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

[Barun Mitra]

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

By Xingyuan Feng, Christer Ljungwall, and Yeliang Xia

This article originally appeared in the 2013 International Property
Rights Index report
(http://www.propertyrightsalliance.org/userfiles/2013%20International%20Property%20Rights%20Index-PRA.pdf),
a project of the Property Rights Alliance
(http://www.propertyrightsalliance.org/).

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Source: Xingyuan Feng, Christer Ljungwall, and Yeliang Xia: Protection
of Property Rights as a Key to Economic Success in China, in: Property
Rights Alliance: International Property Rights Index: 2013 Report,
2013, pp. 125-127.