Chinese Institutional Innovation and Privatization from Below

by Barry Naughton
Chinese Institutional Innovation and Privatization from Below
Barry Naughton
The American Economic Review
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Chinese Institutional Innovation and Privatization from Below

One of the most distinctive features of China's transition to a market economy has been the role played by rural township and village enterprises (TVE's). In the face of sustained rapid growth of TVE's, the share of total industrial output produced by state-owned enterprises (SOE's) has fallen below half, despite steady state-sector growth and the absence of significant priva- tization. Yet most TVE's are "collectives," a form of publicly owned enterprise. This feature seems to make them unique: in no other transitional economy has public own- ership played such a dynamic role. China presents the unusual picture of an economy that has made a transition to a primarily market economy, but in which publicly owned enterprises still produce the bulk of manufacturing output. Surprisingly also, the collective ownership form does not have a precise legal definition in China, leading to some uncertainty about ultimate property rights.

Martin Weitzman and Chenggang Xu (1993) point out that public ownership with vaguely defined ownership ought to repre- sent a recipe for economic disaster. To them, TVE success suggests instead advantages to the internal institutional form of TVE's, which are seen to facilitate cooperation through implicit contracts among commu- nity members locked into an ongoing rela- tionship. Victor Nee (1992) advances a simi-

t~iscussants: Chenggang Xu, London School of Economics; Myron J. Gordon, University of Toronto.

*Graduate School of International Relations and Pacific Studies, University of California-San Diego, La Jolla, CA 92093-0519.

lar interpretation, arguing that long-time community residents create forms of in-come-sharing that may be optimal in the absence of an independent legal system. An alternative, perhaps complementary, view is presented here. The success of TVE's, I argue, is due largely to a set of external conditions to which TVE's are an effective adaptation. TVE's are responses to one of the most distinctive characteristics of the Chinese transition as a whole: the early creation of product markets, which exist for a prolonged period without well-developed markets for factors of production or assets. TVE's are a flexible and effective but basi- cally ordinary adaptation to this environment.

I. TVE Success and Privatization from Below

Rapid entry and formation of new busi- ness has been a feature of nearly all transi- tional economies. Growth of the new private sector is widely recognized as one of the success stories of the economic transi- tion from socialism. Thus Chinese TVE growth is a variant of a more general pro- cess. Ironically, that process in other transi- tional economies is often called "privatiza- tion from below," while in China the same entry process has relied primarily on "col- lectives." The Chinese case shows that the key feature of this process is entry, rather than privatization per se: entry creates com- petition and drives market development, leading to a decline in state control and monopoly. Although private businesses now make up an important part of the Chinese economy, collectives are much more impor- tant. As Table 1 shows, rural collectives account for the majority of nonstate manu- facturing output.



Percentages Ownership 1978 1985 1992

State 78 65 48

Collectives 22 32 38

Urban collectives (13) (16) (11)

Rural collectives (9) (16) (27) Private nega 2 7

Foreign-invested nega nega 4

Sources: Statistic Yearbook, various years; Statistical Abstract, various years. aNegligible percentage.

The fact that TVE's are a variant on a more general process of entry suggests that one should look for the causes of rapid TVE growth primarily in the structural fea- tures common to all transitional economies. In fact, for the following reasons, economic fundamentals strongly favor growth of TVE's. (i) Factor price ratios reflect China's real factor endowment. TVE's faced cheap labor and expensive capital and natural re- sources, causing them to choose appropriate production technologies. As prices were reformed, SOE's found themselves at a competitive disadvantage because of inap- propriate capital and resource-intensive technologies. (ii) TVE's were highly prof- itable because of distortions in the socialist system. At the beginning of reform in 1978, the average rate of profit on TVE capital was 32 percent (capital being defined as depreciated fixed capital plus all invento- ries). Most TVE start-ups were in manufac- turing, where state price controls kept prof- itability high so that the state could harvest revenues from SOE's. Similarly, TVE's entered empty niches for which SOE's had failed to produce. High profits attracted in- vestment and rapid growth. (iii) Taxes were low on TVE's, which paid only 6 percent of profits as tax in 1980, climbing to 20 percent after 1985 (Statistical Yearbook, 1992 p. 390).

These factors appear to be at work in most transitional economies. Low tax rates usually prevail because of inadequate col- lection abilities, while in China this was primarily due to a policy-driven desire to foster rural industrialization. It is not neces- sary to appeal to unique features of TVE's to explain growth, which is amply explained by external economic conditions. It remains, however, to explain why TVE's compete robustly against private firms during this process.

11. What Are TVE's?

There is great diversity in the ownership and management of TVE's, but a few ro- bust generalizations are still possible. Most TVE industrial output is produced by firms that are controlled by local township and village governments. Despite the "collective" label, TVE's themselves were never worker cooperatives: rather, they were labeled "collective" because they were estab- lished and controlled by agricultural collec- tives. When these dissolved in the early 1980's, their functions were either decen- tralized to individual households or else as- sumed by local governments. As a result, most TVE's became subordinate to the township and village governments that replaced the former communes and agricul- tural collectives, but the "collective" classi- fication persisted. This creates a misleading impression that TVE's are in some sense owned by local communities as a whole. However, there are no institutions through which community members can express their individual preferences. China is not a democracy, even at the village level. Village and township leaders are appointed from above, typically by county administrators. Township and village leaders, in turn, desig- nate the managers of TVE's. Local resi- dents possess no "right of membership" in TVE's, nor do TVE workers possess any rights to participate in TVE management. In most cases that have been studied, town- ship and village officials in their official ca- pacity possess all the key components of property rights: control of residual income; the right to dispose of assets; and the right to appoint and dismiss managers and assume direct control if necessary (William Byrd and Qingsong Lin, 1990; Chun Chang and Yijiang Wang, 1993; Susan Whiting, 1993).

Moreover, authority relations and compensation schedules are quite well specified. As Whiting (1993) shows, township leaders are appointed by county officials, most often from outside the township in question. Their compensation is governed by a "managerial contract" with explicit success indicators covering economic and social objectives. TVE output and sales value, profits, and taxes enter into the compensation schedule, as well as family planning, maintenance of public order, and education. These town- ship officials in turn appoint TVE managers, generally from within the township, and sign managerial contracts basing com- pensation on output and profits. Thus, property rights in TVE's are in practice fairly clearly specified. It is'true that there is no independent legal system to guarantee property rights, just as it is true that the overall structure of political power may lack legitimacy. But contingent upon the existing governmental structure, property rights ap- pear unambiguous.

Much research remains to be done on the real incentive systems that prevail in TVE's. While township and village officials control WE property rights, their incentives are not identical to those of private owners. Township and village officials must take into account the interests of the local community to some extent, if they are to be effective in achieving a spectrum of economic and so- cial indicators. That community may have a substantial preference for employment gen- eration, which the official might want to accommodate. Employment pressures plus the presence of output as an argument in the manager's compensation function may push managers to maximize output at the expense of profitability. However, there are strong countervailing reasons to stress profit: the township or village as a unit has a fairly hard budget constraint. It is clear that the successful township official maximizes his own career prospects by producing economic growth during his term as a commu- nity leader and this depends crucially on maximizing net revenue from WE's.

At the same time, most of the benefits of TVE growth remain in the community. The bulk of profits are retained. within the WE sector for reinvestment; the community gains from employment generation; and community governments gain revenues that fund social services. Yet this occurs not because the community instructs its agents to provide those benefits, but rather be- cause officials appointed by higher levels of government are instructed to develop the local economy. Moreover, they are provided with low marginal tax rates to enable them to do so. The surprising thing about TVE's is not that they function without clearly specified property rights, but rather the fact that local government ownership turns out to be a fairly robust ownership form even though it is dependent on delegation of authority from higher levels of government, and even though it must engage in increas- ing market competition with private firms.

111. Why TVE's?

Although rapid growth can be explained by external forces during the transition, it remains to be shown that TVE's are an effective institutional adaptation to the Chi- nese economic environment. The success of WE's should be seen in the context of Chinese transition strategy more broadly conceived. That strategy has relied on the initial creation of product markets, followed only gradually by markets for assets and factors of production. By the mid-1980's, markets and market prices existed for nearly all commodities. But markets for land and labor really emerged only in the 1990's; and financial institutions are still in the midst of a gradual process of adaptation to market forces. TVE's were also part of the "solu- tion": they provided an accelerated entry vehicle that helped push the initial commit- ment to open product markets into a broader marketization of the economy (Naughton, 1994).

TVE's allowed rural communities to translate control over assets into income despite the absence of asset markets. Under the former command economy, natural resources became public property; but man- agement of resources was effectively dele- gated to local governments. Such manage- ment did not involve major decision-making in most cases anyway, since there were no asset markets, and restrictions on factor mobility further reduced the significance of direct management. Rural residents were forbidden to migrate to urban areas. How- ever, growth of product markets provided opportunities to realize value from locally controlled resources.

Development of TVE's provided a way to convert assets into income streams without solving the difficult problems of privatiza- tion. The central government was unwilling, on ideological grounds, to permit mass pri- vatization. Had it been willing, administra- tive difficulties would have been immense, due to China's huge size and the underde- velopment of its administrative apparatus. Local governments had only management control of public resources: should privati- zation be managed nationally since the re- sources belonged to the nation? Should resources be sold or given away? Should community residents have a special claim on local resources? The difficult policy choices involved in privatization were probably in- soluble in China during the 1980's.

TVE development provided local commu- nities a means to appropriate the benefits of a local resource, but only if this was con- verted into an income stream. Ownership of the asset could not be transferred. Since most of the benefits accrued to the local community, this could be interpreted as ap- propriation of a national publicly owned good by a local community. But since bene- fits could only be appropriated in the course of productive exploitation of resources, and since those benefits were reasonably widespread within the local community, there were few objections to the process. A specific example is coal mining, which accounted for 5 percent of WE employment in 1990. Although mineral resources nom- inally belong to the nation, community governments were allowed to extract coal without paying royalties. Development of production went along with a kind of plun- dering of public assets.

More generally, the economic incentives to develop resources were most evident in suburban areas. Low-productivity land clas- sified as "rural" was in close proximity to congested, high-value urban land, and low- income peasants to high-income urban workers. With well-functioning markets, ur- ban firms would have purchased land and hired suburban labor. In the absence of such institutions, TVE's presented an alter- native solution. Urban firms would subcon- tract to WE's, providing technology and equipment as well; or rural governments could take the initiative themselves. Many TVE's grew up as complements to state-run industry. TVE growth has been concentrated in advanced, peri-urban regions. In 1988, three provinces (Jiangsu, Zhejiaag, and Shandong) with 17 percent of China's rural population, produced half of all town- ship and village-level output (Statistical Abstract, 1989 p. 37). In these provinces, link-

ages with urban firms were instrumental in TVE growth.

Similarly, TVE's facilitated access to cap- ital on the part of start-up firms. The expe- rience of other transitional economies has been that new start-up businesses prolifer- ate but that such businesses have difficulty getting access to capital, and as' a result remain small, undercapitalized, and depen- dent on informal capital markets. Banks are ill-equipped in the early stages of transition to process small-scale lending applications and assess risk. Local government ownership in China played a crucial role in finan- cial intermediation. Local governments could better assess the risks of start-up busi- nesses under their control; moreover, they were diversified and served as guarantors of loans to individual TVE's. Government sponsorship served to spread the risks in- curred by start-ups, essentially by having the entire local community absorb the cost of failure. A certain amount of "insurance" provided by local governments almost cer- tainly enhanced social welfare. By under- writing a portion of the risk of entry, local governments enabled start-up firms to enter production with a larger size, starting with some mechanization and exploiting economies of scale. With local governments fa- cilitating the flow of capital to rural enterprises, those firms were able to take advantage of China's relatively abundant household saving. In return, the profitable opportunities and reasonable risk levels in the TVE sector kept real returns high and contributed to high saving rates.


The above has suggested an explanation for the robust survival of local-government- owned firms in the Chinese transition. It needs to be stressed that, in order to achieve such advantages, local-government-owned firms had to be adequate in a number of other dimensions. TVE's must have effec- tive incentive structures and reasonably hard budget constraints. These seem to hold: TVE's can and do go bankrupt, and most TVE's fire recalcitrant workers. Moreover, the flexible institutional form of TVE's is a crucial component of their success. Given the existence of these preconditions, local government ownership of firms operating in a predominantly market environment was an alternative to early privatization. It is conceivable that such an option was admin- istratively less costly than early privatiza- tion, permitting avoidance of difficult and complex problems at an early stage of reform, thus allowing time and managerial energy to be concentrated on more directly productive activities. If this analysis is cor- rect, TVE's will be less important in the future. As markets for assets and factors of production become more complete, the ad- vantages of TVE's will fade. But the demonstrated ability to solve problems of delegation and incentive design indicates that TVE's will not disappear, rather remaining a distinctive feature of the Chinese economic landscape for the foreseeable fu- ture.


Byrd, William and Lin, Qingsong. China's rural industry: Structure, decelopment, and reform. New York: Oxford University Press, 1990.

Chang, Chun and Wang, Yijiang. "The Nature of the Township Enterprise." Mimeo, Carlson School of Management, Univer- sity of Minnesota, 1993.

Naughton, Barry. Growing out of the plan: Chinese economic reform, 1978 -1993. New York: Cambridge University Press, 1994.

Nee, Victor. "Organizational Dynamics of Market Transition: Hybrid Forms, Prop- erty Rights and Mixed Economy in China." Administratice Sciences Quarterly, March 1992, 37(1), pp. 1-27.

Statistical Abstract [Zhongguo tongji zhaiyao].

Beijing: Zhongguo Tongji, annual.

Statistical yearbook [Zhongguo tongji nianjian].

Beijing: Zhongguo Tongji, annual.

Weitzman, Martin and Xu, Chenggang. "Chinese Township Village Enterprises as Vaguely Defined Cooperatives." Mim- eo, Harvard University, April 1993.

Whiting, Susan. "Contract Incentives and Market Discipline in China's Rural In- dustrial Sector." Unpublished manuscript presented at conference on the Evolution of Market Institutions in Transition Economies, University of California-San Diego, July 1993. 

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