth analysis of the factors affecting the disposable income of farmers.

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1. Cash Income Our study reveals that the consumer power of the farmers is directly influenced by their cash income and expected future income. The cash income of farmers has the following features:

(1) Per capita income is too low Farmers’ income has been increasing since China’s reforms and opening up, with the per capita income increasing from RMB 270 in 1982 to RMB 2,210 in 1999. Compared with the income of urban residents, however, such a level is still too low. In 1999, the income of urban residents reached RMB 5,854, 2.6 times as much as that of farmers.

(2) Growth is slowing down Between 1978 and 1999, the annual growth rate off farmers’ per capita income reached 14.3 per cent. (The growth slowed down during the three years of regulation and rectification between 1989 and 1992). The household contract responsibility system in the 1980s motivated farmer initiative, and hike in the price of grain in the early 1990s increased their income significantly. Since 1997, the growth has slowed. The actual growth rates in 1997 and 1998 were 4.6 per cent and 4.3 per cent respectively, and in 1997 the growth rate was only 3.8 per cent, the lowest since 1994. In years to come, the potential for agricultural growth will be smaller, the price hikes of farm products will be more limited, the effect of structural adjustment will be increasingly insignificant, and the difficulty of upgrading township enterprises will be greater. It is forecasted that the income of farmers will maintain a slow growth for a long time.

(3) The source of income is diversified With the development of the market economy in China, farmers’ nonmonetary income has been decreasing, while the source of monetary income has increasingly diversified. Since the 1980s, the ratio of the monetary balance of rural residents (the percentage of the monetary balance per capita in total net income) has increased from 13.9 per cent in 1983 to 75.6 per cent in 1998. The main sources are: labor reward, sale of farm products, non-agricultural revenues, transfer and assets revenues, and deposits, credit, and cash revenue. Looking into the income structure, we find that the key source is the revenues generated from the sale of farm and subsidiary products. However, these revenues are decreasing. In 1985, they took up almost half of the annual cash income, but in 1998 they dropped to 41 per cent. In the meantime, due to the development of non-agricultural industries and the increase of labor transfer,

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the percentage of the labor reward in total income increased from 16 per cent in 1985 to 23 per cent in 1998. The percentage of household industries experienced a similar increase, from 7.5 per cent to 11 per cent.

(4) Expanding regional differences Regional differences are expanding sharply with the unbalanced development of productivity. The inter-province Gini coefficient grew from 0.137 in 1980 to 0.217 in 1996; the inter-province gap in income (the ratio between the highest and the lowest) grew from 2.88 in 1978 to 4.4 in 1998; while the income gap between the east, centre, and the west of China increased from 1.27:1.05:1 in 1978 to 1.94:1.35:1 in 1998. Based on the 1998 survey of rural households, we select the net income per capita, the purchasing power, the purchasing power in the current period, the level of consumption, the Engels coefficient, and the degree of monetization of consumption as the six indices, and use the least square method to group the rural market into four categories after a standardized processing of the data with SAS software. The first category refers to the suburbs of big cities and to the most developed regions, including Beijing, Shanghai, Tianjing, Jiangsu, Guangdong, Zhejiang, and Fujian. The net income per capita in 1998 reached up to RMB 3,543, and the purchasing power up to RMB 5,737. The population accounted for only 17.6 per cent of the total, but its purchasing power was over 31.6 per cent. The purchasing power at the time of writing is RMB 3,274, which is 29 per cent of the total. The per capita annual expenses on commodity consumption are RMB 2,809, accounting for 29.2 per cent of the total. The balance of purchasing power is RMB 2,928, or 34.2 per cent of the total. The market share is much bigger than the population share. In the second category are Hebei, Xinjiang, Liaoning, Jilin, Helongjiang, and Shandong. These are major agricultural provinces, with a high share of farm products and the rural market. These areas also have a high percentage of per capita arable land, and a developed system of transportation. In the north-east, per capita arable land is 5.3 mu (0.8745 acres), and the percentage of commodity grain reaches as high as 60 per cent. The cotton and fruit in Xinjiang and aquatic products, fruit, and vegetables in Shandong province still have a competitive advantage in China. In addition, the consumption in these areas has a high degree of monetization. The rural population makes up 21.5 per cent, but the share of purchasing power is over 25.5 per cent. The market share, or the share of commodity consumption, is 23.9 per cent, while the share of the balance of purchasing power is 27.2 per cent. The market share is slightly higher than the population share.

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The third category includes Shanxi, Henan, Shaanxi, Inner Mongolia, Hubei, Hunan, Anhui, Jiangxi, Sichuan, Yunnan, Guangxi, Hainan, and Ningxia. These are undeveloped areas, with poor transportation and infrastructure. The average income is low, and the consumption environment is poor. The population makes up 49.2 per cent of the total, but its percentage of purchasing power is less than 37.7 per cent. The market share is around 40.5 per cent, and the balance of purchasing power accounts for 34.2 per cent. In summary, its market share is lower than the population share. The fourth category includes Guizhou, Qinghai, Gansu, Chongqing, and Xizang. These are the least developed areas in China. Farmers’ income and consumption levels are low, and the consumption environment is poor. The population accounts for 11.6 per cent, but its share of purchasing power is less than 5.2 per cent. The market share is below 5.9 per cent, while the balance of purchasing power is only 4.5 per cent. The market share is far below the population share. The above analysis shows that purchasing power represents a hierarchy in different regions. Assuming the regions in the fourth category as 1, the ratio of purchasing power among the four categories is 4:2.7:1.7:1, and the ratio of commodity consumption (representing the market share) is 3.3:2.2:1.7:1. Obviously, the distribution of rural markets is unbalanced in China. Purchasing power and the related market share exhibit obvious regional features. The consumption level of residents is dependent on economic factors, and consumer behaviour and environment are decided by regional factors. Our analysis has tried to combine both the economic and regional factors. In developing the rural market, we must take into account the regional differences in purchasing power, social customs, and consumption environment.

(5) Unbalanced distribution of income Gaps have also been identified in farmers’ income. Based on the 1998 data, we have divided 67,000 rural households into five groups (low income, lowermiddle income, middle income, upper-middle income, and high income), and analyzed their purchasing power and consumer demand. The per capita income of farmers was RMB 2,162 in 1998. The per capita income of the low-income group was RMB 822 and many farmers were living in poverty. The per capita income was RMB 1,345 for the lower-middle income group. The Engels coefficient for both groups was over 60 per cent, showing that the farmers remained at the level of subsistence consumption. In terms of population, they account for over 40 per cent, but their purchasing power is less than 20 per cent of the total. Their purchasing power in the current period can

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barely cover living and production expenses. The balance of purchasing power is only 17 per cent, but the effective demand for commodities is over 23 per cent of the total demand, which is higher than the percentage of the purchasing power. It indicates that the farmers in these two groups have consumption desire but, limited by their purchasing power, they will not have a strong demand at the present income level. In addition, their purchasing potential is quite limited. This tells us that they are insignificant in stimulating consumer demand. The per capita income in the middle-income group is RMB 1,815. The farmers in this group have adequate food and clothing. They have a strong desire for consumption, but this is still dominated by life necessities. Their consumer demand is increasing, but as in the low-income and lower middleincome groups, purchasing power is quite limited and the effective demand is inadequate. The per capita income of the upper-middle income group is RMB 2,459. The ratios of net income, purchasing power, balance of purchasing power, and effective demand are over 22 per cent, much higher than the percentage of the upper-middle income population. Per capita cash in hand is RMB 1,054, and each household has purchasing power of over RMB 1,000. On the whole, the farmers in this group are moving from a life with adequate food and clothing to a well-off life, and their demand for consumer goods is moving from the growth of quantity to the improvement of quality. However, the upgrade of their consumption structure will take time, as most farmers still rely on agriculture as their major source of income. Given the relatively low expected income, consumption in the current period is restrained. The living standards of the high-income group have been raised to the level of the wealthy. Their population makes up 20 per cent, but with 40 per cent of net income, purchasing power, purchasing power in the current period, and balance of purchasing power. The ratio of effective demand reaches as high as 39 per cent. The per capita balance of purchasing power is RMB 3,422, of which 52 per cent is cash in hand. The farmers in this group can afford to buy high-end consumer durables, and large and medium-sized agricultural machinery. Obviously, the balance of purchasing power is dominated by the high-income group. The farmers in this group have the largest purchasing power and potential. Their consumption structure is being optimized, and the Engels coefficient has been lowered to 47 per cent, which is comparable to the level of urban residents. The degree of commercialization and quality of their subsistence consumption is high. Without the worry over life necessities, the farmers in this group are turning to high-end consumer durables, such as refrigerators, motorcycles, television sets,

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video recorders, cameras, and air-conditioners. In the past few years, the demand for and growth in high-end consumer durables have mainly been stimulated by this group. In 1998, the per capita cash expenditure in production expenses was RMB 979, 1.6 times as much as that of the upper-middle income group. With a strong desire to upgrade their consumption structure, the farmers in the highincome group are superior to the farmers in other groups in terms of purchasing power and purchasing potential. However, as they account for less than one fifth, their share of the rural market is quite limited. In 1997, the percentage of households with net incomes below RMB 3,000 was 77.8 per cent, that of households with incomes between RMB 3,000–5,000 was 16.63 per cent, and that of households with incomes above RMB 5,000 was 4.94 per cent. In 1998, these figures were 77.8 per cent, 16.63 per cent, and 5.57 per cent. The Gini coefficient, which is used to measure the difference in farmers’ income, was 0.3229 in 1996, and rose to 0.3285 in 1997 and 0.3369 in 1998. The level of 1999 was almost the same as that of 1998. With the development of agriculture and the growth in farmers’ income, the gap in income will likely increase. The percentage of high-income farmers and households will continue to rise, while the percentage of low-income farmers with net incomes below RMB 3,000 will decrease gradually.

2. Productive Cash Expenditure Chinese farmers are both consumers and small producers. Their productive cash expenditure is mainly reflected as cash input in agriculture production. For the past years, the growth of productive expenses has been slow, with an annual rate of 0.5 per cent between 1990 and 1995. Per capita expenditure has increased from RMB 183.55 in 1990 to RMB 517.06 in 1995, and in 1999 it was only RMB 528.36. One of the key factors is the slow growth of farmers’ incomes. Another important factor is the low return on investment in agriculture, especially in grain production. Increased investment can lead to increased production, but not to increased income. In the meantime, farmers are pessimistic about expected income and, as a result, the stability of productive cash expenditure does not result in the growth of consumption. During the 1990s, actual growth in consumption was less than 0.4 per cent in 1997, with the lowest in 1998 and 1999. Another interesting phenomenon was the fast growth of the farmers’ investment in fixed assets after the three years of rectification between 1989 and 1992. It rose from RMB 113.77 billion in 1993 to RMB 254 billion 1996. However, the growth began to slow down in 1996, at an annual rate below 3 per cent. Investment in fixed assets in 1997 was RMB 277.96 billion.

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3. Other Types of Non-Productive Expenditure Other non-productive expenditure refers to the expense of gifts at times of marriage and death of relatives and neighbors. Exact figures are hard to obtain. Our survey in the villages in Jiangxi and Anhui provinces shows that expenses account for 5–10 per cent of the total income of an individual farmer. This will surely have an impact on current purchasing power. On the whole, however, such an impact can be offset as the farmers receive gifts as well as give them.

4. Tax Payments The government has tried to reduce the farmers’ burden and has stipulated that the reserves and welfare covered by farmers should not exceed 5 per cent of their net income in the previous year. Despite the effort, the actual burden on farmers is still heavy in many places. According to one report, the annual income of a household with seven people in northern Jiangsu Province was RMB 4,170 in 1999, and tax payments were up to RMB 2,046. After a deduction of RMB 1,400 in productive costs, the family has virtually no purchasing power at all. Based on the above analysis of the distribution of regional income and farmers’ income, we can now conclude that two thirds of the rural population have no purchasing power due to their low income. Very few groups have both consumer demand and purchasing power. The main factors restricting the development of the rural market are low income, slow growth, heavy tax burdens, and weak purchasing power.

CONSUMER BEHAVIOR OF FARMERS According to theories of consumer behavior, there are numerous factors affecting the consumer behavior of the farmers, such as the propensity to save at the macro level and income and price at the micro level. Moreover, natural and social environments will also have an impact on consumer psychology and behavior. The following is a preliminary analysis of the various factors influencing farmers’ consumer behavior.

1. The Propensity to Save The propensity to save is a typical characteristic of farmer consumer behavior. This is because farmers have been small producers for a long time. Their expected income is unstable, their ability to prevent risks is low, and their sense of self-protection is strong. Between the alternatives of consumption and saving, farmers tend to choose the latter. Their motivation for saving is basically preventative in nature. Savings are usually deliberate, long-term, and

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compulsory, and a means to prevent future consumption beyond the level of an individual’s income. Farmers are not only consumers, but also producers. From our interviews we understand that they have a strong sense of risk, not only in life, but also in production. They are aware of natural risks, market risks, and policy risks as well. The increase of risk awareness and the lack of social welfare and production insurance systems have restricted the current consumption of most farmers, in particular the wealthy farmers. Since China’s reforms and opening up, farmers’ per capita net income and the share of cash income have increased significantly. Accompanied by these increases is the fast growth in the sum of currency balance. Per capita currency was only RMB 27 in rural areas in 1980, and in 1998 it was RMB 1,633. Annual increase was RMB 89, at a rate of 25.6 per cent, which is 11.2 per cent higher than that of per capita net income (14.4 per cent), and 12.1 per cent higher than that of consumption (13.5 per cent). This implies that the increase in the balance of purchasing power is realized on the basis of the restriction of current consumption. In the balance of purchasing power, cash in hand dominates. Its share of the total currency balance has been over 65 per cent since the 1980s. In the saving patterns of farmers, the fear of revealing one’s wealth can be observed and accounts for the percentage of bank deposits in the total currency balance of below 40 per cent. In developed regions in recent years, the number of farmers with bank deposits has been increasing. Based on data from the Jiangxi Branch of the Agricultural Bank, the growth of the balance of deposits in rural credit cooperatives was 4 per cent in 1999, an increase of RMB 756 million, 80 per cent of which came from the farmers. Half of the RMB 1 billion increase in postal savings was contributed by rural residents. The savings in the financial institutions at the town level have experienced a growth of RMB 1.07 billion. Moreover, city banks have attracted enormous deposits in rural areas. To lower risks, farmers also tend to conserve grain. This is a less effective means of ‘saving’. It is estimated that the total reserve of grain is 300-400 million tons, at a cost equivalent to 15–20 per cent of the value of the grain. If the farmers are reserving 250 million tons of grain (at RMB 1,000 per ton) to prevent inflation, the total cost will be RMB 37.5–50 billion. In other words, farmers have occupied capital totaling RMB 250 billion in grain reserves. Such an enormous amount will invariably have an impact on the balance between consumption and saving.

2. The Impact of Cash Income On the Consumer Behavior of Farmers Cash income can be divided between current income and forward income, and

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between expected income and non-expected income. These are all important to, but have a different impact on, the consumer behavior of farmers. Rural residents in China tend to arrange their consumption expenses in line with their expected income. In any given period, current consumption is not affected by current income, but controlled by expected income. As farmers have been less optimistic about their expected income in recent years, current consumption is small and insignificant. The propensity to consume is the relation of function between consumption and income. Empirical research reveals that low-income earners have a high propensity to consume and a low propensity to save, the opposite of highincome earners. Chinese farmers are no exception. According to a survey of the income of rural households, current purchasing power is linearly correlated to commodity demand, with the correlation coefficient as high as 0.92. However, the current income of households with an annual per capita income below RMB 3,000 is virtually all spent on life necessities. The marginal propensity to consume is up to 95 per cent, with the income growth consistent with the consumption growth. The same figure is 85 per cent for households with an annual per capita income of RMB 3,000–5,000. In addition to life necessities, the farmers in this group have also purchased a few consumer durables. Households with an annual per capita income above RMB 5,000 are in principle experiencing income growth much greater than consumption growth. My survey in Jiangxi and Anhui provinces shows that the market for farm products has been brisk in the past few years, with prices going down sharply. The farming income, which accounts for most of the farmers’ net income, has been decreasing. To make matters worse, the urban economy is declining, and the opportunity to get odd jobs in cities is scarce. In farmers’ net income, cash shows virtually no growth. The net income per capita in Jiangxi Province was RMB 2,129 in 1999 and the consumption expenditure per capita was RMB 1,607, an increase of RMB 81 and RMB 69 respectively over the previous year. Almost all extra income is spent on living consumption. On the whole, there is little room to expand consumption. In Anhui Province, 47.6 per cent of farmers experienced a decline in income, and the income gap has been expanding. The per capita net income of the province was RMB 1,900 in 1999, an increase of RMB 37 over the previous year. The income generated from agriculture was RMB 1,139, RMB 23 less than the previous year. My interviews with farmers reveal that the balance of each household is RMB 300–400 for the middle-income group. For these farmers, it is quite risky to spend the whole balance. One can conclude, therefore, that farmers do not have enough income to realize their consumer desire rather than that they are reluctant to spend.

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3. The Price Impact of Consumer Goods on the Consumer Behavior of Farmers The consumer demand of rural residents is seriously affected by the price factor. A quantitative analysis of Jiangxi and Anhui shows that price changes in consumer goods have a significant impact on the overall consumer demand of farmers. Consumption is still at the preliminary stage, where price plays a major rolein purchasing behavior. Most farmers tend to buy cheap and practical consumer goods, without much consideration of brands, styles, and varieties. Tobacco and alcohol, both of which are inexpensive, comprise their daily consumption. In places where shopping is very difficult, farmers tend to buy cheap commodities in large quantities.

4. Preference for Housing Consumption Consumer behavior is not only influenced by a person’s absolute income in the current period, but also by the consumption expenditure and income of others (demonstration effect) and his past income and expenditure (consumer habits). These two factors can account for the long trend of housing construction in the countryside. Influenced by Chinese traditional culture and social customs, rural residents have long viewed the acquisition of a house as their life-long pursuit. Their primary consumption objective is to build a house of their own when their income increases. Because of its high ‘visibility’, a house has become the symbol of achievement, status, and wealth. As a result, some farmers have invested heavily in demolishing and building houses. Very often, a house goes through repeated renovations. Despite the significant growth in income since China’s reforms and opening up, housing consumption has taken up between 14–18 per cent of consumption, only second to food consumption. Our study shows that in China’s developed, developing, and undeveloped areas, every increase of RMB 1 in per capita net income will bring about a similar increase in per capita housing expenses. The increase of income and non-agricultural job opportunities will be conducive to expanding the demand for housing consumption, but will have no significant impact on the marginal propensity to consume. In the middle regions like Jiangxi and Anhui, rural families are beginning to build the third generation of houses – three-storey buildings with doors and windows made of aluminum alloy. These buildings usually have good designs and interior decoration. In one town in Nanchang County in Jiangxi Province, there are 7,000 households, of which 3,800 households have such buildings.

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A three-storey building will need an investment of at least RMB 100,000, sometimes RMB 200,000. Many farmers have to live frugally or even go into debt to realize this dream.

5. The Demand by Farmers for Consumer Durables With their growth in income, farmers’ purchasing desire for consumer durables has been mounting. The 1998 annual report of rural households indicates that the possession rate of low-end consumer durables, such as bicycles, sewing machines, clocks, watches, fans, and black and white TVs, is over 60 per cent, while that of the medium and high-end consumer durables, such as washing machines, color TVs, refrigerators, and motorcycles, is 8–30 per cent. Video recorders, cameras, range hoods, vacuum cleaners, and air-conditioners are still a luxury for most rural families. The farmers’ demand for consumer durables is closely related to their income. This is particularly the case with such high-end products as color televisions, washing machines, refrigerators, and motorcycles. An obvious gap can be observed between the high-income group and the low-income group. In the high-income group, the possession rate is high and grows fast. The increase of the possession rate of color televisions, for example, is positively correlated with the level of income and purchasing power. A similar phenomenon can be observed in all other major commodities except black and white televisions. The level of income is still a major factor restricting the farmers’ demand for industrial products. In 1998, we selected a sample of 27,000 rural households from 10 representative provinces, covering 37 types of consumer durables. In addition to the usual items, we also included some new and expensive products, such as microwave ovens, cars, and farming trucks. The field survey shows that, for ordinary farmers, commodities such as cars, trucks, generators, air-conditioners, and video recorders are beyond their purchasing power, and the actual rate of possession is very low. In the short term, a market for these commodities is unlikely to emerge in the countryside. Other items, such as microwave ovens, heaters, and cameras, are not critical to the improvement of the farmers’ living standards, although the prices of these are affordable. Therefore, it will take time to open the market for these items. The items included in the purchasing list of the farmers remain the same: color televisions, bicycles, fans, washing machines, and motorcycles. The survey reveals that inadequate purchasing power is the major factor affecting the current consumption of farmers. Among the households with no plans to purchase consumer durables, 67 per cent lack the purchasing power,

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11.9 per cent are concerned about product quality, and 28 per cent are concerned about maintenance. Without a doubt, the major factor restricting the farmers’ current consumption is the inadequacy of purchasing power. However, a number of farmers have given up their purchasing plans because they are worrying about the quality of products and after-sale service. It is important, therefore, to increase the purchasing power of the farmers on the one hand, and to take measures to protect the interests of the consumers on the other hand. Product quality and after-sale service will play an important role in increasing current consumption in the rural market. There are another two features in farmers’ consumer behavior. In some regions, farmers buy high-end consumer durables to show their status, skill, or wealth, rather than to consume. In a sense, such consumption represents the lead consumption (beyond existing purchasing power) and ineffective consumption. In addition, purchasing behavior usually takes place in a specific period between engagement and marriage. Farmers accumulate wealth little by little and spend extravagantly on marriages.

6. Fast Growth in Service Consumption Farmers’ health care, education, transportation, and telecommunications expenses have been growing dramatically. In Jiangxi Province in 1999, for example, the Engels coefficient was lowered by 1.1 points to 57.4 per cent. The difference was spent on health care, education, and transportation. Between 1990 and 1998, the annual growth of monetary consumption of family facilities and services was 13 per cent; medical insurance, 17.3 per cent; transportation and telecommunications, 28 per cent; education and recreation, 22.6 per cent; and other commodities and services, 29.1 per cent. The per capita expenses on these items were RMB 402.86 in 1998, 35.7 per cent of the monetary consumption. In summary, the consumer behavior of the Chinese farmers is influenced by a number of factors, in particular income level, traditions and customs, and sense of risk. In general, farmers are quite conservative in consumption, and it is difficult to turn their purchasing potential into actual purchasing power.

THE IMPACT OF THE MARKET ENVIRONMENT ON FARMERS’ CONSUMPTION As China is still dominated by a dual economy structure, the rural economy is relatively backward and the market is far from mature. As a result, farmers’ consumption is quite limited.

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The rural consumer market is an environment in which farmers exchange consumer commodities and services with their money in hand, or the sum of the exchange relations. The more favorable the environment is to the process of exchange, the more it can meet farmers’ consumer demands. A good environment can guide and promote an increase in farmers’ consumer demand, help farmers set up a more reasonable model and structure of consumption, and save farmers’ time and money. From the perspective of complexity science, the consumer market comprises thousands of consumers (including individuals, families, and groups). Although each individual consumer makes purchasing decisions according to his or her own desire or ability, his or her decisions will invariably be influenced by the decisions of others and the environment. The interaction and interplay among consumers will generate an effect of self-organization, pushing the consumer market to develop in a certain direction. The change in environment will also have an impact on the purchasing decisions of consumers, but such an impact will only work through internal factors. The following is a preliminary analysis of the impact of the market environment on the farmers’ consumption decisions.

1. High Percentage of Self-Supporting Consumption Chinese farmers are consumers and small producers at the same time. As most of them have a low disposable income, and as farm products (grain, vegetables, and poultry) are life necessities, farmers tend to support themselves first with the farm products they have produced, selling only surplus in the market. The result is a high percentage of self-supporting consumption. In rural areas, the percentage of self-supporting consumption has remained at 60 per cent since the 1980s. In 1999, for example, farmers’ food expenditure was RMB 829.06, of which half was self-supporting consumption and the cash expense was merely RMB 425.98. The percentage was as high as 85 per cent for staple foods and 42 per cent for non-staple foods. The high percentage of self-supporting consumption will not only increase the difficulty in the adjustment of the agricultural structure, but also limit the development of the rural market and the choice of Commodities. As a result, the development of the rural commodity economy and the related urban economy will be impaired.

2. The Chaos in Commodity Circulation With the establishment of the socialist market economy in China, the channels of rural commodity circulation have been diversified and competition has intensified between state-owned businesses, supply and marketing cooperatives,

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private businesses, self-employed individuals, cooperative businesses, joint ventures, and industrial businesses. The dominance of state-owned businesses has gone forever and the nationwide wholesale system of three-tier distribution centers has disintegrated. It has been replaced by 7,000 wholesale markets throughout the country, supply outlets set by the cooperatives, and the distribution network (including agents) of the industrial sector. At the county level or below, marketing facilities include department stores, supermarkets, wholesale markets, outlets, convenience stores, farm produce markets, and commissioned shops. Although commodity circulation in rural areas relies mainly on the regulation of the market mechanism, the market is still fragmented according to commodity categories and regions as under the planned economy. The phenomenon is more acute in state-owned businesses and supply and marketing cooperatives. On the one hand, their percentage in rural commodity circulation has been reduced to 20 per cent, and on the other hand, their influence is much larger than their market share since they are highly-organized and have an advantage in the supply of bulk commodities. The business network of state-owned businesses and cooperatives formed under the planned economy has been broken, but a new commodity circulation mechanism in line with the socialist market economy system is not yet in place in many regions. Below the county level, in particular, the channel is dominated by private businesses, self-employed individuals, and small stores. In many respects, the channel is fragmented and chaotic. Many small stores do not even have a stable channel of procurement. The result is chaotic organization, obstructed circulation, high cost, rampancy of fake goods, poor after-sales service, and cheating and swindling.

3. Backward Trading By the end of 1998, there were over 95,000 commodity exchange markets throughout the country, of which 80,000 were open fairs, up to 84.2 per cent. At these open fairs, trading is wholly based on spot deals through negotiation. Such a primitive method makes it impossible to use modern trading techniques and to separate commodity flow, logistics, and information flow. It prevents logistics from being the third source of profit, and triggers serious violations of laws and regulations. Under the planned economy system, the commodity circulation authorities were both supervisors of the commodity circulation market and executors of the commodity circulation plans. The situation changed after the establishment of the market economy system. The state-owned businesses and cooperatives

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could no longer play a dominant role. The authorities not only kept shrinking in market share, but also fell behind in management. For a fairly long time after China’s reforms and opening up, problems were acute in the commodity market: chaotic organization, poor management, rampancy of fake goods, fabulous profits through illegal means, and serious violations of laws and regulations. A regulatory mechanism was set up in recent years, comprising the market supervision of the administrative bodies of industry, commerce, and taxation, and the macro control of the related authorities. However, as China is still at the elementary stage of the market economy system, the legislation is incomplete, the execution of law is loose, and management is backward. As a result, the commodity circulation market has not been able to get on the track of healthy development, which can be characterized by the establishment of markets by law, management of markets by law, effective control at the macro level, and relaxation at the micro level. Because of the weaknesses in the existing system of commodity circulation, farmers find it difficult to get what they want. Even if there is a supply in the countryside, they dare not buy consumer durables in open fairs and small stores, which prevents the flow of consumer durables to the rural areas. My survey in Jiangxi Province shows that the number of rural commodity markets accounts for less than 20 per cent of the total. After years of effort, it had increased to 29.3 per cent by 1999. The remaining problem is the size of the rural market and the variety of industrial products. Moreover, most items are unseasonal goods. For this reason, farmers tend to buy consumer durables in cities. Including transportation, the trading cost is increased. It is estimated that in cash consumption, 33 per cent of food, 50 per cent of clothing, and 70 per cent of televisions, washing machines, and refrigerators are purchased in cities at the county, prefecture, or provincial level.

4. Poor credit environment If currency is the blood of the market, then the financial system is the market’s blood circulation system. Without a sound financial system, the market will not be active. At present, the rural credit environment is very poor, and it is extremely difficult for farmers to get loans from the formal financial institutions. Underground usury frightens them away. A 1998 survey shows that loans per household in the countryside amounted to RMB 339.99, of which only RMB 48.2 was borrowed from banks and credit cooperatives. The majority is borrowed from relatives, and in a very few cases from usurers. Due to a lack of a good credit environment, farmers are unlikely to consume significantly. This has also restricted the expansion of the rural consumer durables market.

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From the change and distribution of the currency balance, we notice that farmers have large amounts of cash. This has provided a favorable environment for direct financing in rural areas. However, the balance of purchasing power has not been released effectively, as the users of the capital are not the people who have a real need for it. Very often, idle capital in the hands of wealthy farmers cannot be duly transferred to the people who need it. The result is that the actual purchasing power is inadequate and the balance of purchasing power is stagnant. Moreover, the growth of the currency balance does not keep pace with the growth of income and consumption, which has to some degree reduced the vitality of capital. Therefore, an effective means of turning potential purchasing power into actual purchasing power and of opening and expanding the rural market is to develop and regulate a rural credit market, bring into full play the intermediary function of the banks, and encourage capital flow from high-income earners to low-income earners.

5. Incomplete Market Information An important prerequisite to setting up a sound consumer market is to reverse information asymmetry and allow buyers and sellers to have a complete picture of the market. At present, information is not flowing properly in the rural consumer market. Many farmers have no idea of the brands, quality, features, functions, and uses of consumer goods. They usually follow their relatives in selection, rather than optimizing their selection based on performance and price. This is detrimental to market competition and product upgrading.

6. Weaknesses in After-Sale Service and Protection of Consumers’ Rights After-sale service and the protection of consumer rights are the two weak links in the rural consumer market. The maintenance of consumer durables is extremely difficult in some places. Very often, the cost of maintenance is high while quality is low. In recent years, fake goods of inferior quality have been rampant in the countryside, but most farmers have little knowledge of their rights as consumers, especially the right to know the truth, the right of fair trading, and the right of compensation. As a result, they have great concerns about buying consumer durables. This will invariably have a negative effect on the development of the rural consumer market.

7. Backward Infrastructure The infrastructure of transportation, telecommunications, water, and electricity is directly related to farmers’ income and consumer demand. Although

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the rural population makes up over 70 per cent of the total population, the possession rate of color televisions, refrigerators, and washing machines is less than 20 per cent. The major reason is the backward infrastructure 6fthe rural electricity network. Voltage is unstable and prices are high. In many places, television signals are weak and extra charges are imposed for cable television. In a few places, people even have difficulty getting drinking water, let alone water to supply washing machines. If the rural infrastructure can be improved significantly, the problem of the surplus capability of electrical appliances will be solved. The inadequacy of infrastructure has also restricted the development of the rural market for building materials, furniture, and clothing. To conclude, it is an arduous task to set up a sound system in the rural consumer market. On the one hand, we need to change the farmers’ mindsets and consumption habits through reform and development in rural areas, and on the other hand, we need to develop a series of policies in line with the farmers’ level of understanding, granting them an improved consumer environment, better product quality, and lower trading costs.

POLICY MEASURES TO EXPAND THE RURAL CONSUMER MARKET The above analysis tells us that the prerequisite to expanding the rural consumer market is to increase farmers’ purchasing power. To make this happen, we need to increase farmers’ income, and the key to this is to improve their overall productivity and the per capita GNP. By 1999 the rural labor force amounted to 468.95 million people, almost half the rural population. Their income has three major sources: agriculture, township enterprises, and odd jobs in towns and cities. The latter two can be grouped as income from secondary and tertiary industries. According to complexity science, farmers’ overall productivity can only be improved through internal factors, such as the improvement of their skills, the expansion of the source of income, innovation, and synergy. This is the selforganizing effect of the ‘invisible hand’. The government’s policy measures can improve the farmers’ environment and affect their behavior. This is the external effect of the ‘visible hand’. In theory, policy is a set of action standards developed by the state and the party in power in any given historical period, and policy measures are the specific plans to implement those standards. From the perspective of complexity science, policy comes from social practices and evolves with social development. Therefore, there does not exist any policy that is perfect or immutable. The

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purpose of policy research is to come up with the best choice through a study of the nature, causes, and effects of various policies. In line with this, we have proposed nine policy measures to expand the rural consumer market in China.

1. Adjusting the Agricultural Organization Structure and Promoting Agricultural Industrialization In general, the growth of income from agriculture depends mainly on the increase of the output and price of farm products, and the adjustment of the agricultural production structure. In the past few years, the supply-demand relations of farm products have undergone a major change, and the short supply has been replaced by an overall balance, surplus in harvest years, and oversupply of basic farm products. For this reason, there is limited capacity to increase farmers’ income through the increase of output. In some cases, increased output will reduce income as the unit cost of some farm products has been rising sharply. Some prices have even surpassed those in international markets. Facing strong competition from abroad after China’s accession to the World Trade Organization, the price of major farm products is likely to decrease. The adjustment of the agricultural production structure in line with market needs is a strategic direction in increasing farmers’ income. Focus should be placed on technological advancement. However, this is a long and gradual process. In the short term, it will not play a major role in increasing farmers’ income. To us, system innovation is the only way to increase income from agriculture. We must adjust the organization structure of agriculture, reorganize isolated and fragmented production, shift from the traditional agriculture of self-sufficiency to modern agriculture, and promote the industrialization of agriculture. Given the ingrained habits of farmers, their affection for the land, and the bitter experience of ‘cooperatives’ and ‘communes’, the proper way to adjust the agricultural organization structure and promote agricultural industrialization is to adopt the practice of ‘company plus rural households’. This means that a household signs a contract with a company, organizes production, and sells the products to the company, and the company provides the technology and capital. The success of this practice depends first of all on the existence of ‘dragon businesses’ with strong technology and capital. Second of all, farmers should get more benefits and a cash income. Last but not least, the related parties must observe the contract. We were told in our field study that farmers tend to break the contract when the prices of farm products go up, and companies do the same when prices go down. This should not be allowed. In terms of production organization, the key to the success of the practice is to set up an interface between the company and the household. A good

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example is Inner Mongolia, where dairy companies have managed to set up an interface with the cowherds through village collection stations. The staff at the stations keep in close contact with rural households and provide necessary help in technology and capital, collect the milk, and transport it to the processing factory. This practice has met with great success. We believe that a mechanism of sharing both risks and profit should be set up to enhance the relations between companies and households. When the time is ripe, farmers should also be encouraged to hold shares in the company. In terms of expanding the rural consumer market, the growth of cash income will invariably increase the farmers’ purchasing power. In the meantime, the reduction of self-supporting consumption will also be conducive to the development of the market.

2. Encouraging Moderate Scale Production and Improving Production Efficiency As the scale of production is small, and the input-output ratio is low, it is extremely difficult to increase the competitiveness of farm products and to attract large investment in agriculture. To reverse the situation, we should encourage moderate scale production, provide policy support for big producers, lower the unit cost of farm products, and increase their competitiveness. On a voluntary basis, we can centralize land resources through a long-term contracting system. The key is to find job opportunities for the surplus labor, and shift farmers to the secondary and tertiary industries or encourage them to work in cities. Such a shift can help farmers decrease their dependence on land and realize the strategic transfer of rural labor. In the meantime, we also need to encourage capital flow from cities to the agricultural sector, and try to improve land yield and productivity. In summary, moderate scale production can promote the industrialization of agriculture, because small producers usually have little knowledge of science and technology and their ability to withstand risk is poor. If a company works with big producers, trading costs will go down and things will improve overall.

3. Increasing Job Opportunities For Rural Surplus Labor It is an indisputable fact that there is an enormous surplus of labor in the countryside. We learn from the survey that each mu of land (equivalent to 0.165 acres) demands 15 working days. The enormous surplus of labor has lowered productivity. In many places, key laborers do not work in the fields until the busy reason. As far as we know, labor cost in China is particularly high. For every 100 kilograms of wheat, the labor expense is RMB 44 in China and the

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equivalent of RMB 10 in the United States and RMB 4 in Canada. Although the unit cost of labor is cheap in China, labor efficiency is low as a result of smallscale production. The wheat market will face intense competition after China’s entry into the World Trade Organization. We must therefore simultaneously improve productivity and find employment for the surplus labor. If the rural labor surplus call be re-employed, it would be tantamount to increasing farmers’ income. Even in the countryside, we should be able to open new channels of employment. In Hanshan County in Anhui Province, for example, farmers’ bands are very popular and a performer can earn as much as several hundred yuan in a year. Of course, local governments should play a key role in the process and take measures to create as many opportunities as possible. In Nanchang County in Jiangxi Province, poultry raising is very popular. The local government has set up a large market, which not only ensures the sale of the products but also creates job opportunities in transportation, sales, processing, and storage. The shift of surplus labor is of strategic importance. It cannot only improve rural productivity, but can also reduce reliance on land and promote the rural consumer market. In the long run, tile modernization of agriculture will not be possible until the output of each farmer can support more non-agricultural residents. The shift of surplus labor, the strategic adjustment of agricultural structure, and the increase of farmers’ income are pressing issues that demand our in-depth research. In 1999, the government began to adopt proactive fiscal policies and increased its investment in infrastructure. This has created new opportunities for farmers, and their income from doing odd jobs in cities has grown by 11.7 per cent. However, such job opportunities are easily influenced by the macroeconomic situation and the reform of the state-owned enterprises (SOEs). In fact, farmers are facing an increasingly grave situation. With the deepening of the reform, the number of redundancies has been growing dramatically. As a result, local governments have begun to set limitations on the flow of farmers into cities. In the long run, however, we need to encourage them to find job opportunities in cities through formal channels and to turn them into urban residents. This is the only way to realize modernization.

4. Developing Township Enterprises and Encouraging Urbanization For the past two decades, township enterprises have contributed significantly to rural development and to the increase in farmers’ income. They have absorbed much labor and created huge market demand. In recent years, however, the structural weaknesses of township enterprises have been completely unmasked.

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Aggravated by policy prejudice, most of them met with great difficulties: their competitiveness decreased; their growth slowed down; their profitability slid; their losses increased; their exports fell; foreign investment decreased; and financing became increasingly difficult. These problems will not be solved in the short term. One of the objectives of developing township enterprises was to increase farmers’ income though dividends. Among the enterprises funded by collective reserves, there are very few high performers. After the adjustment of ownership structure, there is almost nothing left as dividends to be distributed among the fan-hers. At most, they can provide job opportunities for a few farmers. The strategic adjustment and restructuring of SOEs will present both challenges and opportunities for township enterprises, which must step up their reforms to adapt to the new market environment. We have conducted a survey in some township enterprises, and found that they are not much related to agriculture. In the top 14 industries, eight industries overlap. The correlation coefficient is 0.806 for the industrial sector, but only 0.46 for the agricultural sector. Presently, there are three major categories of township enterprises. The first comprises the township enterprises in Jiangsu and Guangdong provinces which have developed into large and medium-sized businesses. They are in fact not township enterprises according to the original concept. The second category includes the medium and small-sized township enterprises. They can be grouped under four sub-categories: (1) complementary plants of big companies which mainly produce parts for these companies; (2) businesses that take advantage of the niche market and manufacture products that are least attractive to big companies; (3) businesses that have products with small sales; and (4) businesses concentrated in one particular place. In Zhejiang Province, for example, there are a number of such businesses. Some of them are tile producers, and others are range hood manufacturers. These businesses usually have a high share of the market. Concentration can encourage individual businesses to learn from one another, reduce product price, provide greater choice, and create an effect of scale. This practice, however, will give rise to cutthroat competition during a buyer’s market. In the third category are township enterprises that have a real interest in the countryside. They mainly process farm products and focus on the industrialization of agriculture. The number of such businesses is small. Out of the 20 million township enterprises, only 350,000 are involved in the processing of farm products. The number of ‘dragon businesses’ involved in agricultural industrialization is less than 5,000. These are the real township

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enterprises, and should be a good example to others. In the Unites States, the ratio between food industry sales and sales of agricultural products is 1:4, while in China it is 1:1.3. In Anhui, the ratio is only 1:1.026. There is, therefore, great potential in this respect. Unfortunately, very few township enterprises are moving in this direction. One major impediment is technology. It is unrealistic to rely solely on these businesses to solve the problem of technology. However, the modernization of agriculture does call for a large number of township enterprises that are based in the countryside and can provide the best service for agriculture. Urbanization has provided a new opportunity for the development of township enterprises. In planning their layout, we should encourage them to concentrate on towns and industrial parks. In this way, township enterprises and urbanization can promote each other and create more job opportunities and greater market demand. The fundamental solution to the problem of the rural market and farmers’ income is to change the population distribution between urban and rural areas and to step up urbanization. Urbanization will create new demand, contribute to the shift of surplus rural labor, and stimulate consumption. Urbanization should be based on the realities of different regions, and more farmers should be encouraged to work in cities. To make this happen, we also need to reform and improve the land management and residence management systems. The increase of the urban population will bring about more job opportunities and greater demand for commodities, while the reduction of the rural population will help expand the scale of production and increase rural productivity and farmers’ income. Only in this way can the rural market experience a real boom.

5. Promoting Rural Tax Reform and Reducing the Burden on Farmers Despite the efforts of governments at different levels, the burden on farmers is still too heavy. In our survey, we found that the average expense to be borne by each farmer is around RMB 200, while the minimum is RMB 100. In some parts of Anhui, farmers feel disappointed because the income generated from farming is not much once fees and taxes have been deducted. If the farmers’ burden can decrease significantly in the short term, their purchasing power will be greatly increased. There are various expenses in the countryside, and the major items include education and the salary of the rural cadres. Efforts should be made to streamline governments at different levels and to fix the amount of staff and salary. We learned from a survey in Hubei Province that the size of rural schools is diminishing as a result of family planning. The population is decreasing, and

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the number of school-age children is also decreasing. Therefore, some schools need to be merged. In the meantime, we should standardize the collection of fees and taxes. We are happy to see that the Central Committee of the Party has decided to conduct a pilot experiment in tax reform in rural areas to reduce the farmers’ burden.

6. Changing the Mindset and Behavior of Farmers Through Education The farmers’ lifestyle is considerably different from that of urban residents. Their mindset seems in great conflict with modern concepts of consumption. This situation is unlikely to change in the short term. However, in developed regions or the suburbs of big cities, we need to educate farmers and try to change their consumer behavior. At the same time, we also need to create an environment to facilitate the change, and encourage rural residents to accept the new lifestyle.

7. Establishing and Improving the Social Welfare System in Rural Areas Unlike in urban areas, social welfare is almost non-existent in rural areas. The co-operative medical service during of collectivization was put to an end during the reform. The ‘five guarantees family’ (the aged, the infirm, the old, widows, and orphans) have no real security except in wealthy villages. No insurance companies are willing to provide insurance for agricultural production because of its risks. The living and even safety of farmers who do odd jobs in cities are endangered. To solve these problems, we need to set up a social security system comprising four levels: social relief, social service, social security, and commercial insurance. Such a system can help relieve farmers of worries and boost the rural market. Social relief should rely mainly on the government, while social services can rely on society with the support of the government. Social security should be set up through the sharing of costs, and in the meantime, commercial insurance should be developed. Farmers can buy commercial insurance on a voluntary basis.

8. Improving the Rural Market and Infrastructure If we are determined to resolve the problems in the rural market, we must give due attention to its peculiarities and study the farmer ’s mindset and consumption habits. We must take measures throughout the chain of commodity circulation. Moreover, we must expand the channels of circulation, set up a reasonable logistics system, adopt advanced logistics techniques, turn to the new means of trading, and reinforce the management of the rural market.

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Particular attention should be given to the establishment of the market for farm products to solve the difficulty of sales. Another effective way to expand rural consumption is to improve the infrastructure. Reducing the cost of electricity and water, for example, can increase farmers’ consumption in electrical appliances. Consumer desire can also be stimulated through the rectification and elimination of unreasonable fees.

9. Standardizing the Rural Financial Environment and Increasing the Size and Variety of Rural Credit Rural finance can play an active role in promoting the rural market, and much can be done in this respect, especially during times of deflation. We should develop in the farmers a sense of modem finance, and bring into full play the advantages of petty loans for living consumption. Rural credit cooperatives should set up a system of flexible interest. Urban financial institutions should also set aside a part of their capital for rural production and life. At present, it is extremely difficult for rural households, township enterprises, and private enterprises to secure loans. The cooperative funds that emerged in the countryside in the past have been eliminated because of their illegal activities, which has been very important and necessary from the perspective of maintaining financial order and avoiding financial risk. However, we must admit that there is no appropriate investment channel for idle rural capital. As a result, black market financing and usury are rampant in the countryside, and they have in turn harmed the interests of the farmers and disturbed the financial order. It is well advised to set up special credit for the means of production, and to allow farmers to buy seeds, chemical fertilizers, pesticides, and plastics through bank loans. Farmers can use their own property or harvest as a mortgage. An alternative is to lend money directly to businesses that can provide farmers with physical goods. This can help solve the problem of insufficient capital for the businesses and ensure that the farmers will duly get the necessary means of production. The private credit market in rural areas is still non-standard, and the government lacks a sound supervision and control system in policy and law. This has increased the possibility of disputes among the farmers. To this end, the relevant authorities should implement an in-depth study of the rural credit market, formulate corresponding policies to reinforce its management and supervision, and promote its healthy development through explicit stipulations on credit scope, interest rate, credit procedures, and account management. The development of the rural consumer market is a project demanding research based on facts. There is no single model that can be imposed

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throughout the country. Any research on the countryside, farmers, and agriculture must take into account China’s realities and regional differences. We should make a bold experiment and try to come up with different models through practices that cater to the interests of different groups of farmers. Last but not least, the expansion of the rural consumer market is only one of the important links in solving the problems facing the countryside, farmers, and agriculture. According to historical materialism, human society is a natural process of continuous progress, and its development is decided by the contradictions between the productive forces and relations of production, and between economic base and superstructure. The measurement of social progress is the development of productivity and culture, and the overall development and emancipation of people. In solving rural problems, we must emphasize the unity of the process. We should neither go beyond nor be confined by the realities. Instead, we must develop a vision and actively promote the industrialization of agriculture, urbanization of villages, and knowledge dissemination among farmers. With this solid foundation, we will be able to build China into a wealthy, democratic, and civilized modern socialist country.

CONCLUSION The only way to industrialization is to reduce the rural population and increase farmers’ income. The development of the rural market is an arduous and longterm task. Any research must start with the realities. The prerequisite to expanding the rural consumer market is to increase the farmers’ purchasing power. To make this happen, we need to increase farmers’ income by increasing the farmers’ overall productivity and per capita GNP. Farmers’ income has a number of features: the overall level is low; growth is slowing; the source of income is diversified; and regional differences are expanding. After a deduction of the productive cash expenditure, the nonproductive expenditure, and various taxes and fees, two thirds of farmers have virtually no consumer power. Only a small group of farmers have effective demand and consumer power. The majority of farmers have limited disposable income, which is a major factor inhibiting the development of the rural market. Besides income, the consumer patterns of the farmers are also influenced by traditions and customs. On the whole, farmers are quite conservative in consumption, and have a strong tendency to save. They lead simple lives and do not spend their savings until they build a house or their children get married. This accounts for the fact that potential purchasing power has not been turned into actual purchasing power. Service consumption has witnessed a fast growth

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in the past few years, but passive consumption is much greater. The rural economy is still backward, and the market is immature. The obvious problems are that the percentage of self-supporting consumption is high; commodity circulation is chaotic; trading means are primitive; the credit environment is poor; market information is incomplete; after-sale service and protection of consumer rights are weak; and the infrastructure is backward. All these have restricted rural consumption. B a s e d o n o u r s t u d y, w e h a v e p ro p o s e d n i n e p o l i c y m e a s u re s : ( 1 ) adjusting the agricultural organization structure and promoting agricultural industrialization; (2) encouraging moderate scale production and improving production efficiency; (3) increasing job opportunities for surplus rural labor; (4) developing township enterprises and encouraging urbanization; (5) promoting rural tax reform and reducing the farmers’ burden; (6) changing farmers’ mindsets and behavior through education; (7) establishing and improving the social welfare system in rural areas; (8) improving the rural market and infrastructure; and (9) standardizing the rural financial environment and increasing the size and variety of rural credit. The expansion of the rural consumer market is critical to solving the problems in the countryside. We need to start from the realities and promote the industrialization of agriculture actively and prudently. This is an important foundation of building a wealthy, democratic, and highly civilized socialist modern country. Completed on 1 January 2001

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Devoting Major Efforts to Developing China’s Multinationals

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Economic globalization in the twenty-first century can be characterized by a development trend with knowledge as its base, finance as its centre, information technology (IT) as its vanguard, and multinational corporations (MNCs) as its carriers. In order for China to meet the challenge of economic globalization, it must develop its international markets. It should actively encourage overseas investment, develop Chinese MNCs, leverage overseas resources, and increase its position in the international market by rapid growth. MNCs will play an important role in the process of economic globalization, particularly in international technology transfer, international trade, transnational capital flow, and resource optimization. By studying the laws of development and operational mechanisms of MNCs, China can effectively prevent potential negative impacts and effectively participate in global competition. MNCs have experienced four major developmental stages: start-up, slowdown, revitalization, and expansion. Their organizational structure has evolved from initial line function to the present division system. In future, MNCs will feature global strategic restructuring through mergers and acquisitions, fast growth of knowledge-based service sectors, gradual increase of foreign direct investment (FDI) in developing countries, and more emphasis on flexibility and adaptability in organizational structure. To develop Chinese MNCs in a well-planned and systematic way, we need to follow a four-step strategy: rationalization, integration, congregation, and internationalization. In other words, we need to develop from indirect exports to direct exports, and from overseas subsidiaries to international operations. The present objective of Chinese enterprises in overseas investment is to seek resources or markets, and due attention should be given to the selection of industry and country. In the strategic management of Chinese MNCs, the focus should be on identifying opportunities and avoiding threats due to changing environments. Chinese MNCs need to improve their competitiveness through timely organizational restructuring. In developing their core competence, they also need to create well-known brands. The pressing task for Chinese MNCs is to set up and improve corporate governance, financial management, and internal control systems. Overseas subsidiaries should register as limited shareholding companies, and set up boards of directors and boards of supervisors who will act according to the law. A five-level incentive system should be developed for management and staff, including wages, welfare, bonus, and stock rights and options. Financial management in MNCs should integrate all financial tools and resources to lower financing costs, improve investment decisions, allocate capital flexibly,

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reserve cash reasonably, reduce overall tax burdens, avert exchange risks, control operational costs, and maximize profit. MNCs should not only develop strict regulations and business processes, but should also examine their implementation on a regular basis. Internal auditing is an important part of this work. The government should follow the principle of ‘active promotion, full protection, and adequate supervision’ in overseas investment. To ensure a fast and healthy development of overseas investment and Chinese MNCs, I have put forward eight policy measures: (1) to develop an overall strategy for overseas investment; (2) to step up the relevant legislation and formulate the ‘Law Promoting Overseas Investment of the People’s Republic of China’; (3) to fiscally and financially support competitive enterprises in international markets, develop preferential policies in taxation and credit, and establish an insurance and deposit system for overseas investment; (4) to set up a special fund for overseas investment to support overseas cooperative projects, feasibility studies of investment environments and projects, and training of technical staff involved in overseas investment; (5) to set up an overseas investment promotion centre for the operation of the special fund for overseas investment and for providing such services as market information on overseas investment projects, analysis of investment environments, economic evaluation, and training of legal consultants; (6) to promote and protect overseas investment through diplomatic means, sign agreements of protection with related countries to avoid double taxation, and integrate foreign aid with overseas investment; (7) to reform and standardize the approval system of overseas investment, simplify approval procedures, and move gradually from the approval system to the registration system with the focus on providing consulting services; and (8) to strengthen and improve the supervision over overseas operations, including improving the exchange regulation system, management of state-owned assets, knowledge of the status of operations, and restrictions over technology export and transfer. As a worldwide mega-trend, economic globalization increases interdependence throughout the world. Although academics from different countries have held divergent views on its starting point and features, we believe that globalization began when modern capitalism came into being in

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Western countries. Since the 20th Century, the economic relations between different countries have increased, from procurement of raw materials to commodity trade, and from technology transfer to capital export. With the end of the cold war, economic development has become a priority for every country. The size of MNCs is quickly expanding, science (IT in particular) is fast developing, and capital flow is increasing. All these factors have contributed to the quickening of the process of globalization. Globalization in foreign exchange, securities, futures, and options has particularly helped the fast expansion of the virtual economy. It is reported that since the 1980s the world economy has been growing at an average annual rate of 3 per cent, international trade at 5 per cent, and international capital flow at 25 per cent, while the market value of global securities has increased by 250 per cent. The world’s fictitious economy reached US$ 140 trillion in 1997, five times as much as that of the world’s GDP. The daily flow of virtual capital is as high as US$ 1.5 trillion, about 50 times as much as the daily volume of the world’s real trade. This has increased the economic interdependence between different countries, a good example of which was the rapid spread of the East Asian financial crisis. It can be expected that, with the development of e-business and e-currency, the size of the fictitious economy will increase and a minor problem in one country will affect the whole world. Economic globalization has provided opportunities for every country in the world to develop its economy. Through the free flow of capital and information and the optimization of global resources, the commercialization of scientific achievements will speed up, social productivity will increase, and sustainable economic growth will be maintained. In addition, it will be easier for developing countries to introduce capital, technology, and facilities; to obtain modern management expertise; and to open international markets. Economic globalization is, however, a double-edged sword. With the increasing impact of the confidence factor, economic bubbles are easily formed and financial risk easily spread. As the ‘rules of the game’ in international economics have been created by developed countries with economic and technological advantages, developing countries will be vulnerable and their economic safety and state sovereignty will be endangered. To adapt to economic globalization, the Central Committee of CPC and the State Council decided to join the World Trade Organization (WTO). This was a wise decision. China’s entry will raise the voice of developing countries in the WTO, and improve the situation in which the developed counties dominate the development of the ‘rules of the game’. However, challenges will coexist with opportunities. An important strategic measure is to ‘go out’.

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To ‘go out’ is to further expand international markets and leverage overseas resources by introducing foreign capital and technology and encouraging foreign trade. The final objective is to increase the international competitiveness of Chinese enterprises, promote China’s economic development, meet the challenge of economic globalization, and increase China’s position in international markets. As said above, economic globalization in the 21 st Century has knowledge as its base, finance as its centre, IT as its vanguard, and MNCs as its carriers. Through international investment, production, sales, and research and development (R & D), MNCs can realize technology transfer, liberalization of international trade, free flow of capital, and optimization of resources and, as a result, an integrated international market can be formed. To ‘go out’ in a real sense, we need to develop Chinese MNCs and help them survive in the face of increasing competition. We must be aware that China has long been under the influence of a planned economy system, and the transition to a socialist market economy system is yet to be completed. Since its reform and opening up, China has been implementing a policy of ‘introduction’ and, as a result, overseas investments are small and professionals are scarce. Besides, most Chinese enterprises have not yet established a modern enterprise system, and an obvious gap can be identified when compared with MNCs. Because China does not have MNCs in any real sense, the development of Chinese MNCs will be an arduous and long-term task. In this chapter, I will use the principles of complexity science, management science, and international business to discuss the role of MNCs in globalization, the general laws of development of foreign MNCs, the steps and measures to develop Chinese MNCs, the overseas investment strategies and internal management of Chinese MNCs, and the government’s role in macro management. I will also try to come up with a number of suggestions to encourage overseas investment and the development of Chinese MNCs.

THE ROLE OF MNCS IN THE PROCESS OF ECONOMIC GLOBALIZATION MNCs are companies that set up their headquarters in one country and own or control businesses in more than one country. According to the definition of the United Nations in 1983, MNCs are companies that: (1) have entities in two or more countries, regardless of their legal form or industry; (2) operate in one decision system and implement strategies through one or more decision centers; and, (3) relate each entity through equity or other form, and make one or more

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entities have an important impact on the other entities, especially in sharing knowledge and responsibility. In recent years, MNCs have been considered as companies that operate in two or more than two countries under the strategic management and control of their headquarters, with overseas sales taking up 25 per cent of total sales. According to the statistics of the United Nations’ Trade and Development Conference, there are around 63,000 MNCs throughout the world, with over 700,000 overseas subsidiaries in almost every comer of the world and in every economic field. As an important force in the world’s economy, MNCs have accounted for a quarter of the world’s output, and most of the Fortune 500 companies are MNCs. The role of MNCs in the process of economic globalization can be summarized as follows:

1. To Promote International Technology Transfer The competitiveness of MNCs is represented first of all by their intangible assets and intellectual capital, including technology, expertise, brands, goodwill, and marketing skills. These are the prerequisites for multinational operations. MNCs invest heavily in R & D (e.g. the Fortune 500 usually spend 5–10 per cent of their sales on R & D) and a high percentage of their professionals are involved in R & D. They have core competence in the relevant industries and can manufacture new products with complex technology. It is estimated that 75 per cent of the world’s patent technology is controlled by MNCs. The trade of international technology has been growing fast in recent years: it was US$ 2.5 billion in 1965, US$ 12 billion in 1975, US$ 50 billion in 1985, and $ 250 billion in the late 1990s. Obviously, MNCs have played a key role in this growth. For various reasons, the achievements of large companies, including MNCs, are sometimes not applicable in their own companies or countries. These achievements have to be transferred to other countries to recover the R & D cost. Also, technology is developing at an unprecedented speed, and many large companies tend to transfer old technology (including equipment) to developing countries to recover their investment. Kodak, for example, transferred its old technology (Kodakcolor II) to a Chinese company in Xiamen when it developed a new generation of color film in the early 1980s. MNCs are motivated to transfer their technology to developing countries by their local markets and potential high returns, and developing countries want to ‘exchange market for technology’. The technology assets and management skills brought by the FDI of MNCs can not only help the host country set up new industries, but also upgrade the old industries and promote a shift from home-

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based industries to export-oriented industries and finally to internationally competitive industries. MNCs are imposing stricter control on international technology transfer, as intellectual capital is key to their development. As a result, it is increasingly difficult for developing countries to acquire the most advanced technology from MNCs through technology trade. In transnational operations, however, MNCs have to transfer their technology (including management expertise) to their overseas subsidiaries to maintain international competitiveness.

2. To Promote International Trade Since World War II, international trade has grown at an average annual rate of 7 per cent, which is almost twice that of economic growth. The total volume of international trade in 1990 was US$ 3.3 trillion, and reached US$ 5.3 trillion in 1998. The high growth of international trade can be attributed to a number of factors, and MNCs have certainly played an important role. When MNCs enter one country and set up subsidiaries through FDI, they usually need to export facilities to that country and provide the key raw materials and components. In the meantime, they require their subsidiaries to export part of their products. In countries with foreign exchange control, they require subsidiaries to export a significant part of their products to maintain a balance of foreign exchange. All these factors increase the volume of international trade and promote the growth of technology and service trade. In addition, internal trade (between parent companies and their subsidiaries and between subsidiaries) is expanding rapidly, accounting for 40 per cent of the world’s trade in the early 1990s. At the time of writing, the international trade volume of MNCs makes up two thirds of the world’s trade. Another important role of MNCs in international trade is to promote liberalization. Since World War II, the major capitalist countries have reduced their trade barriers, creating a global wave of international free trade. Almost every country and region has subsequently reduced barriers in international trade. With the development of MNCs, the demand for reduction of trade protectionism, tariffs, and non-tariffs is increasing, which in turn has stimulated the liberalization of international trade and promoted the formation of a global market.

3. To Promote the Transnational Capital Flow A major business activity of MNCs is to set up wholly owned or holding subsidiaries through FDI. This will invariably promote transnational capital flow. In the meantime, subsidiaries in operation will have reciprocal accounts

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with their parent companies. The delivery of profit by subsidiaries, incremental investment by parent companies, and capital turnover of overseas sales will all increase transnational capital flow. MNCs have a strong financial position, large amount of working capital, and great quantity of securities and bonds. These assets will not generate profit except through flow. For this reason, MNCs are particularly concerned about the direction and speed of capital flow. With the rapid development of information and communications technology, the time necessary to obtain investment information has been greatly shortened and transnational capital flow has been stepped up, which has in turn promoted the integration of the international financial market. The relationship between the local financial markets and the international financial market is getting closer and closer, and their interplay is increasing such that a move in one country will affect the whole world. The business development of MNCs has also promoted the international operation of banks. MNCs need the banks in their parent country to provide financial services in the host country and for their subsidiaries. This has increased the overseas business of banks.

4. To Promote Optimization of Resources One of the objectives of MNCs in overseas investment is to acquire natural resources or such production factors as technology, capital, and labor from the local markets. By capitalizing on the competitive edge of these resources, MNCs can realize optimization of resources in their global businesses and in the increasingly global market. As the quantity of global resources is almost predetermined, with unbalanced distribution in each country in quantity and quality, individual countries have decided on their own production based on their competitive advantage in resources and have exchanged products with one another through international trade. This has achieved optimization of resources and redistribution of products throughout the world. With the prosperity of MNCs after World War II, the old international division model has been attacked for its inefficiency. Through integrated international production and inter-company trade, MNCs can find an optimal way to allocate and exchange production factors in each country and take advantage of the global market as a means for social production and resource optimization. They can set up production bases in the host country, and improve the allocation of production factors and the efficiency of resources through inter-company trade and internal transfer price. A transnational production system, with the value chain as the bridge, is being formed. The global production and sales system of MNCs has played

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a key role in adjusting the world’s industry structure, and in such industries as aircraft manufacturing, automobile manufacturing, petrochemicals, mobile communications facilities, and computer and operating systems in particular, MNCs have taken the largest share of the market. To date, they have become the best global coordinator of production factors. In addition, the growth of MNCs has contributed to the economic development of the parent country. They have not only acquired the necessary resources and increased their parent companies’ exports of products and services, but they have also promoted the capital flow of their parent companies’ financial institutions and overseas markets for higher returns. To conclude, MNCs are the catalyst of economic globalization. The development of MNCs has boosted the growth of the world economy, and their market system has increased the interdependence of individual countries. Their competitive mechanism has speeded the concentration of the world’s economic development. Their multilateral expansion has pushed governments to develop two-way encouragement policies, which have in turn contributed to the formation of regional and global multilateral policy systems. In recognizing the positive impact of MNCs, we must also be aware of their negative aspects. Many MNC activities are motivated only by high returns, something which has been detrimental to the social and economic development of the host countries (developing countries in particular), and has even threatened their social stability and economic safety. Examples include the transfer of highly polluted products to the host country; the plundering of resources of the host country; prejudice against employees from the host country; transfer of profit by raising the import prices of raw materials from the parent company while cutting down the export prices of products to the parent company; transfer of capital through internal financing, arbitrage, or speculation; pressure on the exchange balance of the host country through advances or delays in payment; financial speculation in the host country which can lead to financial crisis; and control of the economic arteries of the host country which can result in abnormal development. Some MNCs have even tried to export the culture and values of their parent country together with their product, technology, and capital, which imposes a big shock to the social and historical traditions of the host country. A few MNCs interfere with the economy and politics of the host country, attempting to overthrow the legal government. All these activities have left a bad reputation in developing countries. Despite the fact that the situation is improving, these things still happen. MNCs will enter China in great numbers after China’s accession to the WTO, which will provide Chinese enterprises with opportunities to introduce state-

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of-the-art technology, management experience, capital, and expertise. In the meantime, China will face great challenges and difficulties. Although China has acquired some experience in dealing with MNCs in the past 20 years of reform, it still lacks an effective incentive and control system. To this end, we need to study carefully the laws of development and operational mechanisms of MNCs to prevent potential negative impacts.

EVOLUTION AND DEVELOPMENT OF MNCs As MNCs are both the catalyst and the product of economic globalization, any study of their evolution and development must be related to world economic development. According to complexity science, each individual enterprise is part of the market economy system, which can result in a number of disorderly and random movements or even chaos. However, the decisions of one enterprise are influenced by the decisions of other enterprises and the external environment. The interplay between individual enterprises will result in ‘self-organization’, pushing the economy to develop in a certain direction. The external environment will also affect the decisions of individual enterprises and finally the process of self-organization. From the macro or long-term perspective, the market economy, which comprises millions of enterprises, has intrinsic certainty, despite its seemingly random system. Based on the above understanding, we will first of all discuss the overall development of MNCs in the ever changing economic environment, then examine the impact of such changes on the internal organizational management of MNCs, and finally analyze the development of MNCs from both macro and micro perspectives.

1. The Overall Development Process of MNCs MNCs originated in the sixteenth century. Between the sixteenth and eighteenth centuries, large trading companies emerged in Europe as a result of colonial development. In the mid nineteenth century, FDI began to be popular, which gave birth to modem MNCs. Since then, MNCs have experienced the following stages:

(1) Start-up (c. 1850–1914) By the mid-nineteenth century, the United States and most European countries had completed the primary industrial revolution and set up a capitalist system. To seek resources, grab high returns, and get rid of periodic economic crisis,

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these countries encouraged their enterprises to expand through external investment and reduced the limits on transnational capital flow. The widespread trade protectionism in these countries further pushed large companies to set up production facilities overseas. In addition, the progress of transportation and communications technology, and the development of railways and the telegraph in particular, created a favorable environment for transnational management. An additional motivation for the development of MNCs came from competition among enterprises. In the early 19 th Century, the British Insurance Company opened its first division in the United States, and British banks subsequently began to set up branches in British colonies. In the 1830s, a Swiss company established a cotton mill in south Germany. In 1852, the Panama Railway Company, an American joint venture, built the first railway across Central America. In 1855, Siemens set up a factory in Russia. The first MNC that manufactured and sold a product at abroad was Singer, an American company. Singer invented the sewing machine in 1851. In 1866, it established subsidiaries in Britain and subsequently in other European countries. It soon dominated the European market. The American Addison Electric Light Company, Eastman Kodak, and Otis Brothers followed Singer ’s example, and began to transfer their technologies and production overseas. By the late nineteenth Century, a number of European trading companies had expanded their business to many regions in the world. In 1876, the first large firm, Mitsui & Co., was established in Japan. Beginning in the 1870s, FDI in mining and processing of natural resources, such as metal ore and petroleum, increased rapidly. By the outbreak of World War I in 1914, MNCs had experienced significant growth, with FDI over US$ 14.3 billion, 9 per cent of the world’s output. The United Kingdom accounted for the largest share (45.5 per cent), followed by the United States (18.5 per cent). The rest of the world accounted for 36 per cent. In manufacturing, the United States took the lead (it had 122 overseas subsidiaries while the United Kingdom only had 60), while in other fields the United Kingdom dominated.

(2) Slow-down (1914–1945) Between the start of World War I and the end of World War II, the development of MNCs began to slow down. World War I eliminated almost all of Germany’s FDI, and the investment of the major capitalist countries in Russia was confiscated by the Soviet government in 1917. In 1930, the world was hit by the Depression and the resulting collapse of the international financial system. This pushed many countries to restrict transnational capital flow and impose control over foreign exchange. As a result, MNC profits could not be sent back to the parent country.

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Some host countries strengthened protection of local industries and resources, and imposed prejudiced policies against MNCs. The retreat of Ford and General Motors from Japan is just one of many examples. Many companies preferred to join international cartels rather than to invest overseas. The breakout of World War II further restricted the growth of MNCs. In general, the development of MNCs slowed down or even stagnated during this period. The least influenced country was the United States. Stimulated by its military industry, it began to overtake the United Kingdom and numbered first in FDI during the period.

(3) Revitalization (1946–1970) The European continent was devastated by World War II, and enormous capital was needed for its reconstruction. Under the Marshall Plan, the United States began to give aid to Europe. However, the affiliated terms of free international trade and free international payment paved the way for American capital to enter the European market without barriers. The 1944 Bretton Woods Conference agreed to make the US dollar the only international currency linked to gold, thus establishing it as an international currency. This agreement was conducive to US companies acquiring or merging with European companies. The General Agreement on Tariffs and Trade (GATT), signed in 1948, reduced trade barriers and increased trade opportunities for overseas subsidiaries. The US government encouraged external investment through diplomatic, legal, and taxation policies, and protected the freedom and safety of investment. As a result, US MNCs grew fast. From 1950 to the mid 1960s, the United States accounted for 85 per cent of the increased FDI. In 1957, the European Community (EC) was established, and a large regional market was formed. This was a big attraction for MNCs. US FDI to Western Europe increased from US$ 1.7 billion in 1950 to US$ 27.6 billion in 1971, almost doubling every five years. In such fast growing industries as computers, transistors, and petrochemicals, US MNCs monopolized most of the overseas markets and made enormous profits. However, the arrogance of US MNCs was attacked not only in developing countries but also in some developed countries.

(4) Expansion (1971–present) Beginning in the 1970s, the world’s economic structure experienced a major change with the revitalization of the European economies, the rapid growth of Japan, and the rise of emerging countries and regions. In the meantime, the development of the US economy slowed down, and its currency was devalued and disconnected from gold. In terms of FDI, three powers – the United States, Japan, and Europe began to dominate the world. Japanese companies,

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encouraged by the Department of Trade and Commerce, invested heavily in America and Asia and competed in the international automobile and electronics markets. They even penetrated the US market. Western European MNCs focused on expansion on Asia, and competed directly with US companies. Among the emerging countries, South Korea created a number of world-class MNCs. In 1963, the United States had 63 companies listed in the world’s top 100 companies and in 1979 this figure had been reduced to 47. The diversified layout of FDI changed in the 1990s, despite the continued growth of the US economy, the stagnation of the Japanese economy, the slowdown of the Western European economy, and the financial turmoil in East Asia. In 1999, the United States accounted for 40 per cent of the world’s largest companies, while both Asia (mainly Japan and South Korea) and Europe accounted for 30 per cent.

2. Evolution of Organizational Structure of MNCs According to modern theories of organizational management, organizational structure is not merely the ‘design’ of a company’s leaders. Behind it is the organizational culture and the influence of the external environment. More importantly, organizational structure is a result of the interplay and distribution of power among different members and groups. This coincides with the concept of complexity science. Therefore, in discussing the evolution of the organizational structure of MNCs, we should start from the change of external environment and distribution of power. Initially, the primary purpose of MNCs in overseas investment was to seek new markets or natural resources and to expand sales. Most of the overseas subsidiaries were manufacturing businesses, with a limited variety of products and almost the same technology. Therefore, a popular model in organizational structure was line function, whereby overseas businesses were responsible only for production and other functions (e.g. personnel, finance, sales, and R & D) were managed by their headquarters’ relevant departments. The strength of such a practice is a clear division of responsibilities and a scale economy. The main weakness was that the distribution of rights between the functional departments and overseas businesses needed to be regularly adjusted. While the functional departments stressed concerted efforts, the overseas businesses emphasized local peculiarity and demanded flexibility. The result was that overseas businesses found it difficult to operate because of the very tight control by the functional departments, and the parent companies felt that the overseas subsidiaries were often too willful in decision making. The conflict was more obvious when the external environment changed. For this reason, MNCs were

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slow to respond and often lost business opportunities. Some European MNCs had to rely on personal relations as a means of control, and appointed their close friends or relatives to be managers of overseas businesses. With the increasing size and diversification of businesses, the organizational structure of line function became obsolete and was soon replaced by the organizational structure of business division. Business divisions are departments that combine production and other related functions in line with the business type of the regional market. Such divisions usually have great autonomy. After World War II, almost all MNCs adopted business division, and various forms emerged. Business divisions are profit centers and control several factories (cost centers) and functions. Their headquarters are responsible for developing strategic planning, financing investment, and appointing top management. Many MNCs have even turned their business divisions into strategic business units (SBU). Such SBUs have greater autonomy. When overseas business accounts for a small part of a MNC, it usually divides its domestic business into several divisions according to business type and the overseas business is controlled by one division. However, with the increase of overseas business, several divisions are set up according to business type or region. As business divisions have great autonomy and adequate resources, they can respond quickly to changes of environment but they also tend to do things in their own way. A pressing problem for MNCs with the business division system is how to coordinate regional, business, and functional conflicts and to achieve optimization of resources. Academics have suggested a matrix organizational structure for the problem. Such a structure was popular in a number of MNCs. It takes one side as the latitude and the other side as the longitude. For example, an employee works in a business division, but is managed by functional and regional managers. The practice shows that the matrix model did not solve the above conflicts, and in fact increased the conflict of power due to difficulties in communication. ABB was a strong proponent of this structure, but had to give it up in 1993. The restructuring cost was US$ 500 million. It is worth pointing out that the organizational structure of MNCs is closely related to the nature of their business and the culture of their parent country. Manufacturing, for example, adapts to standard production and sales in different regions, but the service sector should cater to regional differences. Besides, Japanese MNCs are more centralized than US and European MNCs.

3. Development Trend of MNCs With the development of science and technology and globalization of the

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world’s economy, MNCs display the following trends at the beginning of the twenty-first century:

(1) Global strategic restructuring through mergers and acquisitions Since 1994, MNCs have been enthusiastic about mergers and acquisitions. The wave started in the United States and soon spread to Europe and Asia. In 1999, the total volume of mergers and acquisitions reached US$3.4 trillion, up 36 per cent over the previous year. Transnational mergers and acquisitions are increasingly frequent, their scales are increasingly large, and their speed is increasingly fast. This is particularly the case with such technology-intensive industries as automobiles and petrochemicals. For example, the German company Daimler (formerly British owned) acquired US company Chrysler, and British company BP acquired the American Amoco. Mergers and acquisitions are developing fast in the finance, telecommunications, insurance, and retail industries. In 1998, the volume of mergers and acquisitions in banking and telecommunications alone accounted for 60 per cent of the world’s total. At the time of writing, mergers and acquisitions accounted for over 80 per cent of FDI, and most of them were strategic, aiming to increase their global competitiveness by creating a synergy and a scale economy. Mergers and acquisitions can help break down the fragmentation of markets by regional groups, promote international production, and step up the process of economic globalization, all the while intensifying international competition.

(2) Fast growth of the knowledge-based service sector With the rise of the knowledge economy, knowledge-based service industries (e.g. finance, insurance, information, consulting, and medical care) will grow fast. MNCs in service industries are active in expanding overseas business, and MNCs in traditional industries are setting up self-service divisions in the host country. At the time of writing, the service industry took up over 50 per cent of FDI, and the percentage is still growing.

(3) Gradual increase of FDI in developing countries From the direction of capital flow, we find that FDI in the form of mergers and acquisitions is going on mostly between developed countries, and the capital flow to developing countries accounts for only 20 per cent. After global strategic restructuring, MNCs will increase their business activities in developing countries for the purpose of grabbing resources, competing for markets, reducing costs, and transferring technology. It can be expected that, with the economic development and improvement of the investment environment, developing countries will absorb more FDI.

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(4) More emphasis on flexibility and adaptability in organizational structure With the progress of science and technology and the development of the economy, organizations will increasingly emphasize flexibility and adaptability. To survive in a complex and ever-changing environment, an organization should be able obtain accurate and current external information and quickly adjust its internal structure to adapt to environmental changes. In the 21 st Century, knowledge workers will play an increasingly important role in MNCs. They have the expertise and skills, and their clear objectives in selfmanagement, continuous learning, innovation, and work quality will play an increasingly important role. This demands a change in organizational structure and an informal structure without fixed boundaries, a flat structure with minimal layers, a network structure for better internal communications, and a semi-autonomous structure for internal innovation. In addition, cultural conflict during transnational mergers and acquisitions will also have an important impact on organizational structure.

MAJOR STEPS AND MEASURES TO DEVELOP CHINESE MNCS Overseas operations started in China in the 1980s and experienced a fast growth in the 1990s. Statistics show that Chinese overseas enterprises approved by or filed with the Ministry of Foreign Trade and Economic Cooperation (MOFTEC) reached 5,356 by 1998, with an investment value of US$ 6.3 billion. The overseas investment involved a number of fields, such as trade, agriculture, exploitation of resources (e.g. mining, petroleum, forestry, and fisheries), raw materials, machinery, light textiles, post and telecommunications, transportation, project contracting, and hotels in over 160 countries and regions. However, we must be aware that most Chinese overseas investment has concentrated on the exploitation of resources and the processing industry, where China has a competitive advantage. In addition, the investment scale is small, with an average of US$ 1 million per company. Generally speaking, Chinese enterprises are not in a position to make large overseas investments, and they usually lack a global development strategy. Based on a comparative study of the top 100 industrial companies in China, we found that the 10 industries with the biggest increases do not have a competitive edge. The 10 industries with the largest comparative edge are such labor-intensive industries as clothing, textiles, and furniture manufacturing. The 10 industries with the least comparative edge are technology and capitalintensive industries, such as chemicals, metallurgy, electronics, and chemical fiber.

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The State Council’s Development Research Centre has compared China’s top 500 industrial companies with the Fortune 500 companies in size, efficiency, innovation, and international competitiveness. The result shows that the total assets and sales revenues of China’s top 500 companies in 1998 were less than 0.88 and 1.74 per cent respectively of the Fortune 5’00 companies, and the average return on assets, per capita profit, and per capita revenue of China’s top 500 companies were 24.6 per cent, 12.3 per cent, and 9.5 per cent of the Fortune 500 companies respectively. Fortune 500 companies attach great importance to innovation and invest 5–10 per cent of their sales revenues in R & D. In comparison, the technology and facilities of Chinese industrial enterprises are backward, and the capacity for technological development is poor. R & D accounts for less than 1.38 per cent of total sales revenues, and this percentage is still decreasing. Most of the Fortune 500 companies have a high degree of economic interdependence and strong international competitiveness. These companies are usually MNCs, and their investment, production, and sales are global. In contrast, China’s top 500 industrial companies can only compete in the domestic market, and it is a stretch for them to develop international competitiveness. For various reasons, the management level of Chinese enterprises is low. According to an evaluation of international competitiveness by IMD, disclosed on 13 April 1999, China ranked 29 out of 47 countries and regions in terms of international competitiveness (Hong Kong ranked 7), 36 in management (Hong Kong ranked 5), and 46 in GDP per worker, with an average of US$ 5,837 (Hong Kong ranked 20, with US$ 46,848). The above figures show that Chinese enterprises must make painstaking efforts before they can become world-class companies. To create Chinese MNCs in a systematic way, we propose a four-step strategy: rationalization, integration, congregation, and internationalization.

1. Rationalization Rationalization refers to the rational use of human resources, capital, technology, materials, and facilities for a better economic return. Most Chinese enterprises have done a poor job in this regard. For example, a number of large-sized stateowned enterprises (SOEs) are overstaffed, productivity is low, and employees are unmotivated; capital turnover is slow with a low utilization efficiency; financing and investment decisions are unscientific; financial statements are non-standard and some data are even distorted; technology and management lag far behind their overseas counterparts; technological innovation is weak; logistics remains at the elementary stage; the means of procurement and

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supply is backward; marketing and after-sales forces are weak; management of facilities is poor and their use, maintenance, and renovation are poorly scheduled; the degree of informationalization is low; and most enterprises can only use computers for data processing. With China’s economic development, companies with these problems will meet with difficulty in their survival and development, let alone in active participation in international competition. The way to rationalization for Chinese enterprises is to take account of both China’s realties and the peculiarities of each individual enterprise, and to strengthen management with scientific means and methods. Enterprises need to implement scientific management in personnel, finance, production, logistics, marketing, and R & D; to maintain leadership in domestic industries in product quality, cost, and capital turnover; and to gradually narrow the gap between them and their overseas counterparts.

2. Integration Integration means starting from the perspective of system engineering; looking at enterprises as a system comprising a number of interrelated units with different structures and functions; and having exchanges with the external environment in matter, energy, and information. The objective is to achieve optimal performance through appropriate organizational management. According to this definition, we can divide integration into two types: extension and intension. Extension refers to integration through the expansion of the system of units in the external environment that are closely related to the system itself, so as to speed the development of an enterprise and to improve business performance. It can be further divided into vertical integration and horizontal integration. Vertical integration refers to extension in the direction of raw materials and/ or market. Vertical integration towards the market is called forward integration, and includes, for example, the expansion of a refining company towards petrochemicals and the expansion of a petrochemicals company towards fine chemicals. Vertical integration towards raw materials is called backward integration, and includes, for example, the expansion of a phosphate fertilizer factory towards ground phosphate exploitation. Horizontal integration refers to the expansion of an enterprise into areas with a competitive edge, and these areas often have the same raw materials and similar processes, facilities, and product purposes. Intension refers to the improvement of business processes through reasonable organization so as to improve efficiency and quality and lower cost. It is in fact an integration of the internal system and falls within the scope of reengineering.

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Reengineering means redesign of business processes, organizational structure, management systems, and corporate values and culture. From the perspective of management science, reengineering can be seen as an integration of the internal system of an enterprise for overall optimization. The integration of an enterprise develops with the rapid progress of IT, and the increase of informationalization develops with the enterprise. It had two directions in the beginning: the first was the integration of manufacturing systems from MPR to MPRII and to CIMS; and the second was the integration of management systems from EDP to MIS and to DSS. Since the late 1980s, the two directions began to merge, from ERP and SCM to overall integration and optimization. The road to integration for Chinese enterprises is to restructure business processes by combining the principles of restructuring with their own realities, and to realize extension and intension through ERP and SCM. It should be carried out after rationalization is realized, and any attempt to please the public with claptrap should be avoided.

3. Congregation Congregation means alliances in various forms to increase competitiveness and adapt to environmental changes. Acquisition is an effective means for an enterprise to realize fast expansion. It can help avoid investment repetition in facilities, reduce competition, and increase the competitiveness of the enterprise. Facing a new business opportunity, an enterprise has four alternatives: to set up a new division; to give up the business and buy the product and service in the market; to acquire an enterprise in the same line; and to cooperate with one or more enterprises. The choice among the four alternatives depends on cost analysis and on the experience, judgment, and wisdom of the top management. When an enterprise reaches a certain scale, the expansion through integration will no longer be appropriate due to the restraint of resources and management competency. At this critical mass, it will not achieve the scale economy effect. On the contrary, it will reduce the operational efficiency. After World War II, the highly centralized management model of the manufacturing giants began to weaken and was replaced by the business division structure. In the 1970s, the spread of mergers and acquisitions swept the world and diverse business groups and alliances were formed. This was the beginning of congregation. Payment in mergers and acquisitions takes various forms, and the acquiring company sometimes simply wishes to hold shares in the acquired company. In this case, the acquiring company often adopts a business group structure

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to minimize management difficulties resulting from cultural differences and delegates part of the power to the acquired company so that it can maintain a certain independence. The term ‘business group’ was first used in Japan in the 1970s and is now a household phrase in China. It refers to an economic entity with legal status formed out of the business needs of several related enterprises. With the key enterprise at the centre, it has assets as the link. Through assets restructuring, a business group should control its members by shares, and the key enterprise should have advantages in technology and management and strong brands to attract related enterprises to join the group. The transaction costs of takeovers and forming business groups is rather high. Beginning in the 1980s, alliances have been popular with the development of IT and the improvement of management. The purpose of alliances is to lower costs, share technology, develop new products, open new markets, and finance in the capital market. The form of alliances ranges from simple sales agreement, technology service, and cooperative development to joint ventures. As alliances are formed on a voluntary basis, all the members are legal entities with equal positions. The advantage of alliances is the high flexibility and low transaction cost. With the development of the Internet in the 1990s, many medium and smallsized businesses have been working closely in technology exchange and service providing, and a network of businesses has been formed. This network joins together the medium and small-sized businesses that are directly dealing with customers, suppliers, and investors (the innovative high-tech companies in particular). This is an effective way for the related businesses to make use of their resources, technologies, regional markets, and information. The way to congregation for Chinese enterprises is to start from the actual production and operation need, and form an alliance on a voluntary basis in whatever the appropriate form. It should be implemented in line with the law of the market economy and the principle of synergy, without being constrained by such factors as ownership, region, industry, and department. The regional groups formed as a result of administrative commands should be restructured according to the realities; otherwise they will soon disappear from the market.

4. Internationalization Internationalization means transnational operation, from indirect export to direct export, and from overseas subsidiary to international operation. These are the four forms and steps in internationalization. Indirect export is the primary form of transnational operation, and at this stage, an enterprise entrusts a trading company with the export of its products.

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It focuses on the domestic market, and its international business is passive and indirect. In contrast, direct export means that an enterprise deals with its own export business, and sells its products through an overseas agent or overseas representative office. However, its core business still focuses on the domestic market, and the overseas office is only a representative institution. Setting up overseas subsidiaries is the major form of transnational business. At this stage, however, the parent company and the core business remain at home. In the last stage, the business of an enterprise is spread out all over the world and only the headquarters remain at home, functioning as a strategic decision centre. When an enterprise finds an opportunity to sell its products overseas, there are usually five choices. The first is to export its products from home; the second is to franchise an overseas company to produce the same products; the third is to set up overseas production facilities; the fourth is to acquire an overseas company with the same product line; and the fifth is to-form an alliance with other businesses. In recent years, takeovers and alliances have been the major forms of realizing international operation. It is generally assumed that the world has witnessed five waves of takeovers since late nineteenth century. But only the fifth wave, beginning in 1994, has involved transnational takeovers. Since 1998 in particular, transnational takeovers have been increasing, involving many giants and important industries. Many US companies have acquired a great number of European and Asian businesses, and mergers and acquisitions within Europe and Asia have also increased. In fact, the value of takeovers has accounted for over 80 per cent of FDI. Experience has shown that transnational takeovers often result in contention over management power and cross-cultural conflicts. With the increase of the value of intangible assets and the size of takeovers, such contention and conflict will become more and more intense. In contrast, alliances will meet with less resistance and transaction costs will be relatively low. Therefore, not only big companies but also MNCs are seeking overseas strategic alliances. An increasing number of MNCs are active in forming strategic alliances among themselves or in setting up joint ventures so as to create a synergy. This is more obvious in such new industries as microelectronics, IT, and biotechnology. Such alliances are becoming the most important form of cooperation between MNCs. In addition, the business network formed by medium and small-sized enterprises is also expanding to overseas markets and can expect to realize transnational operation through an international network. The path to internationalization for Chinese enterprises must first of all begin with understanding the rules of international business through export practice and then setting up a representative office in the target country in order

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to better understand the local environment, culture, and laws. Such a process should be consistent with the overall strategy of Chinese enterprises to build good public relations. At the same time, they should seek opportunities to build facilities, form alliances, or implement takeovers, and prepare for follow-up activities. When the time is ripe, they should take decisive action and ‘go out to develop international markets’. The above four steps are interrelated and even overlap. Some enterprises might begin transnational operation immediately after the stage of rationalization or integration. However, it is well advised to advance step by step in the creation of MNCs. The experience of some Chinese enterprises in overseas investment shows that any attempt to go beyond the realities and to plan transnational operations too soon will fail. The same applies to any overseas investment that is not related to the development of the parent company.

OVERSEAS INVESTMENT STRATEGY FOR CHINESE ENTERPRISES The word ‘strategy’ is borrowed from military terms. In military battles, we need to have strategic objectives and major procedures and resource allocation (ammunition, weapons, and provisions). It is the same with enterprise management. The top management of an enterprise should not be buried in daily management. Instead, it should think about strategic issues as strategy is related to the survival of an enterprise. Strategic management is the highest level as well as the primary task of modern management. According to the modem management model, it includes strategic formulation and strategic implementation. In developing a strategy, we need first of all to identify a strategic objective and then analyze the environment and resources. Environmental analysis includes analysis of society, industry (competition), and market (customers), and resource analysis includes analysis of labor, assets, and resources within the organization. If the analysis shows that the strategic objective is not achievable, it must be modified. If it is shown to be achievable, it should be broken down in line with time and space, and specific plans and strategic measures to achieve the goals should be formulated. In implementation, timely adjustment should be made to adapt to new changes. The overseas investment strategy of Chinese enterprises is ‘to go out and develop international markets’. This is an important measure for them to meet the challenge of economic globalization. From the perspective of complexity science, an enterprise is not only a system but also an organism comprising a number of ‘people’. As an organism, it must have a vision, mission, and strategic

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objective. The strategic objective is the basis of enterprise management. Vision determines mission, mission determines strategy, and strategy determines structure. Only with a shared vision and mission can an organization create a good corporate culture and motivate its members to strive for great success. In developing a strategic objective, an enterprise must first identify its purpose for overseas investment. An MNC has four motives: seeking new resources, new markets, efficiency (e.g. scale economy), and strategic assets (e.g. brands, trademarks, and patent technology). For Chinese enterprises, the main purpose in the near future is to seek new resources or new markets. China is a populous country with a large territory. Its natural resources are relatively scarce and their quality is relatively poor. We should make a comparative edge analysis and invest overseas to exploit certain resources to meet domestic needs. Priority should be given to resources that are heavily imported in China, are in abundant supply in the international market, and have high price fluctuations. Such resources in China are poor in quality and need to be used as strategic reserves. If comparative edge analysis shows that overseas investment is more cost effective than use of domestic resources, we should select overseas investment without any hesitation. For products that have reached a saturation point in the domestic market and whose export has met with both tariff and non-tariff barriers, we should consider setting up overseas production facilities. In recent years, certain countries have frequently pressed anti-dumping charges on China. (There were 378 cases in total between 1979–2000, among which 87 were pressed by the European Union and 75 by the United States). Overseas facilities cannot only avoid trade barriers in their host country, but can also prevent competitors or potential competitors from entering the market. Overseas investment with the purpose of seeking strategic assets should not be the immediate focus but should not be neglected either. In developing an international business strategy, Chinese enterprises should not focus only on profit and optimization of shareholder ’s equity. Customer satisfaction and social support are critical to success. Chinese enterprises should try every means to satisfy the customer’s needs in price, quality, delivery, and after-sale service. They should be good listeners and continuously improve the quality of their products. In addition, they need to establish good relations with the host country, and respect the local law, culture, and social customs. They should not only contribute to the increase of taxes and creation of job opportunities in the host country, but should also try to become involved in the local community through charitable activities. In terms of industry, Chinese enterprises should take into account the overall

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strategy of China’s overseas investment and select such industries as petroleum, natural gas, steel ore, potash, sulphur, and wood, etc. They should also take into account the competitive advantages of China’s traditional industries, such as textiles, clothing, and toys. For high-tech industries, they should first of all consider the developed countries, and seek partners in America, Japan, and Germany. They can enter these markets through cooperation or joint ventures and bring back advanced technology. In overseas investment, particular attention should be given to the characteristics of the knowledge economy and innovation. Chinese enterprises must increase their input in intellectual capital and human resources, and rely on knowledge, technology, and management in international business. After clarifying the purposes of overseas investment, an enterprise should identify the host country and develop measurable goals, such as output, sales volume, and profit. Decisions should be made after a careful study of the external environment and internal resources. In selecting the host country, MNCs should take into account the investment environment, which comprises political, economic, legal, cultural, and natural factors. These factors include political stability, economic policies, natural resources, geographic position, population, climate, market size, legal maturity, social traditions, level of education, and religion. Decisions should be made after a careful evaluation. In developed countries, investment should observe legal and cultural environments and avoid cultural conflict between Chinese and local employees; in developing countries, investment should pay attention to political and economic environments. Although a few academics have proposed various quantitative methods, such as the cold and hot measurement method of I. A. Litvak and P. M. Banting and the classification rating method of R. B. Stobaugh, we suggest a combination of both quantitative and qualitative methods. A preliminary study shows that countries with favorable investment environments are mainly located in North America, the European Union, and East Asia. In selecting investment areas, enterprises with strength in clothing or Chinese food can increase their input in the United States, Germany, and East Asia, because these countries and areas have a large population of overseas Chinese and a broad market. Enterprises with strength in resource exploitation can select Canada, the United States, Russia, South Africa, and Central and South America, because these countries and areas are rich in natural resources. Enterprises with a technology base should consider the United States, Japan, and European countries, because these countries have advanced technology and good strategic assets. In making an investment, an enterprise should first of all select a centre and consider expansion later. For example, the United

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States could be such a centre in North America. Chinese enterprises can enter the US market first, and then expand into Canada, Mexico, and other countries. In the European Union and South America, Germany and Brazil should be the respective centers. In the meantime, Chinese enterprises should develop economic relations with neighboring countries, and gradually increase investment in these countries. This can not only strengthen our relations and cooperation with them, but also improve border safety. In strategic management, Chinese MNCs should seek opportunities from environmental changes to get rid of potential threats, and increase their competitiveness through organizational restructuring. Competitiveness can be of two types: price and non-price. Price competitiveness depends mainly on cost, and non-price competitiveness can be understood in a broad or narrow sense. In the narrow sense, it includes product quality, delivery, service quality (i.e. after-sale service, quality warranty, operation management, and maintenance capability), and flexibility; and in broad sense, it includes capacity for new product development, capacity for commodity planning (ability to take and deliver orders), uniqueness of product, and attraction to customers. Business leaders should take into account all these factors and identify the strengths and weaknesses of their enterprises. By proper positioning, they can either compete in price or quality, or even produce products of different grades to avoid direct competition. More importantly, they should identify, develop, and bring into full play the core competence of their enterprises. The concept of ‘core competence’ was formulated by two American academics, C. K. Prahalad and G. Hamel, in 1990. They found that technological innovation was barely able to ensure the sustainable development of an enterprise as the market was constantly changing and the competition constantly increasing. Instead, an enterprise should purposefully guide technological innovation, technological cooperation, and technological introduction, and integrate them to form core competence. They maintained that the diversified corporation is a large tree. The trunk and major limbs are core products; the smaller branches are business units; and the leaves, flowers, and fruits are end products. The root system that provides nourishment, sustenance, and stability is the core competence. Therefore, Chinese business leaders should have the ability to identify and develop a core competence that can ensure the sustainable growth of their enterprises and the ability to integrate technological resources with businesses so as to adapt to the fast changing environment. Strong brands are also important in increasing the competitiveness of an enterprise. Of the top 60 brands rated by the Journal of International Brands , the United States has 38, followed by Europe, which has 28. Asia (i.e. Japan)

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has three. Of the top 10 Asian brands (excluding Japan), Hong Kong has three, Taiwan has one, and mainland China has none. In developing core competence, enterprises need to make efforts to create strong brands.

INTERNAL MANAGEMENT OF CHINESE MNCs MNCs are special enterprises, possessing both the individuality of economic organizations and the property of transnational operations. In discussing their internal management, we need to combine the management theories and practices of general enterprises with their own characteristics, and develop appropriate systems. For Chinese MNCs, I believe that the establishment and improvement of corporate governance, financial management, and internal control is critical.

1. Corporate Governance Corporate governance is a system related to the fundamental power of an enterprise and includes the appointment of top management, the allocation of corporate resources, and the distribution of net earnings. It is usually set up after the separation of ownership and management to resolve any disparity in goals. Some people also hold that corporate governance is a set of systems used by the owner of an enterprise to monitor and control operational management and performance. In theory, the stockholders’ meeting is the top organ of power in a company with diversified equities. In practice, however, it is the board of directors that exercises the power of the owner on behalf of the stockholders. Therefore, power, structure, and a working approach have become the crux of corporate governance. The prescriptions governing the power of the board are almost the same in every country, and mainly consist of the appointment of the top management and overall supervision over corporate strategy and finance. Board structure, however, varies from country to country. In China, the ‘Company Law’, effective since 1 July 1994, prescribes that the board of directors of limited corporations should consist of three to 13 members elected at the stockholders’ meeting. The board of directors appoints the general manager and takes responsibility for any consequences. In addition, it should provide supervision and guidance, which is the key to the improvement of corporate governance. The quality of business leaders is a key factor influencing corporate behavior. Quality can be static and dynamic. Static quality refers to the inherent quality of a person, or their so-called ability and integrity; dynamic quality is the capacity for work and learning of a person after being elected, or their so-called

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commitment and devotion. The board of directors selects a general manager on the basis of the static quality of candidates, and the dynamic quality will not show until a general manager is in power. It is more related to ‘moral risk’, given the difficulty of supervision and motivation by the board. MNCs, whose overseas subsidiaries are so spread out, usually give great autonomy to the overseas management, making it more difficult for the board to exercise the power of supervision. Most Chinese enterprises are still at the initial stage of transnational operations and usually have a line function structure in organization. Under such a decentralized model, overseas subsidiaries have great autonomy and are loosely connected to their parent company. Such a connection is often reflected in personal relationships between the general manager of the parent company and the general managers of the overseas subsidiaries: the latter report to the former personally. This organizational structure is not significantly different from that of an SOE. As there does not exist an ad hoc organ responsible for international operations, the supervision over the general managers of overseas subsidiaries is least effective. The subsidiary general managers of some enterprises (SOEs in particular) secretly work for themselves when they get acquainted with the local market, and eventually leave the company and set up their own private businesses. A few of them even steal the old customers and embezzle the original company’s property. There is a great ‘moral risk’ in countries where the registration, procurement of assets, savings, and investment are all done in the name of the general managers of the subsidiaries. To prevent these situations, some MNCs have taken a number of measures, but with little effect. For example, the regular rotation system has only pushed the general managers of subsidiaries to setup independently. The board members or senior executives sent to examine the overseas operations often find it difficult to get at the truth, and some of them even help cover up the truth. The solution to these problems should rely on systems, coupled with legal and moral restraints. The key is to set up effective corporate governance in overseas subsidiaries, which must be registered as limited liability shareholding companies. The board of directors and board of supervisors should be established to provide supervision and guidance according to the law. The board of directors should include a number of independent directors and wellknown local figures with business experience. The supervisory board should consist of representatives of stockholders and employees. The overall quality of an enterprise is determined by the quality of its individual members, their interaction, and their concerted efforts. A mechanism must be set up to motivate all members and to ensure consistency between the

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individual goals and objectives of the organization. A good incentive system for employees and management should include the following five elements:

(1) Wages The employees in overseas subsidiaries receive either domestic or expatriate wages. Some enterprises combine domestic wages with expatriate subsidies, while others offer an expatriate package. In the long-run, enterprises should refer to similar businesses in the host country and provide a full expatriate package.

(2) Benefits In overseas subsidiaries, housing rent, car, and fuel costs are covered by the company. This is considered to be an integral part of employee benefits. However, the byproduct of the practice is grave waste. Therefore, it should be eliminated and included in wages.

(3) Bonus This is proportional to the contribution of each employee. The greater the contribution, the higher the bonus. Egalitarianism should be eliminated, or the employees with greater ability and contribution will lose motivation.

(4) Stock Rights Overseas subsidiaries can be set up as shareholding companies, and employees can become shareholders through equity participation. This can both help develop an effective supervisory mechanism and combine the interests of individuals and the organization. MBO (management buy-out) should be encouraged, and all or part of the shares of divisions or subsidiaries can be sold to the management. This can motivate executives and combine their personal interests with file interests of the enterprise.

(5) Options These are a kind of equity for employees, in particular senior executives. They cannot be cashed until the related persons have served the organization for a fixed number of years with good company performance. This practice helps to eliminate short-term behavior and encourage the management to commit to the organization.

2. Financial Management System Financial management is a weak link in Chinese enterprises. In developing international business, financial management will be more arduous, problems will be more complex, and risks will be far greater. Most Chinese enterprises lack experience in financial management and so financing costs are high,

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investment decisions are poor, efficiency of capital use is low, and tax burdens are heavy. These problems have impaired the economic efficiency and development impetus of these enterprises. To remedy this situation, we need to develop a financial management system that aligns with international practice, meets the legal requirements of the host country, and caters to the realities of Chinese enterprises. The objective of financial management in MNCs is to integrate various financial tools and resources to lower the financing cost, improve investment decisions, allocate capital flexibly, reserve cash reasonably, reduce the overall tax burden, avoid exchange risks, control operating costs, and maximize profits. The headquarters should act as the centre for financing, investment decisions, cash reserves, price transfers, tax advantages, and risk control. In addition, the headquarters should consolidate and prepare the financial statements of the whole company. All the subsidiaries and divisions are profit centers and realize economic benefits through business activities under the guidance and control of the finance department at headquarters. They need to deliver part of their profit as required by headquarters, report regularly on their financial management and economic efficiency, and submit accounting statements without delay. When fundraising, subsidiaries should make an effort to expand resources in addition to the internal appropriations, and finance in the capital market or through financial institutions in the parent and host country. They should also take advantage of the preferential policies of the parent country, host country, and international institutions to lower financing costs. Due attention should be paid to the differences of each individual country in law and economic development, and flexibility can be improved in capital allocation through back-to-back loans, parallel loans, and currency exchange. In investment decisions, subsidiaries should follow the overall corporate strategy to make long-term investments and optimize corporate resources from a global perspective. Investment projects above a certain amount should be approved by headquarters, and autonomy should be given to subsidiaries for small projects and short-term investment. In cash management, headquarters should consider setting up a cash reserve centre in a safe place and should maintain a reasonable level of cash for their own needs and those of subsidiaries. Cash budget management should be strengthened, and the net amount should be duly settled. As subsidiaries are responsible for controlling costs and delivering profit, they will invariably try to acquire the organization’s raw materials at the lowest price and sell the semi- and end-products at the highest price. Headquarters

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need to determine the internal transfer price of raw materials and semi- and end products in line with international prices and the company’s strategic needs. An important element of financial management in MNCs is to take advantage of the legal and tax differences. This is also a weak link in Chinese MNCs. The finance departments of headquarters and subsidiaries should learn how to avoid tax through legal procedures. Headquarters should also set up a dedicated team to implement research on international politics, economics, and science and technology, and to warn the finance departments of potential risks (exchange fluctuation, political upheavals, etc). The overriding principle of financial management in overseas enterprises is to operate in line with the local law, pay tax, implement accounting and financial management, and set up a management system on capital expenditure, earnings, and taxation within the power authorized by headquarters. Overseas enterprises are responsible for ensuring the safe operation of the parent company and for adding value to its assets. The dedicated financial staff sent to overseas subsidiaries should report to the general managers of these subsidiaries and at the same time ensure the implementation of the financial management system developed by headquarters.

3. Internal Control One of the difficulties in the management of MNCs is how to implement effective supervision over overseas subsidiaries. In addition to sound corporate governance, an effective system of internal control should be set up. Overseas subsidiaries should be registered in the name of the company as the ownership representative of the parent company. Individuals should not be allowed to be the representatives of corporate assets. The Administration of State-owned Assets stipulates that overseas state-owned assets, bank deposits, and external investments should not be put in the name of individuals. Ownership transfer with legal force should happen when assets can only be registered in the name of individuals, making it clear that the assets, though registered in the name of individuals, are owned by company. The board chairman or the general manager of overseas subsidiaries should be responsible for the assets of the parent company. When there is a change in these positions, the assets should be legally transferred and the related responsibilities should be transferred to the successor. Financial departments should make a detailed record of the changes of corporate assets. Any decrease, transfer, or write-off of corporate assets should be approved by headquarters, and no organization or individual should be allowed to make any decisions

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concerning these. The liabilities of overseas subsidiaries should be included in tile liabilities of headquarters, and the assets formed through liability investment should be owned by the parent company. In the case of rescission, mergers, sales, or bankruptcy, overseas enterprises should dispose of assets, credit, and liabilities immediately, and report to the parent company the financial status and auditing comments of a local accounting firm. After the approval of the parent company and the disposal of credit and liabilities, they should transfer the remaining capital to their headquarters and any embezzlement or overseas deposits should be prohibited. In line with the law of the host country and international practices, overseas enterprises should set up files for revenues and expenses, and retain copies of original bills for all expenses. Expense applications are drafted and signed by the relevant person and forwarded to the finance department of overseas enterprises after being approved by a department head. Based on the application, the financial staff draws an expense bill or check and the relevant amount cannot be collected until the bill has been signed by two managers of the opening bank (usually the general manager and deputy general manager). Bills and expense applications should be copied and filed in enterprises (the original copy being kept in the bank) and disclosed regularly to the parent company and local accountants. Managers should develop strict regulations and standardized business processes, and perform regular checks on their implementation. Internal audits are an important foundation of such a work. The internal audit department is usually led by a deputy general manager, who manages the internal audit director and international audit manager and reports directly to the general manager or audit committee of the board of directors. The major task of the internal audit department is to evaluate the implementation of the internal supervision system, and its objectives include ensuring the safety of financial assets; examining the accuracy and reliability of financial data; improving operational business; and motivating employees to observe the management system and business processes. Some specific problems can crop up in internal audits concerning local accounting standards, foreign currency, local laws, business practices, language, and customs. Bookkeeping in line with local accounting standards will sometimes increase the difficulty of internal audits. Auditors are usually sent by the parent company, but local auditors or auditors from the parent country or a third country can also be used. Small MNCs tend to use domestic auditors in auditing overseas businesses, while large MNCs prefer to use local auditors.

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With the development of domestic and international capital markets, outsiders expect objective and independent evaluation of financial statements. In countries where auditing is below international standards, domestic companies are inclined to use international accounting firms. This might be an effective way to attract overseas investors. According to company law in the United States, the audit committee of a company should consist of three to five people. The members are often external directors, who are, at the very least, involved in the operations of the company. Such an audit committee serves as a standing supervisory organ. Its tasks and functions are: to discuss the internal supervision system and the status of components; to evaluate the organizational status and qualifications of the internal audit department; to review the work of the internal audit department; to select final auditors and decide audit fees; to review audit scope and the priorities of the final auditors and internal audit department; to discuss the audit plans of final auditors and internal audit department; to examine the annual accounting and annual audit; and to review the consistency between the status report and the business report. In essence, the audit committee of an enterprise is a means to coordinate between the key elements of the supervision system, and to improve the efficiency of the supervisory board.

POLICY MEASURES TO ENCOURAGE OVERSEAS INVESTMENT AND THE DEVELOPMENT OF MNCS Chinese FDI and MNCs have been growing rapidly in recent years, thanks to China’s encouragement of foreign investment and a series of policy measures for parent countries to promote, protect, and supervise overseas investment. The development of MNCs has been speeded up through legislation, taxation, credit, and insurance policies. ‘The strategy ‘to go out and develop international markets’ requires the full play of market forces and the initiative of enterprises, as well as government support and supervision. For the past 20 years, the macro management of overseas investment has been characterized by regulation and control in China, and policies to promote investment have been ineffectual. Investment protection has been almost nonexistent. If we are serious about our strategy ‘to go out’, we must establish and improve the macro management of overseas investment. The government must first of all change its mindset and function, and the relevant authorities should shift from single control to a joint emphasis on promotion, protection, and supervision, and from single administrative means to a joint emphasis on

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administrative, economic, and legal means. It is also important to bring into play the role of market in resource allocation. Based on the need to build a socialist market economy system in the context of globalization and the international experiences of major investing countries in overseas investment management, I suggest that China should follow the principle of ‘active promotion, full protection, and adequate supervision’ in overseas investment. Active promotion means the development of an overall strategy for overseas investment, legislation of overseas investment law, formulation of favorable tax and credit policies for international businesses, establishment of a financial support system and integrated service system for overseas investments, and facilitation of project progress through diplomatic means. Full protection means the establishment of a political risk and credit risk safety systems for overseas investment, and protection of the legal rights of our investors through diplomatic means. It also means expanding bilateral and multilateral agreements to protect the interests of Chinese enterprises in international business. Adequate supervision means approval of overseas investment projects by governments and the relevant authorities at all levels, and the exchange management, taxation management, state-owned assets management, and coordination of foreign markets. These three principles are complementary to one another, but in different countries or at different stages, the focus and the means will be different. In the United States, for example, the priority is investment protection, complemented by investment promotion, and the means include domestic legislation, promotion of bilateral agreements, insurance funds, and international multilateral mechanisms. In Japan, a shift is taking place from investment control to investment promotion and protection, and the means include approval of projects, control of foreign exchange, development of preferential tax policies, credit support, and IT services. In the United Kingdom, the pre-World War II liberalization policy was shifted to a restrictive policy after the war and to the present investment promotion and protection, and the means include financial subsidies, control of foreign exchange, and investment risk protection. Based on international experience and Chinese realities, I propose the following policy measures to promote the healthy development of overseas investment and fast growth of Chinese MNCs.

1. Developing an Overall Strategy For Overseas Investment In many countries, overseas investment strategy is closely related to domestic industrial structure. In the early days, investment strategy encouraged resource

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development industries to invest overseas. Examples are Japan, South Korea, and the United Kingdom. With industrialization, some countries began to push domestic industries with a competitive edge into international markets and promoted the adjustment of domestic industrial structure. France, for example, boosted overseas investment in steel, chemicals, automobiles, aviation, and electronics through its overseas investment strategy. By encouraging the international transfer of mature industries, France upgraded its domestic industrial structure. As the above discussion indicates, the strategic objective of overseas investment during the present stage is to open the international market and to leverage overseas resources. To this end, we should implement a careful study and encourage enterprises with a competitive edge to invest in countries or regions with a favorable environment to promote the export of products, services, and technology. Enterprises with strong financial positions should be encouraged to cooperate with countries or regions possessing quality resources that are direly needed in China. Based on a careful analysis of the comparative advantages of major countries and regions and of domestic industries, the government is advised to set up an ad hoc team to formulate an overseas investment strategy, including strategic objectives, industries encouraged ‘to go out’, preferred countries and regions for overseas investment, and strategic procedures and measures. Specific plans should be developed to promote overseas investment actively and steadily. The local authorities in charge of overseas investment should integrate the overall strategy and local realities in planning development strategy and setting priorities. They need to come up with solutions to problems in the business development of overseas enterprises, and to report to the central authorities if they need government help.

2. Speeding Up the Legislation of Overseas Investment Law Countries throughout the world need to help their local enterprises expand their overseas markets and protect the legal rights of overseas companies through legislation. This can establish the status and role of overseas investment, and clarify the principles and specific measures of the government in its protection. In addition, countries need to meet the need of enterprises in cross-border operation in the new international investment environment. At present, international multilateral and bilateral agreements and the FDI laws of each country constitute a complete legal system, which is playing an important role in promoting, protecting, and regulating the overseas investment of each country. The United States is the first country to provide legal protection for overseas investment. The Economic Cooperation Bill passed by Congress in 1948 set down

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the basic principles of ‘security’ for overseas investors. However, the investment security system was limited to Europe and contained nothing but the exchange of other currencies into US dollars under the contract stipulations. The bill made it clear that the Agency of Economic Cooperation was an organization, under the State Department, responsible for overseas investment security. Since then, the US government has amended the bill several times. The first amendment was made to extend the security system to regions other than Europe, and in 1959 the US government further stipulated that it was limited to investment in developing countries. The second amendment was made to extend the coverage of insurance to requisition risk, war risk, revolution, and riots. Later amendments changed the organization’s name to the Agency of Mutual Security in 1952, the Foreign Affairs Administration in 1953, the Agency of International Cooperation in 1955, and finally to the Agency of International Development in 1966. All these organizations served as administrative bodies of the US government. In 1969, the US Congress passed the eighth amendment to the External Aid Bill, and set up the Overseas Private Investment Company (OPIC), responsible for the security and insurance of overseas investment. The organization is an economic legal entity, and operates in line with the system and regulations of a company. In the meantime, it is still a ‘body under the guidance of the State Department’. Other countries like the United Kingdom, France, Germany, Japan, and South Korea have taken similar measures to protect and support overseas investment through legislation, which has contributed to the fast growth of their MNCs. In the past two decades since China’s reforms and opening up, the government has formulated a number of policy measures concerning overseas investment. However, these measures were distributed to the relevant authorities at all levels as internal documents, and lacked transparency for enterprises and the public. In addition, the legal status of overseas investment was not established. To effectively implement the strategic policy of ‘going out to develop the international market’, China needs to formulate laws and regulations on overseas investment and to standardize the behavior of overseas investment subjects, the interrelations between subjects, and the order of competition in overseas investment markets. In addition, China needs to make clear the overall strategy, basic policy, regulatory measures, and service system of the government, and to increase the transparency of policy so that enterprises will have guiding laws in overseas operations. This will help government bodies to regulate overseas investment and the enterprises to standardize their behavior in overseas operations. Besides, it can solicit government cooperation from

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the host country. To this end, I suggest that the National People’s Congress formulate the Overseas Investment Law of the PRC as soon as possible, specifying the basic principles in promoting, protecting, and regulating overseas investment. Such a law will be the basis for the government to develop the related regulations and the People’s Congress to make amendments.

3. Supporting Strong Enterprises in Transnational Business Through Fiscal and Financial Means International practices show that a combination of financial means, such as taxation, credit, and insurance, is more effective than a simple approval system in promoting and regulating overseas investment. Through open, differentiated tax and credit policies and insurance and reserve systems for overseas investment, China can push some industries to ‘go out’ and can support enterprises in strong positions to compete internationally and to develop into MNCs.

(1) Preferential tax policies The differentiation of tax policies can be reflected in import and export tariffs, corporate income tax, and personal income tax. Each government grants a certain level of tax deductions to encourage overseas investment. The United Kingdom, for example, allows a deduction of 25 per cent of income tax for overseas investment. In Germany, companies with FDI in developing countries are exempted from value-added tax for a period of 12 to 18 years, and citizens holding more than 25 per cent of shares in a foreign company are exempted from dividend tax. In China, enterprises with domestic machinery, technology, semi-products, and raw materials investing overseas should enjoy a lower export tariff than the export of general trade. Enterprises investing overseas to develop raw materials that are badly needed in domestic markets should enjoy a lower import tariff than the import of general trade. Enterprises investing overseas in regional markets and industries that are encouraged by the government should enjoy a deduction of corporate income tax on the basis of avoiding double taxation. In the meantime, Chinese staff working overseas should enjoy a reduction of personal income tax.

(2) Preferential credit policies Many governments provide preferential credit policies for domestic investors with overseas investment through state-owned banks and other financial institutions, including commercial loans or credit guarantee through state banks and investment loans through dedicated financial institutions. For example, the

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National Bank of France and Foreign Trade Bank of France provide long-term industrial development loans for domestic investors with overseas investment, and long-term commercial guarantees for overseas investment. They also provide export loans for enterprises with export volumes three times as much as the investment volume in five years and enterprises involved in foreign trade export. They exchange loans for all enterprises with overseas investment, and undertake the exchange risk during the loan period. The British Federal Development Company, Deutsche Development Company, EU Investment Bank, and the World Bank provide loans for all overseas projects, as long as they are approved by the host country, without any guarantee from the government of the host country or investors. The Japanese Import and Export Bank provides long-term loans for local manufacturers with overseas investment without an upper limit. The rate is below the average of private banks, and the terms depend on the nature of the industry. Middle and small-sized enterprises can enjoy more preferential policies. I suggest that the Chinese government should provide discount interest rates to overseas investment projects in privileged regions and industries with good prospects, and long-term credit or overseas financing guarantees at a preferential rate. For general projects, commercial banks should play a key role and provide credit at a market rate.

(3) Overseas investment insurance system Insurance for overseas investment is a government responsibility, and should cover political risk only. When an enterprise invests overseas, it is vulnerable to losses resulting from wars, nationalization, and foreign exchange control. For this reason, the government should provide investors with insurance against political risk. In general, investors can apply to a special organization designated by the government. When the application is accepted, the insurer will compensate the losses of investors in the case of political risk. In the United States, for example, the government provides insurance support for investment in developing countries with bilateral agreements. In some countries, the government even provides debt insurance for banks that help with the financing of overseas investment. In Japan, for example, the Import and Export Bank is a designated institution of the government that provides financing business and debt guarantee for overseas investment. The coverage and compensation for political risk in overseas investment differ from country to country. Japan began to set up a political risk insurance system as early as 1958, but its coverage was not expanded and the terms and rate of compensation were not improved until a decade later. In the Export

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Insurance Law amended in 1970, the limit was lifted and the insurance coverage was extended from projects conducive to Japan’s international balance to all overseas investment projects; the underwriting recipient included not only the initial investment, but also the net income from such an investment, loans obtained during the investment period, corporate bonds, and real estate; the insurance coverage was augmented by the remittance risk of investment capital, nationalization of investment gains, and losses as a result of war; and the compensation rate for investment capital was raised from 75 to 90 per cent. The United States, United Kingdom, Norway, Holland, and Germany have the same compensation rate as Japan: 90 per cent is covered by the insurer and 10 per cent is covered by the policy holder. In Switzerland, the compensation rate for overseas investment is 70 per cent, and the remaining 30 per cent is covered by the policy holder. In Canada and Denmark, the compensation rate is 85 per cent. Overseas investment insurance is not merely commercial insurance that provides compensation after the event – its more important role is its preventative nature through intergovernmental investment agreements. After the investing country has obtained the representative right of claim according to the agreement, political issues can be resolved on a commercial basis through government negotiation. The representative right of claim refers to the transfer of ownership and right of claim of the original investors to the overseas investment insurance institution of the investing country after its compensation for the losses of political risk. This is the right to claim for reimbursement from the host country on behalf of the investors. To relieve the worries of Chinese enterprises investing in developing countries in Africa and South-East Asia, and to encourage competitive companies to ‘go out and develop the international market’, the Chinese government should establish an insurance system for overseas investment and designate a proper institution (e.g. the State Development Bank) as the insurer with a compensation rate of 70 per cent. The designated institution should acquire the representative right of claim in accordance with international practice and Chinese law, and claim for commercial losses resulting from political risk through diplomatic means and international arbitration.

(4) Reserve system for overseas investment The reserve system for overseas investment, is also referred to as a reserve system against overseas investment losses. Because of the potential losses resulting from all kinds of risks in initial overseas investment, the government of the investing country allows the investors to set up a reserve equivalent to all or part of the

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investment volume in the investing period. The amount of the reserve is deducted from the income tax by steps. This is a preferential tax policy to relieve part or all of the investors’ taxes in the initial period. Many countries, including Japan, France, and Germany, have adopted such measures. However, the percentage of the reserve in total investment and the period of deduction will vary as a result of the differences in investment period, the degree of risk in the host country, and the preferential industries set by the government. The Japanese government, for example, stipulated in 1971 that overseas investment in oil, natural gas, and coal during the exploration period should be allowed an accumulated rate of reserve of up to 100 per cent, and 30 per cent for these industries and the wood industry during the development stage. In 1980, the accumulated rate of reserve was reduced to 12 per cent, and further reduced to 10 per cent in 1984. The German government allows an accumulated rate of reserve of 40 per cent for investment in developing countries, and 100 per cent for investment in the least developed countries. The accumulated rate of reserve for energy and raw material is 60 per cent, with a period of deduction lasting from six to twelve years. The French government allows investors in education and research to set up a reserve equivalent to the losses of their overseas institutions in a period of five years within the investment limit. For companies investing in high-risk countries, the amount of the reserve can equal the total amount of the investment. China needs to set up a similar reserve system for overseas investment through legislation. This is an effective means to encourage competitive enterprises to ‘go out’ and stand firm in the initial period. A proper rate of reserve should be worked out according to different countries and industries to provide guidance for overseas investment.

4. Setting Up a Special Fund for Overseas Investment In addition to providing preferential commercial loans, many countries have set up special funds to promote effectively the development of their overseas investment. Such funds include special funds to aid investment in developing countries, subsidies for feasibility studies, and training for technical staff involved in overseas investment. These funds are allocated from the national budget and entrusted to a designated commercial institution. The US government has set up a number of overseas investment funds through the Agency of International Development and the Overseas Private Investment Company. The funds come from the government and are operated by private companies. The past few years have witnessed a rapid growth of such investment funds by the government and multilateral organizations. Through these funds,

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the US government provides capital support and risk insurance for investment in countries with insufficient private capital but high risks, such as Albania, Bulgaria, Hungary, Poland, Romania, Central Asia, and Russia. The investment funds serve as a bridge between the United States and the host country, and play a constructive role in resolving conflicts. This has avoided direct confrontation between the US government and the government of the host country, and helped resolve political issues through commercial means. The members of the OECD (Organization for Economic Cooperation and Development) often use special funds for foreign aid to support their companies in overseas investment. The French government has even set up a subsidy system for overseas investment facilities, providing a subsidy for investors in equipment export. In Japan, the Overseas Economic Cooperation Fund (OECF) and Overseas Trade Development Association (OTDA) are responsible for providing special funds for overseas investment. Although the beneficiaries of the OECF’s loans are developing countries, the primary objective is to meet the need of Japanese enterprises for capital in overseas cooperative projects. The OTDA, on the other hand, encourages medium and small-sized enterprises to invest overseas, and for this purpose provides free loans for medium and small-sized enterprises with investment projects in developing countries. The interest charge rate is only 0.75 per cent, and the term lasts for 20 years and can be further extended for another seven years if necessary. Another common way to promote overseas investment is to provide subsidies for project feasibility studies. In Japan, for example, the government provides subsidies covering air tickets, accommodation, miscellaneous fees, field study fees, and fees to prepare reports for three people for up to two months. The amount of the subsidy takes up 75 per cent of the total expenses. In addition, the Japanese government also provides subsidies for overseas exploration and mining, up to 75 percent and 50 per cent respectively. The British government provides a similar subsidy, amounting to hundreds of thousands of pounds for major projects. Some countries require investors to return the subsidy within a specified period of time, but most countries do not. To encourage Chinese enterprises to invest overseas, improve their business decisions, and speed up the development of Chinese MNCs, I suggest that the government should set up a special fund for overseas investment on the basis of the existing foreign trade development fund. The special fund can support overseas cooperative projects, feasibility studies, and training for technical people involved in overseas investment projects. The special fund can be operated by a designated institution (i.e. the Comprehensive Service Centre for Overseas Investment).

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5. Setting Up an Overseas Investment Promotion Centre to Provide Comprehensive Service for Enterprises With Overseas Investment In some countries, the government provides information, training, and consulting services for companies with overseas investment in addition to support in law, taxation, and finance. Through state administrative bodies, domestic ad hoc organizations, and economic information and intelligence centers in embassies and consulates, governments in many countries provide relevant economic information about the host country, analyzes investment opportunities, and helps companies make suitable decisions. In the United States, the Overseas Private Investment Company provides a series of first phase services to promote investment in developing countries, including publishing key journals concerning the investment environments of major countries and regions; analyzing political, economic, commercial factors, infrastructure, market, and investment opportunities of these countries; and developing large databases of investment opportunities. In addition, it develops exchange programs and organizes field visits to developing countries prior to investment. The Japanese government provides the best service in regard to information and intelligence about the host country, maintaining that information inadequacy can lead to failure in overseas investment. It is difficult for enterprises to collect all the information by themselves. For this reason, the government should take on the responsibility. Organizations entrusted by the Japanese government to provide overseas investment information include the Asia Economic Research Institute, the Import and Export Bank of Japan, the Overseas Economic Cooperation Fund, the Chamber of Commerce, the Trade Promotion Council of Japan, and the Association of Medium and Small-sized Enterprises. The Asia Economic Research Institute is an intelligence organization set up by the government with a national budget to provide information on the investment environment of major Asian countries and regions. The Import and Export Bank of Japan and the Overseas Economic Cooperation Fund have set up a consulting business to provide consulting services for local companies with overseas investment in regard to financing, investment environment, and regulations. The Chamber of Commerce and Trade Promotion Council of Japan are ad hoc intelligence organizations supported by the government, and both have overseas subsidiaries. Many countries also provide training for management and technical staff from companies with overseas investments, and offer internships to government

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officials sent by developing countries. A common practice is to set up a nongovernment and non-profit organizations funded by the government with the primary responsibility of providing training for management and technical staff from companies with overseas investment and for government officials from the host country. The travel and accommodation costs of the foreign officials can be covered by the government. China is still at an initial stage in regard to overseas investment, and Chinese enterprises are rather weak in terms of their international competitiveness. Market information is obstructed, capital is insufficient, and human resources are scarce. As a result, the risks of investing overseas and of providing commercial credit are increased. Therefore, an overseas investment promotion centre should be set up to provide comprehensive services. The primary function of the centre should be to operate a special fund for overseas investment, and to provide support for enterprises in the preparatory period. Another important role of the centre is to provide market information, investment environment analysis, economic evaluation, legal consulting, and training. Through these endeavors, China can help companies to open their international markets and develop into MNCs.

6. Promoting and Protect Overseas Investment Through Diplomatic Means In international relations, many governments have tried to reinforce economic relations through diplomatic means and placed market entry and national treatment at the centre of diplomatic relations. They have used every means to push local companies into international markets and to protect their interests. Inter-government investment protection conventions and agreements are generally accepted as the government’s responsibility to protect the interests and rights of domestic investors with overseas investments. As an international practice, bilateral investment protection agreements include the investment under protection (usually the investment approved by the host country); investment treatment (such as most favored nation treatment); remittance of profits and other earnings; risk protection against nationalization (including reimbursement or compensation for losses resulting from confiscation, requisition, takeover, or control by the host country); representative rights of claim; and means of dispute settlement (including bilateral talks, negotiation, and international arbitration). The United States has the most bilateral investment protection agreements, reaching 114 in 1980. The Chinese government should take the initiative to negotiate with the relevant countries and sign bilateral investment protection agreements. Through

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a political risk protection mechanism, we can effectively implement the signed agreements. In the meantime, China should also try to integrate foreign aid for

developing countries with overseas investment of enterprises. At present, the World Trade Organization (WTO) and the Asia-Pacific Economic Cooperation

(APEC) are pushing liberalization of investment and trade and seeking to reach a consensus in investment policies. China should continue to take part in the

global and regional multilateral trade systems, and push the liberalization of investment and trade in the direction of fairness, rationalization, and order.

The investing country should sign an agreement with the host country to

avoid double taxation. This can be done through tax credit and exemption. Tax

credit means that the investing country allows a deduction of the same amount from taxable income when its domestic investors have paid taxes in the host country. Tax exemption means that the investing country fully recognizes the

income of its domestic investors after they have paid overseas taxes, and gives up the right to taxation. Such host countries include Sweden, Holland, Finland,

France, Germany, Belgium, Poland, and Hungary. Other countries like Japan and

the United States have adopted tax credit as their policy. China can implement tax credit first and shift to tax exemption when its overall strength is increased.

The commercial offices of Chinese embassies should strengthen enterprise

management in the relevant countries. The first priority is coordination of market entry. Through a market survey of the host country, the office should

understand the economic development plans, government policies, and market conditions of the host country; help control the number of enterprises entering that country; and seek business opportunities for them. The second priority

is policy guidance for enterprises in the relevant countries. The commercial offices should track the status and development of Chinese enterprises, keep

a close eye on changes in the political structure and economic policies of the host country, and analyze the impact of these changes on Chinese enterprises.

At the same time, the offices should report to the Chinese government, and should help and protect the interests of Chinese enterprises through diplomatic channels. The third priority is coordination between enterprises in the same

market. This can help them to set up an internal negotiation system and

association to create a better competitive environment. The fourth is supervision of Chinese enterprises. This should ensure that they are operating in line with laws and duly reporting to the relevant authorities.

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7. Reforming and Standardizing the Approval System of Overseas Investment The approval system means that an investing country entrusts one or more government bodies with the right to review and approve overseas investment projects in accordance with the state law. The approval period usually lasts from 30 to 90 days. In some countries, the law prescribes that any failure to complete the review within a legal period should be deemed as consent. The approval procedure varies from country to country, and even in the same country can be under continuous amendment as the economy develops. In Japan, for example, all overseas investment projects were approved through strict review before 1969. In January 1970, the Japanese government began to loosen its control, and any overseas project with Japanese investment below US$ 1 million, Japanese investment above 50 per cent, or Japanese investment of 25–50 per cent but under the management of Japanese staff could be approved by the Bank of Japan. After 1972, the Department of Finance decided to lift the investment limit and transferred the right of approval to the Bank of Japan. In China, the approval system is still essential for overseas investment. The simple reason is that Chinese companies lack international competitiveness and the state exercises a strict control of foreign exchange flow under capital accounts. However, the existing approval system must be amended and adjusted to meet the needs of establishing a socialist market economy and developing an export-oriented economy. This should be done through improvement of overseas investment laws and regulations. The approval criteria should be gradually relaxed, and the procedure should be simplified. The approval system should be finally replaced by a registration system with consulting services as its major responsibility. Commercial banks should be involved in feasibility studies and serve as investment consultants. Projects with small investment volumes and loans from banks can be approved by banks on the basis of the feasibility studies and filed with the MOFTEC. Projects with large investment volumes or in sensitive regions or industries should be submitted to the relevant authorities for approval after a review by banks. In general, the authorities should weaken their approval of overseas project contracts and company regulations and focus on such sensitive issues as political risk, asset structure, source of capital or foreign exchange, and technology transfer.

8. Strengthening and Improving Supervision of Overseas Operations To ensure that overseas investment will be favorable to the development of its

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own economy and balance of international payments, the investing country should take steps to regulate capital outflow while promoting and protecting overseas investment. Such measures include the implementation of overseas investment approval systems and foreign exchange regulation systems, requirements to disclose related information, prescriptions of operational objectives, control of technology transfer, and other restrictive policies. Government-led market economies such as Japan and South Korea often take on these restrictive policies. Other free economies have developed similar policies to limit overseas investment in a certain period or in certain fields. The United States, for example, limits US companies from exporting and transferring hightech products or technologies. The foreign exchange regulation system governing overseas investment covers the regulation of overseas investment with foreign exchange and remittances of foreign exchange income from overseas investment. With regard to overseas investment with foreign exchange, each country develops foreign exchange control regulations in line with its foreign exchange reserves and the needs of investing companies, and works out specific methods for the use of foreign exchange. The foreign exchange administration and the authority responsible for overseas investment review the application on the basis of the regulations and give a definite reply. The overseas investment control of foreign exchange requires a guarantee of remittance for any outflow of foreign exchange, including the license of the host country and the promise of investors. In some countries, investors are required to provide a written promise and a deposit in applying for the use of foreign exchange in overseas investment. Foreign exchange control regulations also have clear stipulations on overseas reinvestment with foreign exchange. The management of foreign exchange remittances in overseas investment covers capital remittances of foreign exchange investment, including the remittances of foreign exchange income resulting from overseas projects after the input of such production factors as spot exchange, facilities, technology, labor, semi-products, and raw materials. Investors must send back the foreign exchange earnings and capital within a specified time, and the inward foreign exchange must be controlled by the related government authority. The time limit for remittances is 180 days after the realization of earnings. Despite the fact that China’s foreign exchange reserve reached US$ 165.6 billion by 2000, the government still needs to maintain a large reserve to ensure the healthy development of the domestic economy and the sound operation of the financial system. It also needs to strengthen foreign exchange management in overseas investment. In the meantime, the strict control of foreign exchange

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should be shifted to limited deregulation, as China has been maintaining a favorable balance in international trade. This is essential for the development of overseas investment. In China, the problems of arbitrage and the illegal remittance of foreign exchange are serious in transnational business. According to an estimate by the International Monetary Fund (IMF), the capital outflow of foreign exchange without review and approval is as high as US$ 20 billion per year. In 2000, the favorable balance of China’s foreign trade was US$ 24.8 billion, but the foreign exchange reserve only increased by US$ 10.9 billion. Such problems should be eliminated through system innovation. Practice shows that any foreign exchange regulation in violation of the law of the market economy not only impairs the development of overseas investment, but also restricts the export of domestic mechanical and electrical products driven by overseas investment. Therefore, the foreign exchange regulatory body should work closely with the relevant authorities and map out an approval procedure for overseas investment in foreign exchange that can meet the need of China’s socialist market economy. The relevant authorities have made a survey of the state-owned assets in overseas investment and worked out a number of regulations, but to little effect. We believe that the management of the state-owned assets in overseas investments should be based on the state law, inter-government investment protection agreement, and agreement to avoid double taxation. We can get twice the result with half the effort if the Chinese government can use economic means (e.g. insurance and guarantee) as the lever, implement management through the parent company, and allow the parent company to manage and supervise the state-owned assets in overseas subsidiaries. On the basis of the deposit rate of commercial banks in the same period, the related authorities should set a return rate for SOEs in overseas investment. Enterprises involved in overseas investment should provide information on their overseas operations to the relevant authorities or business administration department. They need to regularly provide financial statements signed by an authorized accounting firm. Based on this information, the government can understand the status of overseas investments and levy a reasonable level of taxes. Overseas investment must involve technology and equipment. As this concerns technology secrets and national security, restrictions must be written into the related laws on export and transfer of certain technologies in overseas investment and trade export. Completed on 4 May 2001

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Chapter

Strategic Directions and Policy Implementation for Reforming China’s Institutional Units

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Like state-owned enterprises (SOEs), institutional units in China are a product of the planned economy, operated and managed by the state. The only difference between the two is that the former are engaged in physical production and contribute their gains to national finance in the form of taxes and profits, while the latter are involved in non-productive activities in such fields as science and technology, education, culture, health care, and sports and is funded by national finance. In the transition from planned economy to socialist market economy, both SOEs and institutional units must implement reforms to adapt in a changing economic environment. On the whole, the reform of institutional units lags far behind the reform of SOEs. This is partly due to the priority given to economic development in the reforms, and partly due to the greater difficulty facing the reform of institutional units. In China, there are over one million institutional units, with over 28 million employees. The expenditure of these institutions comprises one third of total fiscal expenditure. To us, the greatest difficulty in the reform of institutional units is the lack of a target model, which has made it impossible to develop proper strategic procedures and policy measures. Some maintain that institutional units should be disconnected from the government in finance and their employees should be engaged in profit-making activities. Others, however, emphasize that institutional units are non-profit organizations, and therefore should be funded by national finance. During the reform, and at the initial stage in particular, the widespread approach is to ‘cross the river by feeling the stones’ (experiment on a trial basis). The difficulty often exceeds expectation, especially when the ‘bank’ on the opposite side is unknown. As a result, the related policies are neither consistent nor effective. In this chapter, I will try to integrate the realities and experiences of China with the latest international research findings, and propose a target model, strategic procedures, and policy measures for China’s reform of its institutional units.

EMERGENCE AND EVOLUTION OF INSTITUTIONAL UNITS IN CHINA There is exact equivalent to Chinese institutional units in other countries. As a product of the planned economy system, institutional milts in China have the following features: ♦ They are sponsored and managed by the government. Under the planned economy system, state ownership held a dominant position in the ownership structure and it was impossible for individuals or other social organizations to start an institutional

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unit. In the early years after the establishment of the People’s Republic of China in 1949, there were a number of privately owned institutions, such as schools, hospitals, clinics, publishing houses, and shops. These private institutions, however, were soon transformed into public institutions through joint state-private ownership. Since then, the government has steadily begun to monopolize all institutions. Except for a few collectively owned institutions, all scientific, educational, cultural, medical, and sports institutions have been sponsored and managed by different levels of government. ♦ Funds are provided by national finance. Under the planned economy system, most of the funds needed by the institutional units came from fiscal appropriation. The government developed a uniform financial system for institutional units, including accounting items in the budget, levels of budget, specific regulations, write-offs, management and supervision of funds, and scope and standards of expenditure. Under this highly centralized financial management system, institutions had neither an independent source of funds nor the power to use funds at their own discretion. This suppressed the initiative of institutions to expand their sources of income and manage their finances independently. As a result, they relied fully on the authorities and the ‘big pot’ of national finance. Their development was mainly decided by the importance and any financial support given by the government. Despite a swift increase in the percentage of institutional appropriations of public expenditure, many institutions are calling for greater input from the government. ♦ Staff is included in the quota of government bodies. Under the planned economy system, the staff of institutions was included in the quota of government bodies and supported by the ‘iron bowl’ of national finance. Statistics show that the number of staff in institutions funded by national finance is three times that of the government bodies. Over 60 per cent of China’s intellectuals are working in these institutions. The personnel management system is the same as in government bodies, the institutions and their employees have positions corresponding to those in government bodies, and staff of the same position receive the same pay. This practice has both encouraged people to flood to the increasingly swollen institutions and suppressed the motivation and innovation of the employees. ♦ All activities must observe state planning. Under the planned economy system, the government was responsible for developing plans for science and technology, education, culture, health care, and sports, and provided directives for all institutions whose only task was to implement state plans. The state needs to formulate a development plan for education, through which the relevant authorities can develop directive plans for enrollment and placement for the subordinate institutions of higher learning. ♦ Business is separated from economic subject. Under the planned economy system, institutions were grouped under units in non-productive fields, and therefore their business activities were considered as social rather than economic. They did not have any economic accounting, and their development was divorced from economic development. The research institutions focused on research and the government was responsible for the application of their research findings. Educational institutions provided training and the government was responsible for the placement of

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graduates. The separation between business activities and economic subjects has triggered imbalance in China’s social, economic, scientific, and cultural development.

Despite weaknesses in their systems and mechanisms, institutional units made great progress between 1949 and 1978 in the fields of science, education, culture, health care, and sports through their self-reliance and hard work. At the Third Plenum of the Eleventh CPC Central Committee held in December 1978, it was decided that the focus of the party and of the state would be shifted to the construction of socialist modernization and to China’s opening up and reform. This strategic decision marked the beginning of the reform of institutions. Through over 20 years of experiments, continuous improvements have been made and the reforms have deepened. The whole process can be roughly divided into three stages:

(1) The experimental stage (1979–1987) The first stage had a focus on rectifying the weaknesses in the system of institutions. The reform began with a change in the personnel system and structure of institutions which were encouraged to provide services related to economic construction. The work during this period included: rationalizing the systems of higher and basic education; adjusting the structure of higher learning and research institutions; experimenting with the socialization of logistics in institutional units; resuming the review system of professional titles; implementing the appointment system of professional and technical positions; and delegating personnel management power in institutions. Beginning in 1985, the Central Committee of the Party, State Council, ministries, and local governments announced their decisions to kick off reform in such areas as science, education, culture, sports, and health care. In March 1985, a Decision by the Central Committee of the Communist Party of China on the Structural Reform of Science and Technology was promulgated; in May 1985, the Decision by the Central Committee of the Communist Party of China on the Structural Reform of Education was promulgated; in April 1985, the General Office of the Central Committee and the General Office of the State Council transmitted the Ministry of Culture’s Views on the Reform of Performance Troupes; in April 1986, a Decision on the Structural Reform of Sports was brought in by the Commission for Physical Culture and Sports; and in April 1985, the State Council approved and distributed the Report by the Ministry of Health on the Reform of Health Care . These documents elaborated on the significance, objectives, guidelines, tasks, means, and measures of the reforms in the relevant fields, and thus laid a solid foundation for the next stage.

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(2) The all-round stage (1988–1995) The stage during which reforms progressed in depth and breadth. The focus of this period was to decentralize and expand the power of management in institutions while straightening out those institutions affiliated to government bodies. Government at all levels, together with related departments, worked out a series of specific policies and measures, and began to experiment on a vast scale. The main work included establishing a system of special government allowance; implementing a classified management; reforming the compensation system; establishing talent markets; experimenting with the resignation and dismissal system for management and technical staff; and going further with the appointment system of professional and technical positions. At the Fourteenth National Congress of the Communist Party of China, the socialist market economy system was adopted and the reform of institutions was further clarified. Since then, experiments have begun with the establishment of a new system in institutions which aligns with the socialist market economy system. In the meantime, legislation in the fields of science, education, culture, health care, and sports witnessed great progress. In 1995, the State-owned Assets Management Bureau and the Ministry of Finance developed and promulgated the Methods for Managing the State-owned Assets in Institutional Units.

(3) The in-depth stage (since 1996) In 1996, the Structure and Size Management Office of the CPC Central Committee and the Ministry of Personnel promulgated the Views on the Reform of Institutional Units. The views spelled out guidelines for separating government bodies from institutional units; promoting the socialization of institutions; and setting up a dynamic management system, an operating mechanism, and a self-control system able to adapt to the socialist market economy system and the law of self-development of institutions. The basic concept was to set up an overall scientific layout and develop in the direction of socialization; implement diversified and classified management; and exercise a systematic overall control. In this period, breakthroughs were made hi institutions in personnel systems, distribution systems, social security, and evaluation systems. In November 1998, the State Council promulgated the Interim Provisions for Registration Management of Institutional Units and the Interim Provisions for Registration Management of Private Non-business Units. In 1999, the State Staffing Commission centralized the registration of institutional units throughout the country, aiming to grant them independent legal status, protect their legal rights, and regulate their market behavior. This signified that the

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reform of institutions had made substantial progress, and institutions could now be market-oriented. At the same time, the Structure and Size Management Office of the CPC Central Committee required local governments to thoroughly clean up existing institutions during the process of registration, aiming to reinforce and improve the central government’s management of institutions. The reform of institutions began to speed up in 2000. The Ministry of Health promulgated the Views on the Reform of the Health Care Monitor System; and the Ministry of Health, the National Administration of Chinese Traditional Medicines, the Ministry of Finance, and the State Planning Commission promulgated the Views on Implementing the Classified Management of Urban Medical Institutions. In August 2000, the Organization Department of the CPC Central Committee and the Ministry of Personnel jointly promulgated the Views on Stepping up the Reform of Personnel Systems in Institutional Units, marking the official start of the reform. The departments of science and technology, higher education, and health developed a reform proposal, and the departments of television and broadcasting, news and publication, and culture are in the process of developing one. Beyond doubt, the reform of institutions is becoming deeper and broader in line with the spirit of the Fifteenth National Congress of the Communist Party of China. While great achievements have been made in the past 20 years in the progress of reform, from the strategic perspective, however, such reform still requires much improvement, especially in the following aspects:

1. The Target Model is Yet to be Clarified. At the initial stages of the reform, institutions were encouraged to conduct a bold experiment to eliminate malpractice. The government did not propose any target model for the reform. This kind of experiment can mobilize the enthusiasm of the management and employees of the institutions, but without a distinct target model it increases the difficulty of measuring the effects of the reform. For example, a series of measures were adopted, such as ‘expanding the source of income’, ‘sharing profit’, and ‘providing tax exemption’, to eliminate weaknesses resulting from a long reliance on fiscal appropriation. Institutions were encouraged to bring their potential into full play, and to increase revenues by diversifying their business. The state provided a number of preferential policies and measures for the business activities of institutions outside their business scope. This increased the sources of income and revenues of institutions; contributed to the solution of the problem of insufficient funds; and improved the institutions’ ability to survive, develop, and adapt to social changes. However, instead of providing a clear definition of how to generate revenues,

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the government simply encouraged and sometimes pushed institutions to develop activities outside their business scope, which led to some adverse effects. When an institution focuses on such profit-making activities, it often undermines its primary social service function. For example, many public gymnasiums, cultural centers, scientific centers, and libraries often close their doors to the public and try to increase their income through renting their buildings out on a private basis. A number of other institutions simply invent excuses to collect charges. Coupled with poor management, this malpractice soon became widespread. In the business activities of some institutions, enormous non-operating assets are gratuitously transferred to operating assets and, as a result, the ownership becomes obscure and profit distribution is almost wholly geared towards individuals. Instead of promoting the reform of institutions, such business activities will result in great loss of state-owned assets. The Views on the Reform of Institutional Units promulgated in 1996 by the Structure and Size Management Office of the Central Committee and the Ministry of Personnel summed up the experiences and lessons of the initial stage, and spelled out the guidelines and fundamental path for the further reform of institutions. With the deepening of reforms in the past few years, its direction is increasingly clear. A fine example is the Views on the Reform of the Urban Medical System which was jointly promulgated by eight departments in 2000 and transmitted by the State Council. It explicitly demands a classified management of medical institutions and divides them into profit and non-profit organizations. This is a milestone in the reform and signifies that is now the time to develop a target model for the reform.

2. The Design of Procedures is Yet to be Improved. The reform of institutions is in principle ‘path-dependent’, which means that the measures of each step will produce an effect on future steps. As the target model was not in place at the initial stage of the reform, the widespread practice was ‘to cross the river by feeling the stones’. Some reform procedures were ill designed, and the reform had to start ‘from the very beginning’. For example, the government decided to ‘decentralize’ and to ‘invigorate the institutions’ when those problems brought by the highly centralized management became acute. The purpose was to increase the autonomy of the institutions, and to enhance their ability to survive, develop, and adapt to the changing environment. However, as the target model was obscure at the time, it was impossible to define, divide, and readjust the relations of rights and responsibilities between the government and institutions. This has increased the difficulty of streamlining and decentralizing in a planned way. As a result, what should have been decentralized

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was not delegated to institutions, and what should not have been decentralized was delegated to institutions. In a similar way, what should have been streamlined was maintained while what should not have been streamlined was eliminated. With the intensifying of those reforms, the objectives are increasingly clear, and the balance of rights and responsibilities between government and institutions has to be readjusted. Despite the necessity of the readjustment, it will inevitably increase the cost of reform and trigger worries about the continuity and stability of the reform policies. The leaders of the institutions concerned tend to make use of the policies in the interest of their organizations and employees and leave the problems to their successors and the government.

3. Policy Measures are Ineffective. At the initial stage, the reforms of institutions in different systems were carried out independently, and great difference can be observed in their progress. Moreover, the reform of institutions as a whole did not match other reforms in China. Consequently, the policy measures were not effective and the desired results were hard to achieve. For example, although the institutions had adopted a recruitment system in personnel management, they could not make employees redundant because a social security system had not been established. Staff mobility was encouraged in policy but presented an insurmountable difficulty due to the slowness of the reforms in housing and residence systems. The research institutions were pushed to transform into businesses, but the reform of SOEs was still incomplete and many problems still had to be solved. For various reasons, the reform policies and measures have met with great difficulty in implementation, and many institutions take a ‘wait and see’ attitude and lack the momentum for further reform. The reform of institutions is a system project which must be designed with great care and clear objectives. We must seize the opportunity and progress steadily. The key to ‘cracking the nut’ is to develop a target model based on past experience, define the strategic direction, and come up with a series of policies and measures for the reform.

THE TARGET MODEL FOR THE REFORM OF INSTITUTIONAL UNITS The target model for the reform of institutional units should combine the realities of China and the international experiences of non-profit organizations, and cater to the needs of the socialist market economy. Such a model should include the following six elements:

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1. Providing Public Goods Public goods are articles, products, or services to be consumed by the public. Examples of pure public goods include national defense, public security, fire-fighting, roads, environmental protection, weather reports, and public television. According to Samuelson, an individual’s consumption of pure public goods will not reduce another individual’s consumption. In a sense, the consumption of pure public goods is non-competitive, and their use is nonexclusive. It is impossible to exclude particular groups of individuals in the consumption or use of public goods. Opposite to public goods are private goods, which are competitive and exclusive. These goods include most of the commodities supplied in the market. Between public and private goods are products that are exclusive or competitive, but consumed by a number of people. These are mixed goods or public goods in a broad sense. For example, people can watch sports events together, but they have to buy tickets first, which excludes those without tickets. When there are unsold seats, there is no competition among people who want to buy tickets. However, when the events are exciting, people have to compete with one another and a black market is thus formed. As the marginal opportunity cost for users is zero, profit-maximizing businesses will not provide public goods. The resulting ‘market failure’ has to be solved by the government. In some Western countries, the supply of public goods was once dominated by the government. In other words, the government provided all public goods for people ‘from the cradle to the grave’. This has proved to be unsuccessful. Since the 1970s, non-profit organizations have experienced fast growth and formed a third sector that is independent from the government and businesses. These organizations are small and flexible, and expert at mobilizing the enthusiasm and initiatives of the masses. They can bridge the various chasms resulting from modern society and the inadequacy of social welfare resulting from market failure and government failure. Non-profit organizations can play a critical role in supplying public goods. First of all, they can make up for the inadequacy of the government. Public goods provided by the government are meant to meet the needs of the masses, but not the particular needs of particular groups. These specialized needs can only be satisfied by non-profit organizations, such as the American Heart Association and American Cancer Association, which carry out medical research with funds donated by individuals and provide services for particular groups of patients. Non-profit organizations can effectively prevent the phenomenon of ‘car lifting’, whereby some individuals use public goods without making

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any contribution. Through non-profit charges and voluntary endowments, they can provide society with public goods and prevent people from taking advantage of free goods. In the past few years, foreign non-profit organizations have been growing in influence. They not only help maintain social stability but also boost economic development. In particular, they have succeeded both in mobilizing all social forces and in using private resources to develop science and technology, education, culture, sports, and health care. Given the realities of China, it is neither practical nor necessary for the government to provide all public goods. Some can be produced and supplied by the government (e.g. national defense and law), while others can be tendered to businesses. Others can be produced and supplied by institutions and partially funded by the government. Institutions in China should be positioned as organizations to provide public goods, and any institution (including scientific, cultural, and medical institutions) that produces private goods should be transformed into a business.

2. Integrating Social Resources Non-profit organizations have developed momentously, but consensus on their operation has not yet been reached in different countries. In the United States and the United Kingdom, non-profit organizations are expected to replace the government’s expenditure in welfare; in Germany and France, they are expected to eliminate poverty; in Italy and Sweden, they are expected to promote value diversification; and in Japan and Thailand, they are expected to help establish a civil society. Differences can also be found in their names and definitions among different countries. In the United States, they are called non-profit organizations; in the United Kingdom, they are called public charitable organizations; in Germany, they are called voluntary organizations; in France, they are called social economic organizations; in Italy, they are called foundations; in Sweden, they are called national social organizations; in Japan, they are called public legal entities; and in Thailand, they are called charitable organizations. Non-profit organizations can thrive because they are able to integrate social resources. The income of non-profit organizations has three main sources: government funds (including direct appropriations and contract payments for particular services); private endowments (including direct or indirect donations of individuals, legal entities, and foundations); and payment of beneficiaries (revenues generated from sales of products and services provided by non-profit organizations). One statistic shows that of the total income of overseas non-profit organizations, 47 per cent comes from payment of beneficiaries, 43 per cent from government support, and 10 per cent from private endowments (60 per cent

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of which are individual donations). This is supported by our research on nonprofit organizations in the United States, the United Kingdom, Germany, France, Italy, and Japan. In the United States, the United Kingdom, Italy, and Japan, the primary source of income is the payment of beneficiaries, making up 52 per cent, 48 per cent, 53 per cent, and 60 per cent respectively. In Germany and France, the primary source of income is government support, accounting for 68 per cent and 60 per cent respectively. In all these countries, private endowment is not the main source of income. The highest percentage, up to 19 per cent, is found in the United Kingdom. In addition, government support is also related to the particular types of non-profit organizations or fields. For example, government support for medical and health care organizations, social services, education, and culture in the United States, the United Kingdom, Italy, and Japan takes up 59 per cent, 51 per cent, 42 per cent, and 22 per cent respectively of the total income. Over 80 per cent of the expenditure of non-profit organizations is spent on education and research, health care, social services, and culture and recreation, of which 25 per cent is spent on education and research (mostly on compulsory education and fundamental research), 20 per cent on health care (mostly on hospitals and clinics), 20 per cent on social services (mostly on family consulting, fighting drug abuse, and kindergartens), and around 16 per cent on culture and recreation (mostly on symphony orchestras, art museums, and sports clubs). In the United Kingdom and Japan, education is in a dominant position; in the United States and Germany, the focus is on health care; and in France and Italy, the focus is on social services. Generally speaking, funds for associations, charitable organizations, environmental protection, education and scientific research, and mutual aid housing organizations come mainly from private payments (over 50 per cent); medical services and health care, social services, and organizations initiated by citizens are mainly supported by the government (over 49 per cent); and international aid organizations depend mainly on government support and private endowment. To make the best use of social resources in providing public goods, we propose to include other organizations in the list of institutions providing public goods in science, education, culture, health care, and sports. These would include organizations to aid those who cannot afford education; environmental protection organizations; mutual aid housing organizations, associations, and societies; and international aid organizations. Their income can come from the government support, private endowment, and payment by beneficiaries.

3. Enjoying Preferential Policies M a n y c o u n t r i e s h a v e d e v e l o p e d p re f e re n t i a l p o l i c i e s f o r n o n - p ro f i t

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organizations. In the United States, for example, Section 501(C)(3) of the Income Act divides non-profit organizations into 26 types in terms of tax exemption, including educational, research, and charitable institutions. These organizations are exempted from most federal and state income taxes once their qualifications are confirmed by a regulatory institution. When individuals or businesses make an endowment to these organizations, the same amount of endowment can be deducted from their taxes payable. To enjoy tax exemption, nonprofit organizations must satisfy three conditions: (1) they must be charitable, educational, religious, and scientific organizations in nature or in other purposes prescribed by the tax law; (2) their net income cannot be used in the interest of any individual; and (3) their activities should not influence legislation or interfere with open elections. The institutions covered by Section 501 (C) (3) include: medical and health care organizations, religious organizations, scientific and research institutions, educational institutions, art institutions, and sports associations. As non-profit organizations, they are not allowed to be involved in any political activities, and their net earnings cannot be distributed to shareholders or individuals. The institutions covered by Section 501 (C) (4) can also enjoy tax exemption, but donations to these institutions cannot be deducted from taxes payable. Such organizations include non-government organizations and social welfare institutions. To a v o i d t h e m i s u s e o r a b u s e o f p re f e re n t i a l p o l i c i e s , n o n - p ro f i t organizations are required to be systematized in many countries. They must be incorporated foundations or aggregate corporations that are registered with a legal status. Moreover, they must formulate specific rules and regulations, hold regular board meetings, and maintain a stable management system. In European countries other than the United Kingdom, these organizations must obtain special legal authority and approval from the government. Institutions in China should be defined in an unambiguous way, and be systematized through reform. They should also enjoy relevant preferential policies. The government should set up an organization responsible for the registration and approval of institutional units, and preferential policy entitlements must be clarified.

4. Recruiting Volunteers One important feature of overseas non-profit organizations is that their members volunteer to take part in their activities. However, this does not mean that most or all of their income comes from voluntary donations, nor that most of their employees are volunteers, though these organizations must display a voluntary nature to some degree.

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In 1993, there were over 89.2 million volunteers in the United States, 48 per cent of the total number of adults (above 18 years old). Per capita average voluntary work hours were 4.2 hours per week, or 218.4 hours per year. The total value generated by volunteers was around US$ 183.2 billion per year. These days, there are over 90 million volunteers in the United States (half of all adults) who work for non-profit organizations for three hours a week. Many people see social work as a means to success and self-fulfillment. In Canada, there were 5.3 million volunteers working for different types of non-profit organizations between 1986 and 1987. They accounted for 28 per cent of the total population of people over 15 years of age, and this percentage reached 40 per cent in 1995, when the fastest growing segment was volunteers under 25 years of age. In the late 1990s, non-profit organizations were employing 1.3 million people, 9 per cent of the total labor force. The annual revenue generated was C$ 86 billion, 12 per cent of GDP. In the United Kingdom, over half of the population takes part in all kinds of voluntary work, contributing 100 million hours per week. In 1995, the number of volunteers in France accounted for 19 per cent of the total adult population; in the Netherlands, 36 per cent; in Denmark, 25 per cent; and in Ireland, 39 per cent. In a 1993 survey in Hong Kong, over 20 per cent of citizens were willing to take part in voluntary services on a long-term basis. The primary motive of many volunteers is to help others and to repay society out of sense of social responsibility. Some volunteers want to learn new skills and gain new experiences, make new friends, and develop a sense of leadership. Others want to set a good example to their children. Most institutional units in China are funded by the government. They seldom use volunteers or obtain voluntary donations. However, with the socialization of institutional units and the increase in social responsibility among people, stateowned institutions, social organizations, and non-government organizations should accept voluntary donations and use volunteers. In other words, Chinese institutional units must include a voluntary aspect.

5. Reinforcing Legislation Under the planned economy system, the survival and development of institutional units would be impossible without the support of law. As a result, one of the most important features of the target model for the reform of institutions should be the development of a complete legal support system. Such a legal system should include laws in three areas: ♦ Laws regulating the behavior of institutions, in areas such as governing registration, fund-raising, staff recruitment, acceptance of endowments, and governance systems;

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♦ Laws regulating relations between institutions and other units, such as laws governing cooperative development, agencies, and provision of services; and, ♦ Laws encouraging the development of institutions and protection of their rights and interests, such as laws governing voluntary services, tax reductions, administrative litigation, and administrative compensation.

The legal status of institutions should be clarified through legislation so that they are independent from government and enjoy independent legal status. They should be able to operate independently according to the law while accepting the guidance, help, and supervision of the government. In addition, the legislation should also be systematic, scientific, fair, and gradual in line with the development of China’s socialist market economy.

6. Implementing Scientific Management T h e p u b l i c i s p l a c i n g a n e v e r- g re a t e r d e m a n d o n t h e e ff i c i e n c y a n d professionalism of non-profit organizations as they are increasingly involved in the solution of social problems. In developed countries, non-profit organizations have become increasingly professional. In Germany and Japan, for example, employees of non-profit organizations work like public servants, receiving training and salaries. In many other countries, however, the employees of nonprofit organizations are underpaid, and opportunities to train are scarce. This is typical in France, where non-profit organizations are small and internal labor unions are weak. Most of the employees are women who have a low recognition of the objectives of their institutions. However, this situation has been improving in recent years. Peter Drucker, a 20th-century management guru, states in his book Management Challenges for the 21 st Century that the growth sector in the 21st century will be non-profit organizations, and that their management will be as important as that of businesses. In fact, there are many-similarities between non-profit and profit-making organizations. Drucker maintains that there is a difference between the management of chain store and the management of church, but the difference is not as significant as their respective managers would imagine. The main difference lies in application rather than in principle. Ninety per cent of management skill can be applied to both types of organization. For example, the managers of different organizations spend almost the same amount of time on interpersonal issues, and these issues are virtually the same in all organizations. Managers of non-profit organizations need learn not only the basic skills of management, but also an understanding of the exigencies of the management of non-profit organizations, in particular their history, theoretical basis, and the

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special needs of fund-raising, promotion, and interaction with volunteers and with boards of directors. In addition, they need to draw on the experiences of business management to improve and expand their business. For example, they can launch market-oriented promotional activities, implement strict financial management and accounting, establish a scientific system of management by objectives and performance measurement, and begin capital operations and market-oriented activities without sacrificing the principle of public welfare. In the United States, the United Kingdom, and many other countries, p ro f e s s i o n a l t r a i n i n g h a s b e e n p ro v i d e d f o r m a n a g e r s o f n o n - p ro f i t organizations. However, this is only a beginning and more efforts still need to be made. In addition, employees must understand the particular demands on them created by the new management. I believe that the proper operation of non-profit organizations will not be possible until the establishment of a scientific management system. We need, therefore, to integrate the experiences of both Chinese and foreign business management with the realities of China and Chinese institutions, and to develop a framework of theory and methodology that can meet the demand of the management of Chinese institutions.

STRATEGIC PROCEDURES FOR THE REFORM OF INSTITUTIONAL UNITS IN CHINA As soon as a target model for the reform has been formulated, efforts need to be made to reverse the present situation and to work out plans and procedures to develop in the direction of the target model. We consider the following three strategic procedures to be critical:

1. Classifying Institutions and Encouraging the Flow of Employees First and foremost, we should classify institutions according to the public services they provide and group them under two categories: profit and nonprofit institutions. The former should be gradually transformed into businesses. In positioning institutions, we should avoid two fallacies. The first being that all non-profit organizations should provide free services, and that any institution that charges for its service is not a non-profit organization. This is wrong. Except for the non-profit organizations that provide pure public goods, most non-profit organizations should not only charge their beneficiaries, but also try every means of increasing their profits. However, profits can only be used for self-development, and should not be distributed among investors or managers. As discussed above, 47 per cent of the income of overseas non-profit

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organizations comes from charges to beneficiaries. In the United States, the United Kingdom, Japan, and Italy, this figure is over 48 per cent. However, the items and standards of charges should be reasonable, and prior approval from the relevant authority is necessary. The second fallacy is that all institutions in the fields of science, education, culture, health care, and sports are non-profit organizations, and that they should be funded by the government and enjoy preferential policies. This is again wrong, because some of these organizations are set up to meet the needs of a particular group of people. They do not provide services for the whole of society. Like businesses, these organizations should be market oriented and provide their products on the basis of mark-up pricing. They should gradually be transformed into businesses, and move in the direction of industrialization. In the transition period, the government should provide financial support and preferential policies for a period of time. In the long run, however, these organizations should become sources of revenue rather than recipients of government spending. In the past few years, some people have proposed the industrialization of scientific, educational, cultural, and medical institutions. This idea is unacceptable to us. As we know, industry comprises productive businesses or organizations that produce or supply goods and services on a profit basis. Industrialization of institutions means transforming all institutions into businesses. This is obviously correct for profit-making institutions. However, non-profit organizations should not be and cannot be industrialized. Compulsory education, for example, should not be industrialized, while vocational education should be industrialized. In the United States, as in many countries, private universities are still non-profit organizations, and their profits cannot be distributed to the board of directors. Over half the hospitals in the United States, and one third of the hospitals in Germany, are nonprofit organizations. The general concept of industrializing institutions will be detrimental to the development of non-profit organizations as a whole. The first step, then, is to classify institutions as non-profit organizations. A further classification of institutions is necessary to further reform and strengthen management. Based on the theory of modern public economics, we can classify institutions in two streams: The first stream concerns the public nature of institutions, or the social function and the usefulness of the products or services provided. In this stream, institutions can be classified as pure public institutions and quasipublic institutions. Pure public institutions are organizations that provide pure public goods, and include organizations conducting fundamental research into

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the natural sciences and social sciences, public libraries, historic and cultural sites, museums, public culture organizations, and health care organizations. Quasi-public institutions are exclusive organizations that provide products and services to meet the needs of the public. Such institutions include organizations in applied research, middle and high school education, further and higher education, broadcasting and television, and basic medical services. The second stream concerns the degree of socialization, or the system of institutions. In this stream, institutions can be divided into government institutions and non-government institutions. Government institutions are initiated and funded by central or local governments, and non-government institutions are initiated by the public and supported by the government. If we accept the above classifications, then institutions in China can be grouped under four categories: ♦ Government pure public institutions ♦ Government quasi-public institutions ♦ Non-government pure public institutions ♦ Non-government quasi-public institutions

China’s socialist doctrine requires that everyone should have the right to education, knowledge, cultural services, and medical services. This is the principle of ‘wide coverage’. But not surprisingly, such coverage is at a low level compared with developed countries. The practice of grouping government public services under an umbrella is not a realistic proposition in China and cannot meet people’s increasing needs for education, culture, science and technology, and medical services. The government should motivate society’s enthusiasm and expand the channels of service supply. Pure public goods should be provided mainly by the government and supplemented by non-government institutions, and verse versa for quasi-public goods. Through price levers and competition, a balance needs to be maintained between the demand and supply of public goods so as to meet the increasing demand for public services. In classifying institutions, we should also encourage the flow of people. Each institution should maintain the kind of high-quality team that is necessary for service supply, and allow its affiliated units to be transformed into independent businesses. The size of institutions should be strictly controlled. A serious problem occurred when many institutions tried every means possible to swell before the reform proposal of the State Council was made known to the public in 1998. These institutions managed to swell in function (i.e.

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to transfer government functions such as the administrative power of collecting fees and charges to institutions); in structure (i.e. to increase in number, layer of management, and structure); and in size (e.g. to transfer the redundant people in government bodies to institutions). An effective solution to this type of problem is to ‘freeze’ the quota of institutions and to encourage the flow of redundant people to businesses.

2. Establishing a Modern Institution System After the classification of institutions and the laying-off of staff, an important step is to set up a modern institution system that caters to China’s realities and to international practices. Such a system should feature the following:

(l) A clear legal personality status A legal entity is an organization set up by a person with civil rights in the name of an individual or with that person’s assets. An organization sponsored by the government is a public legal entity, and an organization sponsored by individuals is a private legal entity. Presently, most overseas non-profit organizations are private legal entities that fall into two categories: incorporated foundations and aggregate corporations. Incorporated foundations are legal entities formed by assets from donors with a definite purpose. Such entities are also known as endowment legal entities, and include all foundations, private schools, hospitals, libraries, museums, research institutions, temples, and charitable organizations. An important feature of an incorporated foundation is that it is an aggregate formed by independent assets without its own members, and its purpose cannot be changed arbitrarily once it is defined by the donors. Prior to the setup of an incorporated foundation comes the founder ’s endowment act, which includes the donation of assets and formulation of rules and regulations. The purpose, name, and organizational structure should be specified in the regulations. Approval from and registration with the related authorities is necessary. The act of endowment can be provided before the death of the founder or in a will. Most countries require an endowment act to be in writing. Incorporated foundations need to set up executive bodies to develop their business activities. According to the law, the board of directors is a necessary body in an incorporated foundation, and any legal issues should be referred to the board of directors. An aggregate corporation is a legal entity formed by several members with a specific purpose. Its key element is its members, who form the basis for setting up the organization. Corporations, cooperatives, associations, clubs, and societies all fall into this category. An important feature of an aggregate

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corporation is that it is based on a certain number of members, but a change of members will not affect its existence. The purpose of an aggregate corporation is specified in its regulations, and the general meeting of its members is final in making business decisions. The founder of an aggregate corporation must first of all obtain its membership and develop regulations that should include the nature of the organization, its name, purpose, calling procedures for general meetings, funding structure of the members, and the procedures for obtaining membership. The highest organ is the general meeting, which decides changes in regulations, appointment of the board of directors, and penalties. Aggregate corporations can be subdivided into public organizations, profit organizations, and intermediary organizations. However, none of the incorporated foundations are profit organizations. In Chinese civil law, there are no such things as ‘incorporated foundations’ or ‘aggregate corporations’. The Provisions for Registration Management of Public Organizations and the Provisions for Management of Foundations promulgated in October 1998 included all the associations, societies, and foundations in the aggregate corporations. However, the basis of a foundation is assets. A foundation is not an aggregate of people. Therefore, China should introduce the concept of incorporated foundations that can include such nonprofit organizations as foundations formed on the basis of assets. The status of incorporated foundations needs to be clarified through legislation.

(2) A clear responsibility In the Interim Provisions for Registration Management of Institutional Units brought in by the State Council in November 1998, it is explicitly stated that institutions are social service organizations serving the interest of the public, sponsored by state bodies or by other organizations with state-owned assets, and engaged in such fields as education, science and technology, culture, and health care. The Quota Control Office of the State Council and the quota control organs above the county level are responsible for the registration of institutional units. In the Interim Provisions for Registration Management of Private Nonbusiness Units promulgated in the same month, it is made clear that private non-business units are social organizations engaged in non-profit social services, sponsored by businesses, social bodies, other social forces, and individuals with non state-owned assets. The Ministry of Civil Affairs under the State Council and civil affairs departments above the county level are responsible for the registration of private non-business units. From this definition we can see that the only difference between the institutional units and private non-

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business units lies in the nature of assets (i.e. state-owned assets versus non state-owned assets) and registration bodies. Therefore, a more proper definition of institutional units should be as follows: institutions are independent legal persons that are sponsored by governments at different levels, businesses, incorporated foundations, or individuals according to the law, and are engaged in non-profit social services in such fields as education, science and technology, culture, health care, and sports, with independent civil responsibilities. In line with the realities of China, the following points need to be stressed. Firstly, institutions can be sponsored by the government, but they should not have any administrative function and, in particular, they should not be allowed to become a ‘quasi-government’ after the streamlining of government organizations. Secondly, institutions are independent legal persons, running independently from the government. They can undertake tasks delegated by the government after singing a contract, but they should not become affiliated government organizations, nor the means of accommodating redundant government employees. Thirdly, the earnings of institutions (including dividends from investment) can only be used for their own development, and can never be allowed to be distributed among their founders.

(3) A sound governance structure The governance structure of businesses and institutions is also referred to as corporate governance, a system which decides who has fundamental power and when. The governance structure is not only affected by historical, cultural, legal, and economic factors, but also by the power structure, decision models, and strategic objectives of a particular organization. The highest decision-maker in both businesses and non-profit organizations abroad is the board of directors. Compared with businesses, however, the governance structure of non-profit organizations is still incomplete. Non-profit organizations do not have a counterpart to the shareholders’ general meeting of businesses that can represent the interests of all owners. The board of directors in most non-profit organizations is only responsible for itself, including the selection of board members and setting of their terms. In addition, non-profit organizations are less transparent and their performance does lend itself easily to quantitative measurement. This has increased the government’s difficulty in increasing proper supervision. In the United States, for example, the board of directors of a non-profit organization is only subject to regular review by the National Tax Bureau or state judicial departments. Therefore, it has great autonomy in guiding and managing non-profit organizations. There are many ways for a non-profit organization to form its board of

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directors. This is basically decided by the nature and history of the organization, the personalities of key leaders, and the positions of the founders in the organization. Many universities, for example, have adopted a closed method in the past and board members were selected without external consultation. This practice has now been replaced by an eclectic approach which integrates the old closed method and the new open method. At Princeton University, for example, some directors are selected by the board, some are nominated by the alumni association and appointed through election, and some are nominated by students and appointed through election. A number of foundations and universities, however, have retained the traditional approach, and their new directors are basically nominated by the governors and board chairman and approved by the board. This has in fact guaranteed that all the directors are allies of the key leaders. In selecting board members, many factors combine to play a role, but the interpersonal relations between the key leaders and the nominees are most critical. Of course, the ability, fame, and background of the nominees are also important. In different non-profit organizations, the board of directors can range from the passive approval of the decisions of key leaders to an abrupt refusal of those decisions. In essence, however, the primary function of the board is to develop policies and appoint qualified professionals to implement its policies under the leadership of key leaders. Rather than being directly involved in the management, the board ensures that organizations are managed by qualified professionals. Board members in non-profit organizations should provide necessary support for the management while retaining their independence. Their main responsibilities should include: ♦ Continuously measuring management performance in achieving the objectives set by the board, and developing a compensation system based on performance; ♦ Identifying the policy issues that deserve management attention but have in fact been neglected, with the advantage of ‘the onlooker sees the game best’; ♦ Improving the quality of management decisions, and pushing the management to take a holistic approach in decision-making; ♦ Performing an independent evaluation of the daily management, which can prevent such grave problems as abuse of funds, conflicts of interests, internal reports containing distorted information, and improper management behavior.

In general, the efficiency of the board can be improved if the management of an organization is cooperative. Although the board of directors is not in a position to arbitrate internal disputes among managers, it tends to seek a compromise that can satisfy each side.

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(4) A focus on culture The management of institutions has its own characteristics in terms of its organizational structure, staff recruitment, cost control, and performance measurement. In addition to stressing such traditional management concepts as scientific management, standardization and systematization of management, and effectiveness of management, institutions should also focus on the cultural side of management. Organizational culture is a new management concept proposed in the 1980s, and its core is the concept of values. Values are objective properties pursued by humans to meet particular needs, such as economic values, cultural values, scientific values, and historic values. Values are human preferences in selecting the objectives and behavior that represent a particular value. From the perspective of complexity science, the values of an organization represent the overall quality of the interaction among all members of the organization. Therefore, as the core of organizational culture, organizational values are decided by the existing values of each member of the organization and the interaction between them. The values of an individual before he becomes a member of an organization are influenced by his gender, nationality, class, profession, and experience. Research shows that nations are different in coping with authority, collectives, norms, careers, and long-term interests. The values of an individual are basically formed before the age often. When he grows up and becomes a member of an organization, he will be ready to accept the organizational culture if his values are not significantly different from those of existing members. Otherwise, cultural conflict might arise, which in turn increases the difficulty of management. As the reformation of an individuals’ existing values takes a fairly long time, managers need to ‘seek common ground while reserving differences’ and to encourage them to make a concerted effort towards the strategic objectives of the organization. With volunteers, the management of culture is increasingly important. Most volunteers are driven by their own values to participate in charitable activities. They are not pushed by compensation or promotion. Thus, particular attention should be given in guiding them towards organizational values.

3. Moving Towards Socialization Most overseas non-profit organizations have realized socialization and comprise a third sector independent from government and business. China should make a similar effort and realize the socialization of non-profit organizations in 15–20 years. The key signs of socialization will include:

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♦ Social forces becoming the main sponsors of non-profit organizations. ♦ Revenues of non-profit organizations coming mainly from society. ♦ A great number of volunteers working for non-profit organizations. ♦ Non-profit organizations becoming the main source of innovation in social services.

In the socialization of institutions, the government should strengthen its supervision and help them improve their effectiveness and efficiency and achieve their social goals. In fact, the effective supervision of non-profit organizations has become a daunting task that needs in-depth research. Proposals have been put forward, but their effects are yet to be proved. Professor Herzlinger of Harvard Business School, for example, has proposed a program of ‘disclosure-analysis-declaration-sanction’ (DADS). According to this model, non-profit organizations are required first of all to disclose their performance, effectiveness (e.g. customer satisfaction), and financial data. Based on this information, they should then make a detailed analysis and regularly announce the information and results of the analysis. The government should disclose any improper behavior on the part of non-profit organizations in good time and implement necessary sanctions, including the withdrawal of preferential tax policies and legal actions. When the objective of socialization is achieved in China, the target model for the reform of institutions will be formed.

MAJOR POLICY MEASURES FOR THE REFORM OF INSTITUTIONAL UNITS IN CHINA The reform of institutions in China has met with great difficulty, due to the mindset and inertia developed under the planned economy system and the constraints of many objective factors. To push reform forward, we need to take a series of effective policy measures which can only be worked out on the basis of comprehensive investigation and research. Here are our preliminary thoughts:

1. Defining the Scope of Support Non-profit organizations should be supported by the government in the form of fiscal appropriation and preferential tax policies. However, the means and scope of support should be differentiated according to the relevant requirements. Scientific research, for example, usually goes through four stages from concept to product: research (including basic and applied research), development (engineering), testing (commercialization), and promotion (industrialization). As the main product of basic research is ‘knowledge’, a

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public good, it should mainly be supported by the government. The support can take the form of a foundation with government appropriation. The objects of support should be selected through open bidding and evaluation. Repeated low-level research should be avoided and powerful institutions or individuals should not be allowed to monopolize funds and to dampen academic freedom and innovation. The selected researchers should be provided with reasonable compensation, allowed to work in a friendly environment, and given opportunities for academic exchange with the international community. Statistics show that research and development (R & D) expenses in 1998 were RMB 55 billion, making up 0.7 per cent of GDP. Basic research costs account for 6 per cent of R & D, and most of the funds are from the government (about one third of the funds are allocated through the National Natural Science Foundation). To boost the development of basic research, the government should increase its input, raising funding for basic research in R & D from 6 per cent to 10 per cent. In the meantime, most government funds should be allocated through the National Natural Science Foundation to increase their effectiveness and prevent corruption. Businesses, social organizations, and individuals should be encouraged to donate to specific research projects (such as projects to fight against AIDS, to explore the origins of life, and to protect the ozone layer). The amount of the donation should be tax deductible. Applied research is a quasi-public good, and its funding can be raised through diversified sources (e.g. venture capital, funding by businesses, bank loans, and social donations). The government can increase funding in such fields as environmental protection, energy conservation, and agriculture. Testing and promotion are more profit-oriented, and the government should encourage investment from investment companies and credit institutions. Direct funding from the government should be avoided.

2. Encouraging Cooperation Non-profit organizations are set up in the interest of the general public and should win support from all stratums of society. However, as they have been dominated by the government for years, the public’s sense of social obligation is weak. Thus, the government should make efforts to increase the public’s sense of social responsibility and win society’s support for non-profit organizations. From the perspective of complexity science, the government should guide the interaction among the related parties and create a synergy. Nine-year compulsory education, for example, provides a pure public good. In our inspection of the implementation of the Compulsory Education Act, however, we find that many problems arise from a weak sense of social

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obligation. In our opinion, the government should take the initiative to set up schools; headmasters should take the initiative to manage schools; teachers should take the initiative to teach; parents should take the initiative to send their children to school; and society should take the initiative to contribute to education. The government should play a leading role in compulsory education, and try its best to win the support of all sides. Degree education above the senior middle-school level provides quasipublic goods, and the government should provide the necessary support. However, reasonable charges should be paid by the beneficiaries, and the old concept of free higher education should be abandoned. Social resources should be mobilized to support education, including the setting up of primary and secondary schools. Charges can be increased to reflect the relation between the demand and supply of the market. The non-profit nature of these schools must be clarified and all profit must be used for the development of schools. Vocational and after-school education provide private products, and should be run totally as profit organizations. The final objective of such education is industrialization.

3. Reforming the Personnel System The reform of the personnel system is an important element of the reform of institutions. For a long time since the founding of the People’s Republic of China, the personnel system in institutions has been modeled on that of the government organizations of the planned economy system. The weaknesses of such a system become increasingly prominent with the deepening of reforms. Most institutions do not have the autonomy to recruit, and problems such as overstaffing, egalitarianism, low efficiency, and excessive power are grave. A series of reforms have been launched in personnel systems since the Third Plenary Session of the Eleventh National Congress of the CCP, and after years of experiments, a new model has been formed, which includes the following aspects:

(1) Management structure The old system would be replaced by a new system in which the chief administrative officer has ultimate power in decision-making. The chief administrative officer is the central authority and has power over operations, organizational structure, recruitment of staff, and distribution of resources. This new system has helped to eliminate the weaknesses of the old system and stimulate the enthusiasm of the chief officer. In addition, it has improved the decision-making process and efficiency through coordinated management. Except for institutions of higher learning and a few institutions wholly

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sponsored by the government, most institutions have adopted the new system with the chief officer at the core.

(2) Management power Some departments and local governments have practiced decentralization and begun experiments in separating administrative levels and evaluating leaders based on their performance. For example, some places have decentralized the power of quota control in staff management and some research institutions have restructured positions so that heads of research are no longer viewed as departmental officials.

(3) Appointing administrative leaders The single appointment system has been supplemented with an employment and recruitment system. Some institutions have tried to select the top management through open recruitment, while others have introduced an overall examination for candidates selected through recommendations or application. Without doubt, these institutions have created a competitive mechanism and improved democracy in recruiting top management. The successful candidates are required to sign a contract with the related authorities and their management performance is measured against certain objectives. All professional and technical positions are appointed on the basis of professional titles; most of the management staff are employed through recruitment; and a review system of technical levels has been introduced for support staff.

(4) Appointing professional and technical positions The reform towards standardization in this area began in July 1985. Some institutions have even tried to promote professionals with junior titles to senior positions, to demote professionals with senior titles to junior positions, and to suspend or even discontinue the appointment of certain positions. This reform has not only improved the structure of the technical team and increased their compensation, but has also provided a chance for talent to show itself and stimulated the enthusiasm of technical staff.

(5) Setup and implementation of an employee system Many areas and departments have actively begun such an experiment combined with a new compensation system based on positions. The main content of the reform is to discontinue the administrative levels of management staff and to turn them into employees. Employees are then reemployed under the principle of openness, fairness, competition, and optimization. The reform has motivated management and improved their overall quality.

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Based on experiences from the initial experiment, the Organization Department of the CPC Central Committee and the Ministry of Personnel jointly promulgated the Views on Stepping up the Reform of Personnel System in Institutional Units in August 2000. This marked the beginning of the all-round reform of the personnel system in Chinese institutions. The basic tenets of the reform are: ♦ To discontinue the method used in party and government organizations; ♦ To eliminate the administrative levels of institutions and the compensation system based on administrative levels; ♦ To set up a personnel system based on social functions, sources of funds, and nature of positions; ♦ To exercise classified management based on the features of different institutions and positions; ♦ To increase the autonomy of personnel management of institutions after a division of the responsibilities between the government and institutions and to set up and improve the self-control system of institutions; and, ♦ To introduce a system of competition under the principles of openness, fairness, competition, and optimization’.

Through system innovation and matching reforms, we should be able to motivate the initiative and creativity of all employees; provide abundant opportunities for talents to manifest themselves; increase the. self-development of institutions; reduce the financial burden of the state; and step up the development of a high-quality and socialized technical team. With regard to professional and technical positions, the principle of competitive selection should be observed and professional titles and technical positions should be integrated. For positions with important responsibilities that can only be assumed by people with technical qualifications, a professional qualification registration system should be set up and practice entry should be controlled. Through the reform of professional titles, the appointment system of professional and technical positions should be strengthened and improved. Under the macro control of the government, a new system that integrates individual application and socialized accreditation should be established, and the power of appointing professional and technical positions should be delegated to the relevant institutions. The Organization Department of the CPC Central Committee and the Ministry of Personnel require local governments and related departments to implement the reform step by step. Not surprisingly, the reform will create a favorable environment for the transition to the target model.

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4. Improving the Distribution System Improving the distribution system of institutions is an important measure in breaking the deep-rooted ‘big pot’ mentality and in mobilizing employee initiatives. Valuable experience has been gained through years of experiment. For example, many areas and departments have begun the structural reform of institutions according to the relevant state regulations. Institutions whose funds are all allocated by the government are transformed into institutions with a gap of funds sponsored by the government; institutions with such funds sponsored by the government are transformed into institutions responsible for their own revenues and expenditure; and institutions responsible for their own revenues and expenditure are transformed into independent businesses. In the meantime, the personnel system goes through a similar reform. In some areas and departments, R & D institutions are even transformed into shareholding companies. Various management systems are adopted, with a focus on the contract and responsibility system. As different institutions have different sources of funding and degrees of autonomy, the contract and responsibility system mainly takes three forms. Institutions responsible for their own revenues and expenditure fully implement the contract and responsibility system, and begin to practice independent accounting-like businesses. Institutions with a gap of funds sponsored by the government are encouraged to implement the contract and responsibility system, and to strive to be financially independent. Institutions with all the funds allocated by the government are required to adopt management in which operating expenses are separated from overhead expenses (based on the headcount). A quota is imposed on overhead expenses, and over-budget amounts are not compensated although the surplus can be retained. The contract and responsibility system has strengthened the internal management of institutions, and motivated employees by breaking the ‘big pot’. The reform of the compensation system also takes various forms. Institutions responsible for their own revenues and expenditure should relate the gross payroll to the objectives, and be allowed to withdraw a certain percentage of the annual balance or profit after tax as salaries, if the objectives are achieved. Institutions with a gap of funds sponsored by the government should relate active salaries or subsidies and welfare to the headcount, and be allowed to increase the active salaries or the percentage of subsidy and welfare, if the objectives are realized. Institutions with all funds allocated by the government should relate active salaries or subsidies to the objectives, and be encouraged to increase active salaries or subsidies through their own efforts. In 1993, a

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nationwide wage reform began. A new wage system (different from that of government organizations) was set up to reflect the features of all kinds of institutions. The reform divided the wages in institutions into five systems, three types, and two parts, in line with the principle of classified management of institutions. The division of wages into two parts (i.e. the fixed part and the active part) was particularly helpful in rationalizing the internal distribution system and motivating employees. On this basis, many institutions began to implement an internal wage system. In the Views on Stepping up the Reform of Personnel System in Institutional Units jointly promulgated by the Organization Department of the CPC Central Committee and the Ministry of Personnel, it is made clear that an important element of the reform is to set up a diversified and flexible compensation and incentive system. Under the principles of efficiency and fairness, institutions should be given more autonomy in distribution, and be encouraged to set up a flexible compensation and incentive system that is based on performance and contribution and is favorable to talented people and key positions. They should also be allowed to withdraw a certain percentage of the profit to reward people who have been involved in important projects and the industrialization of scientific achievements, and to attract talented people with high salaries. The objective is ‘first-class talents, first-class management, first-class performance, and first-class remuneration’. In May 2000, the Organization Department of the CPC Central Committee, the Ministry of Personnel, and the Ministry of Science and Technology promulgated the Views on Deepening the Reform of Personnel Systems in Scientific Institutions. It requires setting up a flexible and effective compensation and incentive system that caters to the realities of scientific institutions. The distribution system of scientific institutions must be revitalized through connecting the compensation to positions, tasks, and performance. The means of involving scientific production factors in distribution must be enriched and improved so that the compensation of scientific workers will be based on their contribution and performance. Scientific institutions should be given more autonomy in distribution, and encouraged to set up an independent and flexible compensation and incentive system. They need to make bold experiments and find multiple distribution forms that are in line with state regulations and can reflect the value of technology. Scientific institutions that are transformed into businesses should implement a new distribution system based on positions, tasks, and performance, and be allowed to make their own decisions on internal distribution. Scientific institutions funded mainly by the government should observe state policy on the distribution and wage system,

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and further increase levels of income. Scientific institutions running as nonprofit organizations should implement an overall rationing system for the total payroll. A few institutions that are self-sufficient and running as businesses should adhere to the principle that the growth of the total payroll must be lower than that of economic benefits and the increase of actual per capita income must be lower than that of productivity. Approved by the relevant authorities, scientific institutions can recruit top people with high salaries. The policies prescribed in the Several Regulations on Promoting the Commercialization of Scientific Achievements should be implemented, and the reward methods should be worked out. Measures must be taken to ensure that the reward promise will materialize after scientific achievements are commercialized and industrialized. Scientific workers should be allowed and encouraged to get rich first through the commercialization of their research products. Compared with the reform of the personnel system, the reform of the internal distribution system is much more complicated. Despite many policy measures by the government, the key is to expand the sources of income for institutions of public interest, and to set up a scientific, fair, and effective system of performance measurement.

CONCLUSION Chinese institutional units are a product of the planned economy system. They are funded and managed by the government, and required to operate in line with state plans. Most of these institutions are involved in non-productive activities in such fields as science and technology, education, culture, health care, and sports. Their employees are included in the quota of government bodies and supported by national finance. Since China opened its doors to the outside world, the reform of institutions has gained great momentum and moved from an experimental to a deepening stage. However, as the reform is a system project, we must set clear objectives, develop detailed plans, seize opportunities, and move forward steadily. The pressing issues are to work out a target model for the reform on the basis of years of experience, define the strategic direction of the reform, and come up with a series of policy measures and implementation procedures. Such a model should include six elements: providing public goods; integrating social resources; enjoying preferential policies; recruiting volunteers; reinforcing legislation; and implementing scientific management. Three strategic procedures are critical to the realization of the target model: classifying institutions and encouraging the flow of employees; establishing a modern

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institution system with a clear legal person status, a clear responsibility, a sound governance structure, and a focus on culture; and moving towards socialization. Not surprisingly, the reform of institutions will meet with great difficulties. On the one hand, we need to overcome the mentality and inertia developed under the planned economy system, and on the other hand, we need to be aware of the constraints of the objective conditions. To push the reform forward, we propose to take four policy measures: defining the scope of support; encouraging cooperation; reforming the personnel system; and improving the distribution system. Completed on 5 October 2000

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Chapter 2 Venture Capital Business and its Emergence in China Bygrave W. D. et al. (1992), Venture Capital at the Crossroads , Boston: HBS Press. Cheng, S. W. (1996), “The Transformation of Research Fruits Calls for Venture Capital”, Science and Technology Daily , 1st August. Cheng, S. W. (1998), “Developing the Venture Capital Industry in China”, People’s Daily , August 31. Cheng, S. W. (1999), “Some Comments on Promoting the Venture Capital Industry in China”, Economic Community , Vol. 4: 4–10. Cheng, S. W. (2000), “Explore Actively and Progress Steadily–On the System Innovation of China’s Venture Capital”, Exploring the Operating Mechanism of Venture Capital in China , Beijing: Democracy and Construction Press: 5–22. Cheng, S. W. et al. (2000), Venture Capital in China , Beijing, Yintuoluowang Press. Cheng, S. W. (1997), Collection of Papers on High-tech Venture Capital , Beijing: Democracy and Construction Press. Cheng, S. W. (1999), Promoting the Venture Capital Industry , Beijing: Democracy and Construction Press. Cheng, S. W. (2000), Operating Mechanism of China Venture Capital , Beijing: Democracy and Construction Press. Gu, S. Z. et al. (2001), Government and Venture Capital , Beijing: Democracy and Construction Press. Liu, M. H. (1998), Venture Capital: Innovation and Finance , Beijing: Renmin University Press. Mosimar, R. et al. (2000), The Monk and the Riddle , Boston: HBS Press. Quindlen,R. (2000), Confessions of a Venture Capitalist , New York: Warner Books. Saxenian, A. (1996), Regional Advantage , Boston: HBS Press. Sheng, L. J. (1999), Venture Capital: Operations, Mechanisms and Strategies , Shanghai: Far East Press.

Chapter 3 Fictitious Economy and the East Asian Financial Crisis Alba, P. A. et al. (1999), “Volatility and Contagion in a Financially-Integrated World: Lessons from East Asia’s Recent Experience”, paper presented at the PFTAD 24 Conference, May 1998. Cheng, S. W. (1998), “Nip at the Bud: Precautions against Financial Crisis”, Economic Community 2.

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Chapter 7 A Systematic Analysis of the Housing Reform in China’s Urban Areas The Housing Reform Office under the People’s Government of Beijing (1996), Handbook of the Housing Reform in Beijing , Prentice Hall. Cheng, S. W. et al. (1999), The Housing Reforms in China’s Urban Areas: A Target Model and Difficulties in Implementation , Beijing: Democracy and Construction Press. Dipasquale, D. and Wheaton, W. C. (1996), Urban Economics and Real Estate Markets , Prentic Hall. The National Bureau of Statistics (1999), 1999 China Statistics , Beijing: China Statistics Press.

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Hou, X. M. (1998), “Increasing the Effective Demand for Housing through Classification”, People’s Daily , 12 January. Hou, X. M., “A Preliminary Discussion on the Housing Reform” (Unpublished). The Housing Reform Office under the Ministry of Construction (1999), Questions and Answers on the Housing Reform Policies , Beijing: China Pricing Press. Liang, Y. P. (1998), A Close Look at the Housing Distribution in Currency , Beijing: China Pricing Press. Liang, Y. B. (1997), “Housing Construction Should Not Be Allowed to Separate from the Real Estate Industry”, Economics Reference , 12 May 1997. Lin, W. Q. (1998), “Adopt a Correct Attitude towards the Housing Distribution in Currency”, People’s Daily , 5 August. Lu, X. Y. (1998), “To Sell Public Residences at a Discount Is a Matter of Course”, People’s Daily , 6 April 1998. Lu, Y. H. (1996), “A Summary of the Situation after Deng Xiaoping’s Southern Tour”, Essentials of Real Estate Economics , Prentice Hall. McKenzie, D. J. and Betts, R. M. (1996), Essentials of Real Estate Economics , 4th Ed., Prentice Hall. The Legal Construction Committee under the National People’s Congress (1998), A Complete Book of the Housing Laws and Regulations of the People’s Republic of China , Beijing: Democracy and Construction Press. Tang, J. X. (1998), “When Can Each of Us Get a Shelter – A Quick Look at the World’s Housing Problem, People’s Daily , 22 December. Wang, C. (1998), “On-the-spot Report of the Housing Consumption Mechanism in Shenzhen”, People’s Daily , 29 May. Yu, X. L. (1992), Housing Reform and Housing Finance , Beijing: Knowledge Press. Selected Documents of Real Estate Finance , Beijing: China Finance Press. China Tertiary Industry Yearbook 1993 , Beijing: China Statistics Press. “The Housing Industry Has Become the Engine of China’s Economic Growth” (1999), Xinhua News, 23 May.

Chapter 8 An Analysis of China’s Rural Consumer Markets Cheng, S. W. et al. (2001), Analyzing and Expanding the Rural Consumer Market , Beijing: Democracy and Construction Press. Cheng, S. W. et al. (2000), The Reform and Improvement of China’s Social Security System , Beijing: Democracy and Construction Press. Ding, J. H. (1999), The Way to Modernization in Developed Countries (ed.), Beijing: Beijing University Press.

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Jiang, Z. M. (1998), “Implement an all-round reform in rural areas, and open up a new dimension in agriculture and agricultural work”, People’s Daily , 5 October. The National Bureau of Statistics (1999), The 1999 Statistics Yearbook of China , Beijing: China Statistics Press. The National Bureau of Statistics (2000), The 2000 Statistics Yearbook of China’s Rural Areas , Beijing: China Statistics Press. Ling, Y. F. (1998), “A market-oriented reform is the key to the reduction of burden”, People’s Daily , 12 November. Ling, B. P. and X. H., Zhang (2000), Consumer Economics Dictionary , Beijing: Economic Science Press. Luo, R. Q. (1993), New Perspectives on Modernization , Beijing: Beijing University Press. Solomon, M. R. (1996), Consumer Behavior (Third Edition), Prentice Hall Inc. Wang, Y. H. (1998), “An effective measure to reduce the farmers” burden: accurate accounting of the farmer’s income”, People’s Daily , 6 October. Yue, J. D. and J. Ming (1999), “The negative impact of the policies on the farmers”, China Youth Daily , 17 December. “Decisions of the Central Committee of the Communist Party of China (CPC) on Several Important Issues in Agriculture and Agricultural Work”, 14 October 1998. “Proposals of the Central Committee of the CPC on Developing the Tenth Five-Year Plan of National Economy and Social Development”, 11 October 2000.

Chapter 9 Devoting Major Efforts to Developing China’s Multinationals Arrow, A. A. (1999), Transnational Operations , Beijing: Enterprise Management Press Cao, J. M. and Jing, W. (1995), Comparative Studies of Legal Issues Surrounding FDI , Shanghai: East China University Press. Chen, A. (1985), American Legal Protection of Overseas Investment and Case Studies, Lujiang: Lujiang Publishing House. Chen, F. (2001), “No Other Alternatives — China Facing Antidumping”, Globe , 2: 36–40. Chen, J. Y. (1993), A Study on American FDI , Wuhan: Wuhan University Press. Cheng, S. W. (1977), “An Integrated Approach in Studies of Soft Science”, China Soft Science , Vol. 3.

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Cheng, S. W. et al. (2000), Enterprise Management in China: Problems and Solutions , Beijing: Democracy and Construction Press. Cheng, S. W. et al. (2001), Chinese FDI: Strategy and Management , Beijing: Democracy and Construction Press. Doz, Y. L., et al. (1998), Alliance Advantage , Cambridge: Harvard Business School Press. Editorial Committee of Japanese History of Trade Policies (1995), Japanese History of Trade Policies , Beijing: China Youth Press. Fu, R. (2000), “An Overview of the Fortune 500”, Information Industry Daily , 17 July. Prahalad, C. K. et al. (1990), “The Core Competence of the Corporation”, Harvard Business Review , Vol. 90, No. 3. Shen, Y. H. (1994), FDI by Western Europe , Beijing: Times Press. Sudarsanam, P. S. (1995), The Essence of Mergers and Acquisitions , Prentice Hall Europe. Sun, S. L. (2000) “The Fifth Wave of Global Takeovers”, China Economic Times , 25 February. Warner, M. International Encyclopedia of Business and Management (translated by the School of Economy and Management of Tsinghua University), Liaoning: Liaoning Education Press, 1999.

Chapter 10 Strategic Directions and Policy Implementation for Reforming China’s Institutional Units “An all-round reform of the personnel system in institutional units”, Guangming Daily , 14 August 2000. Boadway, R. W. (1984) Public Sector Economics (Second Edition), Little Brown Press. Brown, C. V. (1996), Public Sector Economics (Fourth Edition), BlackweI1. Chen, C. J. (2000), “Institutional units have got swollen before government organizations are streamlined”, People’s Daily , 3 September. Cheng, S. W. (1997), Soft Science and Reforms , Beijing: Democracy and Construction Press. Cheng, S. W. et al. (2000), The Reform of Chinese Institutional Units , Beijing: Democracy and Construction Press. Drucker, P. F. (1999), Management Challenges for the 21 st Century, New York: HarperBusiness. Herzlinger, R. E. (2000), Managing Non-profit Organizations , Beijing: Renmin University Press.

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Huang, H. X. (1998), A Study on the Structural Reform of China’s Institutional Units , Beijing: Tsinghua University Press. Jiang, J. J. (1985) Economics of Non-productive Sector (translation), Shanghai: Shanghai Translation Press. Samuelson, P. A. (1954), “The pure theory of public expenditure”, Review of Economics and Statistics , 36: 387–9. “The clean-up of registration for institutional units should be completed by the end of the month” (1999), Guangzhou Daily , 6 October. The Ministry of Health (2000), “Views on the Reform of the Health Care Monitor System”, 19 January. The Ministry of Health (2000), “Views on Deepening the Reform of Personnel System in Medical Institutions”, August. The Ministry of Health, the National Administration of Chinese Traditional Medicines, the Ministry of Finance, and the State Planning Commission (2000), “Views on Implementing the Classified Management of Urban Medical Institutions”. The Organization Department of the CPC Central Committee and the Ministry of Personnel (2000), “Views on Stepping up the Reform of Personnel System in Institutional Units”, Guangming Daily , 14 August. The Organization Department of the CPC Central Committee, the Ministry of Personnel, and the Ministry of Science and Technology (2000), “Views on Deepening the Reform of Personnel System in Scientific Institutions”, Science and Technology Daily , 4 May. The World Bank (1992), The 1992 World Development Report: Development and Environment , Beijing: China Finance Press.

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Index Act of Incentives for Economic Development 177 after-sale service 24, 124, 126, 245, 285, 289, 299, 323, 325 aggregate demand 2, 19, 168–69, 172, 237 agreement, bilateral investment protection 342–43 agriculture 29, 111, 162, 169, 173, 268–69, 278–79, 282, 290–95, 298, 316, 370, 386 APEC (A sia-Pacif ic Economic Cooperation) 343 ASEAN countries 70, 105 Asia Economic Research Institute 341 assets, fixed 93, 245, 279 bad debts 69, 79, 100 Bank of China 250, 259 barriers, non-tariff 23, 323 Beijing 48, 51, 54, 142, 232–33, 252, 261, 380–88 bubbles, economic 79, 86–87, 89, 96, 104, 304 business models 16–17, 54, 63, 65 capital, registered 46, 49, 61, 63 capital flow 10, 23, 69, 78, 80–82, 84, 89, 98, 101, 107, 258, 304, 307–9, 311, 315, 345–46 capital-intensive industries 162, 316 capital markets 13, 37, 59, 79, 91, 101, 147, 157, 205, 320, 329, 381 CE D (Co m m i tte e f o r Ec o n o m i c Development) 205, 384 centers, reemployment service 217–18, 221 central bank 20, 70–71, 76, 99–100, 102, 176 centralization 137, 139

centre, overseas investment promotion 303, 341–42 China New-tech Venture Capital Company 45 China's Development Research Center 114 China Venture Capital 66, 380 Chinese MNCs 302–3, 305, 317, 325–26, 330, 333, 340 circulation 2, 4, 8–9, 14–15, 17, 83, 87, 110, 115, 240, 296 Classified Management of Urban Medical Institutions 352, 388 collectivism 132, 137, 139, 179 commercial banks 69–70, 100, 176, 212, 220, 252, 337, 344, 346 commodities 9, 83, 87, 94–95, 97, 159, 227, 238–41, 274, 278, 284–86, 295, 355 commodity circulation 240, 286–88, 296, 299 commodity residences 236, 238, 240, 248, 256–59, 261 companies, foreign-invested 197–98, 217, 225, 256 Company Law 35, 49, 52, 58, 60–61, 135, 161, 326, 332 competitiveness 25, 95, 113–14, 124–26, 129, 147, 149, 173, 176, 191, 292, 294, 302, 306, 319, 325 complexity science 82, 115–16, 130, 132, 136–40, 150, 157, 269, 273, 286, 290, 305, 310, 313, 322, 368 complex system 11, 85, 114–16, 138, 140, 149 Comprehensive Ser v ice Centre for Overseas Investment 341 Confucianism 150, 178–79 conglomerates 122–23, 176, 252 congregation 302, 317, 319–20

385

Index

consumer durables 270, 272, 278–79, 282, 284–85, 288–89 consumer goods 270, 273, 278, 283, 289 control, macro-economic 89, 96, 98 cooperatives 287, 291, 364 core competence 113–14, 128, 130–31, 143, 146, 149–50, 302, 306, 325, 383, 387 corporate culture 120, 128, 131–33, 137, 139 corporate governance 60, 133–35, 302, 326, 330, 366, 383 Corseti 78, 381 CPC (Communist Party of China) 62, 92, 119, 154, 197, 236, 251, 258, 350–52, 386 CPC Central Committee 92, 196, 236, 251, 258, 268, 296, 304, 350–53, 373, 375, 386, 388 credit policies, preferential 175, 336 CSRC (Ch i na Se c u r i t i e s R e g u lato r y Commission) 119 currencies 12, 70–71, 74, 79, 86–87, 89, 172, 226, 260–61, 288, 312, 335, 385 deficits 68–69, 77–79, 89, 97, 172 Democracy 142, 179, 383 depreciation 8, 106, 113, 228–29, 254 deregulation 38, 107, 162, 170 devaluation 12, 69–72, 79, 87, 106 developed countries 2, 7, 15, 21–24, 28, 76, 111–13, 189, 191, 200, 239, 244, 261, 304, 312, 324 developers 14, 127, 243, 245, 248, 252, 257, 259, 261–63 developing countries 22–25, 28, 76, 96, 111, 156, 180, 302, 304, 306–7, 309, 312, 315, 324, 335–43 directors board of 51, 55–56, 60–63, 135–36, 141, 163–64, 326–27, 331, 362, 364–67 external 135–36, 332 disposable income 274

386

East Asian Financial Crisis 67, 69, 71, 73, 75, 77, 79, 81, 83, 85, 87, 89, 91, 93, 95, 97 e-commerce 11, 14, 16, 18, 20, 84, 111 economic crises 78, 174, 192 economic efficiency 27–28, 38, 107, 162, 171, 174, 205, 216, 329 economic globalization 2, 23, 30–31, 84, 94, 97, 110–11, 146, 268, 302–6, 309– 10, 315, 322 economy agricultural 5, 22, 112, 268 global 76–77, 103, 106–7 knowledge-based 4, 111, 379, 383 Eleventh CPC Central Committee 196, 350 endowment 356–59, 364 Engels coefficient 272, 276–78, 285 enterprises collectively-owned 195, 197–98 foreign 122, 126 non-public 119, 219 private 135, 197–98, 209, 297 entrepreneurs 30–31, 35–37, 41, 44, 46, 53–54, 56–57, 60, 62–63, 65, 128, 138, 140 exchange rates 70–71, 73–75, 86–87, 97, 105, 123 expenditure, non-productive 274, 280, 298 exports 8, 31, 69, 79, 81, 88–89, 94, 119, 163, 177, 294, 307, 309, 320–21, 323, 346 FDI (foreign direct investment) 69, 302, 307, 310–13, 315, 321, 336, 386–87 fictitious capital 4, 8, 10, 24, 82–86, 88, 99, 111 fictitious economy 2, 4, 8–13, 21, 40, 67, 69, 71, 73, 75, 77, 81–89, 91–93, 95–97, 107, 110–11 Fifteenth CPC Central Committee 268, 273 financial crisis 10, 68–75, 77–82, 87–89, 91–94, 96, 99, 102–4, 107, 111, 122–23, 304, 309, 379–82

Index

financial institutions 9, 52, 59, 78–79, 81, 90, 93, 99–100, 102, 106, 176, 261, 281, 309, 329, 336 financial liberalization 81–82, 90, 102 financial markets 2, 4, 9–11, 74, 76, 80–81, 83–87, 90–91, 99, 101–2, 105, 172, 176 financing costs 10, 329 firms 37, 41, 55–58, 90, 107, 158, 160 fiscal policies 20, 81, 168, 172 Five-year Plan 177 forced savings 204, 206–8, 212 foreign capital 69, 76, 79–81, 90–91, 96, 98–99, 101, 103, 106, 305 foreign debts 69, 71, 98 foreign exchange 84, 89, 110, 160, 304, 307, 311, 333, 344–46 foreign exchange reserve 70–71, 73–74, 76, 92, 105, 345–46 Fourteenth CPC Central Committee 207, 235 free competition 155, 167–68, 170–71, 180, 184 funds pension 44, 57, 197, 208, 212–14 social financing 208–9, 212, 215, 220 GDP 4, 19, 22, 29–30, 75, 93, 96, 105, 107, 111, 118, 122, 172–73, 213, 237, 271 generations, second 126, 129, 199 globalization 23, 76, 91, 110, 138, 140, 156, 303–5, 314, 333 GNP 23, 207, 209–10, 245 go out 304–5, 336, 339 government central 118–19, 214 municipal 232 government failure 89, 158, 355 government intervention 100, 119, 156, 158, 161, 170–71, 174, 176, 192 guidance, administrative 165–66, 175–76, 178, 181 Hainan 258–60, 277, 384 Hang Seng Index 72–74 hazard, moral 62, 79, 81, 90, 100

health care 42, 120, 148, 188, 285, 348–51, 356–57, 362, 365–66, 376 high-tech enterprises 7, 46, 59, 63, 123 high-tech industries 2, 30, 34, 37, 44, 46– 48, 93–94, 96, 107, 121, 146, 169, 177, 324 Hong Kong 22, 28–29, 68, 72–76, 105, 125, 261, 317, 326, 359 host country 24, 308–9, 312, 315, 323–24, 328–29, 331, 336–43, 345 housing allowance 228, 242, 246, 249, 251, 254–57, 260, 272 housing consumption 243, 246–47, 254, 261, 263–64, 283 housing reform 223, 225–29, 231–35, 237, 239, 241, 243, 245–53, 255, 257, 259–61, 263, 265, 384–85 IBM 18, 64, 129 idle capital 9, 83, 289 IMF (International Monetary Fund) 68, 71, 73, 76–77, 346, 381 incentive system 3, 35, 51, 62–63, 141–42, 162, 375 income, household 242, 246 income tax corporate 49, 336 personal 40, 49, 208, 336 industrialization 2, 22, 30, 34, 37–38, 43, 46, 269, 298, 334, 362, 369, 371, 375 industries key 169, 171, 173, 175 tertiary 13, 93, 270, 290, 292 inflation 2–3, 19–20, 96, 103, 107, 164, 168, 191, 205, 228, 255, 270, 281 information technology 2, 82, 84, 102, 110, 129, 146–47, 149, 302 infrastructure 22, 96, 157, 166, 171, 277, 289–90, 293, 296–97, 299, 341 legal 157, 175, 181–82 input-output, virtuous investment cycle of 235–36 institutional investors 57

387

Index

institutional units 197–98, 347–53, 355, 357–59, 361, 363, 365–67, 369, 371, 373, 375–77, 387–88 institutions 115, 155, 195, 202, 211, 220, 225, 246, 249–50, 256, 338, 348–54, 356–66, 368–76 designated 212, 337–38, 341 quasi-public 362–63 reform of 350–54, 359, 369, 371, 376–77 interest-bearing capital 8–9, 83 interest rates 70, 75–77, 86–87, 93, 97, 100, 102, 169, 215, 271, 297 Inter-government investment protection conventions 342 In te r i m Prov i s i o n s f o r R e g i s t r at i o n Management of Private Non-business Units 351, 365 Internet 2–4, 14–20, 63, 147, 320 interplay 110, 132, 137, 139, 286, 308, 310, 313 investment companies 40, 43, 52–53, 61–63, 100, 212, 220, 370 invisible hand 159, 167, 251, 290 IPD (Implicit Pension Debt) 212, 214 IPOs 14, 34–36, 43, 53, 56–58 knowledge economy 2–8, 22, 25–26, 30– 31, 34, 38, 94, 111, 113, 138, 140, 146, 315, 324, 379, 382 knowledge society 8, 27, 379 labor cost 8, 29, 113, 292 labor market 157, 212–13, 219 legal entities 320, 356, 364 legislation 35, 48–49, 51, 53, 148, 162, 170, 184, 192, 200, 288, 332–35, 339, 351, 360, 365 liquidity 11, 91, 98, 101–2, 243 listed companies 43, 57–58, 71, 96, 119, 142 logistics 287, 317–18, 350 low-cost residences 236, 238–39, 248, 252, 256–58

388

macro-control 147, 159–60, 180, 248, 251, 258–59, 264, 288, 373 management centralization of, 137, 139, 353 market economy 11, 26, 28, 51, 91, 95, 110, 119, 121, 124, 148, 155, 157–62, 174–75, 182, 184 market failure 147, 158, 162, 192, 355 marketization 240, 249, 252, 257 maturity 10, 43, 55, 57, 123, 273 measurement index 143 mergers 106, 113, 131, 171, 302, 315, 319, 321, 331, 387 metastability 2, 11, 85–86, 88 Microsoft 30, 65, 127, 131 Ministry of Finance 164, 178, 196, 250, 259, 351–52, 388 Ministry of Health 350, 352, 388 Ministry of Personnel 351–53, 373, 375, 388 Ministry of Science and Technology 48, 62, 375, 388 miracles, economic 68, 78, 104 MNCs 302–17, 321–24, 326–27, 329–30, 332, 335–36, 342 MOFTEC (Ministry of Foreign Trade and Economic Cooperation) 316, 344 monetary policies 97, 100–101, 107, 168– 69, 172 money market 74, 98, 101 National Bureau of Statistics 384, 386 national income 193, 199 non-profit organizations 261, 342, 348, 353–62, 366–70 OECD 3–4, 39, 105, 111–12, 340, 383 OECF (Overseas Economic Cooperation Fund) 340–41 old age security 203, 206–7, 220, 335, 339, 341 open market operations 101, 168–69 O P I C (O ver seas Pr i v ate Inve st m ent Company) 335, 339, 341

Index

optimization 16–17, 122, 150, 185, 304, 319, 323, 372–73 organizational structure 36, 137–40, 302, 313–14, 316, 319, 327, 364, 368, 371 Organization Department 62, 352, 373, 375, 388 OTDA (Overseas Trade Development Association) 340 over-investment 68, 78–79, 89 overseas investment 302–3, 305, 308, 313, 316, 322–24, 332–46, 386 overseas subsidiaries 302, 306–7, 311–13, 320–21, 327–28, 330–31, 341, 346 overstock 69, 87, 89, 259–60 parent companies 307–9, 313, 321–22, 327, 330–31, 346 partnership 34–35, 39–42, 49, 60–61 Peking University 384, 386 pensions 120, 141, 173–74, 188, 190, 197, 204, 212–17 per capita arable land 29, 276 per capita consumption expenditure 272 per capita emissions 23 per capita GDP 21, 28, 113, 237 per capita GNP 23, 68, 290, 298 per capita income 6, 26, 114, 148, 200, 237, 269–70, 272, 275, 277–78 planned economy 51, 159, 161, 184, 287, 348 plunge 70, 73–75, 87 population 23, 29–30, 224, 237, 268–69, 276–78, 295, 324, 359 power, distribution of 137, 139, 313 preferential policies 62, 169, 181, 206, 216, 218, 221, 257, 303, 329, 337, 352, 357–58, 362, 376 price competitiveness 95, 124, 325 privatization 170, 191, 250 production costs 8, 17–19, 207 productivity 2, 6–7, 15, 24–25, 29, 38, 68, 110, 112, 143, 149, 165, 244, 290, 292–93, 298 projects, reemployment 216–18, 221, 384 property rights 101, 134

public goods 121, 355–56, 361–63 public residences 229–33, 240, 246, 250, 253–57 purchasing power 29, 86, 94, 105–6, 249, 254, 263, 268, 270–74, 276–80, 284– 85, 290, 292, 295, 298 balance of 274, 276–78, 281, 289 rate, statutory reserve 168 real estate industry 12, 69, 72–73, 87, 89, 235–36, 243, 248, 252, 258–59, 263, 385 reemployment 29, 185, 216–17, 219 reengineering 25, 114, 120, 138, 140, 150, 318–19, 379, 382 Reform of Institutional Units 351, 353, 361, 369, 373, 375, 388 regulations, foreign exchange control 345 reserve, rate of 176, 339 residence market 240 retirement age 190, 194, 205, 209, 213, 220 rural consumer market 267–71, 273–75, 277, 279, 281, 283, 285, 287, 289–93, 295, 297–99, 385 rural consumption 271, 273, 297 rural households 270, 276–77, 282, 284, 292, 297 S B I C s (s m a l l b u s i n e s s i n v e s t m e n t companies) 44–45 SBUs (strategic business units) 137, 139, 314 second board 35, 43–44, 53–54, 57–59 securities markets 9, 11–13, 20, 47, 83, 91, 96 service industries 42, 315 Shanghai 46, 48, 54, 216, 232–33, 250, 276, 380–81, 386, 388 shareholders 35, 61–62, 82, 124, 135–36, 141, 144, 328, 358, 366 Shenzhen 48, 54, 58, 228, 230, 255, 261 Silicon Valley 12, 39–40, 53 small-sized enterprises 43, 321, 337, 340– 41

389

Index

social equality 27–28, 147, 157, 168, 171, 174, 185, 188, 193, 198, 202, 219 social insurance 188–89, 194–95, 198, 200–204, 209–10, 220 socialist market economy 28, 47, 118–20, 144, 147, 154, 161, 180, 184, 188, 197– 98, 219, 235–36, 239–41, 251–52, 261 socialization 15, 203, 210–11, 216, 228, 232, 251, 350–51, 359, 363, 368–69, 377 social relief 193–94, 198, 200, 202, 220, 296 social security contributions 209–10 social security expenses 194, 202, 217 social security funds 190, 194, 196, 198, 206, 208–9, 211, 220 social security system 27–28, 171, 174, 181, 188–90, 192–202, 204–7, 209–10, 212–13, 216, 219–21, 296, 354, 384 social security taxes 174, 208, 220 social welfare 168, 173–74, 188, 190, 192– 94, 210, 281, 296, 355 SOEs (state-owned enterprises) 93, 114, 118–20, 133–34, 136, 154, 163–66, 170–72, 182–83, 195–98, 214–18, 225, 293–94, 327, 348, 382–83 Soft Science and Reforms 383, 387 Standing Committee 49, 58 State Council 45, 48, 114, 195, 197, 208, 211, 216, 228–32, 234–36, 244, 250– 51, 258–59, 304, 350–51, 365 state-owned assets 118, 182, 215, 260, 303, 330, 333, 346, 353, 365–66 stock market 70, 73–75, 83, 98, 105, 107, 135, 211–12, 220 stock rights, diversification of 134–35, 142, 146 structural reform 45, 133, 181, 350, 374, 387 Structure and Size Management Office 351–53 subsidies 53, 59, 98, 147, 159, 163, 169, 175, 185, 200, 203, 226, 231–33, 244, 339–40, 374 substantial economy 4, 10, 12–13, 20, 87–89, 92–93, 96

390

surplus labor 29, 292–93 system innovation 35, 60, 128, 130, 291, 346, 373 taxes, value-added 44, 336 tax exemption 183, 206, 343, 358 tax policies, preferential 242, 333, 336, 339, 369 technological innovation 16, 22, 30–31, 34, 37–38, 64, 85, 107, 115, 128, 130, 317, 325 technological progress 63, 137, 139, 157– 58, 201, 216 technology-intensive industries 176, 315 telecommunications 42, 162, 167, 169, 171–73, 176, 285, 289, 315–16 township enterprises 29–30, 197–98, 219, 290, 293–95, 297 trade unions 163–64, 174, 201–2 transaction costs 20, 94, 320–21 transformation costs 188, 212–15, 219–20 transnational operations 307, 320–22, 326–27, 386 transparency 2, 4, 16, 18, 100, 205, 335 UN (United Nations) 16, 224, 305 unemployment insurance 173–74, 196– 98, 203, 208, 218 urban dwellers 197, 237, 262 urbanization 2, 28–30, 295, 298–99 venture capital 2, 30–31, 33–66, 123, 370, 380 web economy 2–4, 12, 14–20 welfare states 174, 189–90, 193 workers, laid-off 29, 217–19, 221 World Bank 6, 8, 23, 76, 104, 156, 337, 379, 381, 383, 388 World Capital Outlook and International Capital Markets 381 World Development Report 379, 383, 388 WTO (World Trade Organization) 23, 29, 146, 291, 293, 304, 309, 343

Index

391

Interpreting China’s Economy through the Eyes of a Chinese Statesman

Selected Works of Cheng Siwei: Economic Reforms and Development in China Volume 1 This book, in three volumes, presents the thoughts and reflections of the highly regarded Chinese scholar and statesman, Cheng Siwei. The author outlines his theories for bringing economic reform to China in the context of a global economy. Using the principles of complexity science and finance, the author also elaborates on the characteristics and laws of fictitious economy in China and from this perspective, studies such issues as venture capital, financial crises, capital and monetary markets, inflation and deflation, housing system reform, the social security system and enterprise management in contemporary China. The book has been highly regarded by top-ranked Chinese politicians and distinguished scholars and is essential reading for anyone wishing to understand the economic complexities of the development of China. • Authoritative commentary by a leading Chinese statesman • Comprehensive coverage of economic and financial complexities facing China • Detailed examination of developmental issues facing China • Unique insight into China’s unparalleled growth and development

Author Cheng Siwei is the Chairman of International Finance Forum, a former Vice Chairman of the Standing Committee of the National People’s Congress of the People’s Republic of China. He is the Dean of Institute of Management at the Graduate University of the Chinese Academy of Sciences, and Honorary Professor of the Faculty of Business Administration at the Chinese University of Hong Kong. He was an academic advisor to the World Bank Institute and Director at the Department of Management Sciences at the National Natural Science Foundation of China. He is now leading the Research Center on Fictitious Economy and Data Science at the Chinese Academy of Sciences. His research mainly covers complexity science, fictitious economy and venture capital. Over years, he published 22 books and 200 articles. His proposal entitled ‘A Proposal on Speeding up the Development of Venture Capital in China’ was ranked No.1 in the first meeting of the Ninth National Committee of the Chinese People’s Political Consultative Conference in 1998 and he has been dubbed the ‘Father of Venture Capital in China’ by practitioners in the field for his groundbreaking work in this area. Chinese Economic Studies