CHINA'S ECONOMY IN 1985: A TEST FOR REFORM AND REFORMERS

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP04T00794R000200710001-9
• Release Decision: RIPPUB
• Original Classification: C
• Document Page Count: 24
• Document Creation Date: December 22, 2016
• Document Release Date: May 16, 2011
• Sequence Number: 1
• Publication Date: May 1, 1986
• Content Type: REPORT

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Directorate of eunfiden"
Intelligence 25X1
China's Economy in 1985:
A Test for Reform and
Reformers
onfidentia
EA 86-10019
May 1986
Copy 19 5
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Directorate of
Intelligence
Reformers
China's Economy in 1985:
A Test for Reform and
Division, OEA
This paper was prepared by~ Office of
East Asian Analysis. Comments and queries are
welcome and may be directed to the Chief, China
Confidential
EA 86-10019
May 1986
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Summary
Information available
as of 15 May 1986
was used in this report.
Reformers
China's Economy in 1985:
A Test for Reform and
Problems associated with the implementation of major economic reforms
arose in full force in 1985, severely testing the economic skills and political
resolve of China's reformers. According to Chinese statistics and press
reports:
? Confusion surrounding new agricultural policies was compounded by
poor weather, causing grain output to fall for the first time in five years.
? Industrial output, spurred by economic incentives and relaxed central
controls, grew at an excessive 18-percent rate, increasing the strain on
China's inadequate infrastructure.
? Inflation tripled, the trade deficit grew to almost $7 billion, and foreign
exchange reserves declined 29 percent.
? Low-level officials took advantage of relaxed controls to engage in price
gouging, speculation, and fraud.
Although industrial production has slowed since July, Beijing remains
concerned with inflation, excessive investment spending, and the large
trade deficit. In major speeches in early 1986, Chinese leaders called for a
period of consolidation and adjustment in the reform program, and Premier
Zhao Ziyang stated in January that no major price reforms would be
implemented this year. Reform leaders emphasize that the readjustment
period will be temporary, and they have indicated that important reforms
are being contemplated for 1987. For this year, however, we look for the
Chinese to try to curb imports and expand exports; make more selective use
of foreign exchange reserves; increase incentives for grain production; and
emphasize efficiency, profitability, and specialization in industry.
Beijing's success in making these adjustments will have important implica-
tions for China's economic relations with the United States. Because of
China's large trade deficit and declining foreign exchange holdings, Beijing
will push hard for increased sales to the United States of oil, light
manufactures, and textiles. In addition, China may restrain domestic
consumption and try to increase exports of corn and soybeans to Japan,
South Korea, and the Soviet Union-making small, but noticeable inroads
into traditional markets for US grain. Planned restrictions on imports of
consumer durables and production lines that process foreign-supplied
components will probably have a greater impact on East Asian trading
partners than on the United States; the Chinese will continue to purchase
technologically advanced industrial equipment from US suppliers.
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To conserve foreign exchange, China has also decided to slow or postpone
major infrastructure projects-such as construction of a nuclear power
plant near Shanghai-for which US firms expected to compete. And
increased restrictions on the use of foreign exchange may make joint
ventures with China less attractive to US investors.
Finally, Beijing appears resigned to cover part of its expected trade deficit
with increased commercial borrowing from the world financial market. At
a meeting in March with US Embassy officers in Beijing, Chinese banking
officials stated that the government was willing to increase China's debt
service ratio from the current 5 to 7 percent to 15 percent by 1990-
implying that China might borrow more than $25 billion over the next five
years. Increased Chinese commercial borrowing would provide new oppor-
tunities for US banks to benefit from Beijing's opening to the West, as well
as greater competition for international investment funds.
The success of the economic adjustment period will also have important
implications for the political strength of the reform coalition. Reformers
are under pressure from party opponents to show better results from their
policies. When the extent of economic problems became evident last year,
tensions within the leadership rose quickly-with conservatives attacking
Deng Xiaoping and his supporters for excessively decentralizing economic
decision making and weakening the role of central planning. Reform
leaders acknowledged the economic problems, but defended the reforms
and pointed to significant gains during the year-such as an estimated 11-
to 12-percent increase in real GNP, an 8-percent jump in energy produc-
tion, and a sharp increase in government revenues that allowed Beijing to
record a budget surplus for the first time since 1978.
Conservatives thus were not able to exploit economic difficulties for
political gains, but the pace of reform, nevertheless, slowed sharply during
the latter part of the year. Popular disenchantment with the reform
program surfaced in the form of protests by university students and
grumbling about rising food prices. In our view, Beijing's greatest single
challenge will be to maintain price stability, if it is to keep the conserva-
tives at bay and implement further reforms in 1987.
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We believe there is a better-than-even chance that Beijing will be able to
slow economic growth and ease pressure on prices, thereby setting the stage
for reforms next year. But because Chinese leaders lack experience
managing a partially decentralized economy, and because pressures for
rapid growth exist throughout the country, we expect China will continue
to experience periods of excessive growth and inflation-followed by
government-induced retrenchment-as Beijing implements additional re-
forms. The fluctuations in China's economic growth, in turn, will impart a
"stop and go" character to Beijing's reform program during the next five
years.
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Shifting Patterns of Agricultural Production
1
Improved Budget Picture
4
Readjustment and Consolidation
8
A Report Card on Economic Reforms 11
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China's Economy in 1985:
A Test for Reform and
Reformers
China's economic performance in 1985 was driven by
the expanded economic reform program adopted by
the Central Committee in October 1984. Relaxed
central controls sparked significant gains in produc-
tion, but economic policy makers had difficulty steer-
ing the economy through the transition to a more
market-oriented system. Reform-related problems be-
came embroiled in the party and government debate
over the Seventh Five-Year Plan (for 1986-90}-the
draft of which was approved in April by China's
National People's Congress (NPC). Although the
draft reaffirmed China's commitment to economic
reform, Beijing has announced that 1986 will be a
year for consolidating and improving past policies.
Beijing's ability to reestablish economic stability this
year will play a key role in determining reform
policies for the rest of the plan period.
Figure 1
China: Grain Production,
1975-85
L___~
250 1975 76 77 78 79 80 81 82 83 84 85
Since the economic reforms were launched in 1979,
agriculture has been the centerpiece of Beijing's effort
to improve economic efficiency. Although agricultural
reforms are still the most important success of the
reform program-the gross value of agricultural out-
put increased at an average annual rate of 11 percent
from 1981 to 1984-growth rates fell in 1985. Ac-
cording to China's State Statistical Bureau, agricul-
tural output increased only 3 percent last year.'
After three consecutive years of record harvests, grain
output fell 7 percent in 1985 (see figure 1)-as a result
of reduced acreage, flood damage, and confusion over
reforms that eliminated grain quotas in favor of a
market-oriented contract system. Rapidly developing
rural industries also pulled peasants away from less
lucrative grain production.' Reform leaders maintain,
however, that surpluses from previous years will more
than make up for the shortfall.
Notwithstanding the smaller harvest, China became a
net grain exporter in 1985. According to Chinese
trade data, China exported over 9 million metric tons
of grain last year-almost triple the 1984 level.
Chinese grain imports were approximately 5.4 million
tons-with about 800,000 tons coming from the
United States (see figure 2).
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Figure 2
China: Imports of Grain,
by Source, 1977-85
Figure 3
China: Growth in Industrial Output,
1979-85
0 1979 80 81 82 83 84 85
25X1
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Efforts to diversify agricultural production were bol-
stered by officially sanctioned price hikes. Outputs of
sugarcane, peanuts, rapeseed, and sesame increased
by more than 25 percent last year, according to
Chinese press reports. Production of meat increased
by 14 percent, and eggs by 23 percent.
Overly Rapid Industrial Growth
China's industrial output increased 18 percent last
year, according to Chinese statistics, continuing a
trend of double-digit growth in industrial production
that began in 1983 (see figure 3). During the first half
of 1985, industrial output expanded at a 23-percent
annual rate, but efforts to cool the economy reduced
the growth rate to 10 percent in the fourth quarter'
(see figure 4).
Rural industry was the fastest growing sector of
China's economy for the second year in a row.
Chinese media reported that the output value of rural
factories shot up by 35 percent and accounted for
almost one third of total industrial production. In
light industry, buoyant consumer demand sustained a
boom in the production of electrical home appliances.
Output of washing machines, electric fans, and televi-
sion sets increased over 50 percent, and production of
refrigerators more than doubled. Production of build-
ing materials, heavy equipment, and machinery gen-
erally increased more than 15 percent during the year,
while production of rolled steel increased about 9
percent.
We believe, on the basis of incomplete statistical
evidence, that rapid industrial growth has been caused
by skyrocketing investment spending-up by 35 per-
cent in 1985-and a surge in wages and bonuses for
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Figure 4
China: Growth in Industrial Output,
by Quarters
tons. Recent gains in production have been the result
of policies that eased restrictions on private and
collective small-scale mining operations, that per-
mitted state mines to sell overquota production at free
market prices, and that rewarded workers for in-
creased productivity.
China produced about 2.5 million barrels of oil per
day (compared with 2.3 million in 1984), exporting
one-fourth of the total. Gains in oil production were a
result of new finds and improved recovery technol-
ogies. Increases in electric power generation came
largely from completion of new coal-fired facilities
and increased deliveries of coal to power plants.
Loosened central oversight of foreign trade and a
surge in investment and consumer spending led to a
flood of imports-up 54 percent last year, according
to our estimates based on partner trade data. Because
of the surge in domestic production, Chinese exports
increased by about 13 percent-leaving Beijing with a
1985 trade deficit of $6.9 billion.' Because of the
deficit, China's foreign exchange reserves fell by
almost one-third during 1985, and China devalued its
currency about 12 percent against the US dollar (from
Burgeoning Trade Deficit
ucts.
industrial workers. Successful rural reforms have
increased the availability of raw materials for indus-
trial use, while boosting rural incomes and fueling
consumer demand. Rapid industrial growth also has
been facilitated by industrial reforms, particularly
those allowing enterprises to sell overquota production
at prices above the state-set levels. To a lesser extent,
rapid growth last year may have been caused by the
technical modernization of some segments of Chinese
industry-such as steel, textiles, and electronic prod-
Significant Gains in Energy Production
China's production of both coal and electricity in-
creased about 8 percent last year, and oil output grew
9 percent.' China was the world's second-largest coal
producer in 1985, with output topping 850 million
2.8 yuan/dollar to 3.2 yuan/dollar).6
' Customs data reported by China's State Statistical Bureau show
exports increasing less than 5 percent last year, giving China a
trade deficit of $14.9 billion. The discrepancy between Chinese
customs data and partner trade data results, in part, from differ-
ences in accounting practices. First, China's customs data includes
the costs of insurance and freight in its import totals, and excludes
them from its export totals-which inflates the reported trade
deficit. Using International Monetary Fund methodology to ex-
clude the costs of insurance and freight from import values, China's 25X1
trade deficit would be $11.4 billion. Second, we believe that China
includes in its import totals payments for certain services-such as
training, blueprints, and royalties-that are related to capital goods
imports. This may inflate China's reported trade deficit by over $1
billion, relative to partner trade data. In our judgment, the
discrepancy between Chinese customs data and partner trade data
may also result from attempts by Chinese traders to circumvent
their customs service through smuggling, underreporting the value
of their exports, and overreporting the value of their imports.
6 China's currency is inconvertible. The State Administration of
Exchange Control (an organ of the central bank) adjusts its value
25X1
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Figure 5
China: Budget Deficits and Surpluses,
1977-85
R
-20 1977 78 79 80 81 82 83 84 85
Strong industrial growth, rising prices, and increased
tariffs on some imports pushed up government reve-
nues by over 24 percent in 1985, despite difficulties-
including widespread tax evasion-in implementing a
new tax system. The gains in revenue allowed Beijing
to record a budget surplus of 2.8 billion yuan ($880
million), the first since 1978 (see figure 5). Chinese
accounting practices, however, record government
bond sales and Ministry of Finance foreign exchange
borrowing from Chinese banks as revenue. As mea-
sured by Western standards, China's budget had a
deficit of about $2.7 billion dollars.
Although Chinese leaders tout rapid growth as an
indicator that industrial reforms are working, media
commentaries suggest that Beijing is concerned that a
continuation of the fast-paced expansion will exacer-
bate longstanding economic problems, heighten social
tensions, and undermine reform efforts. Despite the
sharp increases in production of coal, oil, and electric-
ity last year, energy supplies in China are strained.
Additions to the transportation network have not kept
pace with the growth in industrial output, and the
system remains seriously overburdened. Chinese me-
dia report that factories still must suspend production
frequently because of shortages of electricity and
delayed shipments of raw materials.
tion.
Chinese media reports also suggest that key reform
goals, such as improvements in industrial efficiency
and product quality, are being undermined by the
rapid growth. Beijing acknowledges that higher out-
put in some cases is caused not by efficiency gains but
by the use of large amounts of inputs. A Hong Kong
newspaper reported that losses by state-owned enter-
prises were up by over 9 percent during the first nine
months of last year. Press reports also suggest that
rapid growth is wearing out equipment at excessive
rates, increasing occupational hazards in factories,
and generating higher levels of environmental pollu-
in March 1986,
Premier Zhao Ziyang acknowledged that recent out-
put levels were possible only because China imported
large amounts of raw materials and industrial compo-
nents. Imports of rolled steel last year, for example,
were equivalent to one-half of China's total rolled
steel production, yet China's machinery industries 25X1
experienced shortages of rolled steel-as well as pig
iron, copper, zinc, and other raw materials-during 25X1
the year. We believe Beijing recognizes that its
industrial development cannot be based on imports of
raw materials and equipment, and that its foreign
exchange holdings cannot sustain such high rates of
growth. 25X1
When their accelerated reform program was approved
in 1984, reformers claimed that increased competition
between state-owned enterprises would spur improve-
ments in the quality of products. The shortages caused
by strong demands for consumer and investment
goods, however, have actually eased pressure on firms
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to maintain quality standards.
weakness" of China's economy.
Although output grew rapidly in 1985, it was not
sufficient to meet the demand for consumer durables,
industrial equipment, and building materials. China's
retail price index showed prices rising 8.8 percent,
triple the rate in 1984. Beijing probably is concerned
that rising prices will jeopardize popular support for
economic reforms. Although large increases in wages
and bonuses have cushioned the impact of -higher
prices for some consumers, a jump in retail food prices
caused widespread complaints among urban residents,
and the rising cost of living was a factor in protests by
university students last fall.
When the extent of the economic problems became
known last year, political tensions within the leader-
ship rose-with conservatives attacking reform lead-
ers for economic mismanagement. We believe that the
political strength of the reform coalition and the
increased economic sophistication of its leaders was
evident in Beijing's reaction to the economic problems
in 1985. Chinese leaders did not halt reforms and try
to dampen the overheated economy abruptly by reim-
posing strict administrative controls-as they might
have in the past. Instead, after industrial output
increased at a 23-percent annual rate during the first
quarter of 1985, they implemented a combination of
market-oriented macroeconomic adjustments and
state directives to slow the economy gradually.
China's 1985 budget, announced that April, called for
narrowing the budget deficit by slowing the growth of
government spending. In particular, Beijing ordered a
10-percent cut in administrative expenditures. Beijing
also began pursuing a tight money policy:
? In April, Beijing raised interest rates on time depos-
its and on loans for working funds. In August,
Beijing boosted rates on capital construction loans
and again hiked time deposit rates.
? Lacking an established secondary market for gov- 25X1
ernment securities, China's central bank cannot
conduct open market operations. Instead, Beijing 25X1
reduces the money supply by increasing sales of
goods from state-run stores. To soak up excess
currency, Beijing announced that it would use $2
billion in foreign exchange reserves to import scarce
consumer durables,' and the Ministry of Commerce
was ordered to mark down prices of overstocked
domestic commodities and increase sales to the
public. Banking authorities also made vigorous ef-
forts to collect savings deposits from households-
including mobile bank teams that went door to door.
To slow growth, Beijing ordered a halt in some capital
construction projects. Many other administrative con-
trols were employed through China's banking system:
? According to official statements, China's central
bank was ordered to set and enforce quarterly credit
limits for its branches and the specialized banks
(such as the Agricultural Bank and the Industrial
and Commercial Bank).
? Banks were ordered to stop offering loans to ineffi-
cient enterprises and to firms that produce poor-
quality products.
? Banks were prohibited from extending credit for
capital construction projects whose spending ex-
ceeds the state quota or for projects not listed in the
state plan.
? To prevent indiscriminate increases in wages and 25X1
bonuses, enterprises were required to place wage
funds in special accounts to be monitored by the
banks. Apparently, the payroll accounts of some
units were frozen.
' Although conclusive evidence is lacking, the $2 billion foreign
exchange set aside may have been announced, in part, to put a
better gloss on the surge in imports of consumer durables that was
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Western economists have been cautious about accept-
ing Chinese economic statistics at face value. Like
those of most developing countries, China's statistical
collection and measurement techniques are crude,
and economic data sometimes are deliberately dis-
torted at local levels. Our concerns with the reliabil-
ity of Chinese statistics have been heightened in the
past year by the very rapid industrial growth rates
reported by Beijing and by the sharp changes in
values of other economic indicators, such as the trade
balance and foreign exchange reserves.
Although we generally have confidence in gross pro-
duction statistics for individual products-particu-
larly in heavy industry-we believe recent figures
may overstate Chinese industrial performance for a
number of reasons:
? Enterprises increasingly purchase semifinished
goods and industrial components from other firms
rather than manufacture the inputs themselves, and
these transactions may be recorded in calculations
of overall industrial output.
? Although industrial output in urban areas is mea-
sured in constant prices, the output of rural indus-
tries is not adjusted for inflation.
? On occasion, production data may be exaggerated
by local officials and enterprise managers.
Nevertheless, we believe the economy grew at a very
rapid pace last year, albeit more slowly than Chinese
figures indicated.
Although industrial production has slowed since mid-
1985, statements by Chinese leaders at the recent
NPC suggest to us that Beijing remains very con-
cerned with inflation, excessive investment spending,
and its large trade deficit. We believe Beijing will
continue to tighten control over credit and capital
construction this year.
We also have noticed some anomalies in other eco-
nomic data released by Beijing:
? Cotton. Beijing implemented policies last year to
reduce cotton production, and China's State Statis-
tical Bureau reported a 33 percent drop in output.
On the basis of weather patterns and acreage
planted, however, we believe the actual decrease
was less than Beijing reported.
? Trade Balance. China's Customs Bureau and the
Ministry of Foreign Economic Relations and Trade
each publish an estimate of China's balance of
trade. The two estimates for 1985 differed by over
$7 billion (neither accorded with projections based
on partner trade data). Although each calculation is
based on different accounting methods, the differ-
ence between the estimates appears to have widened
more than can be explained by the growth in
China's trade.
? Foreign Exchange Reserves. Last year, Beijing ap-
parently changed the way it calculated foreign
exchange reserves to include its holdings of foreign
government securities. Although not officially ac-
knowledged by Beijing, the change does explain
why China's foreign exchange reserves appeared to
increase $1.7 billion between June and September
even though trade deficits (according to Chinese
customs figures) averaged about $1 billion a month
during the quarter.
In addition to macroeconomic problems, Beijing has
been confronted with rampant economic corruption,
with some of the worst cases caused by party officials.
Although Chinese leaders probably expected that an
increase in economic corruption would accompany a
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and the output of rural industries.
In our judgment, the reliability of Chinese statistics
may have been eroded somewhat by recent economic
decentralization, China's statistical reporting system
was set up to measure the performance of a planned
economy, but economic reforms have decreased the
portion of the economy operating under direct state
controls. Beijing may be having difficulties accurate-
ly recording and valuing outside-of-plan production
included in the totals.
We believe China's top officials probably do not
deliberately distort economic statistics. Beijing, how-
ever, is not above `packaging" data for political
purposes. For instance, last year Beijing announced
that the output of village industries would henceforth
be included in the total for gross value of industrial
output (GVIO), instead of in the total for gross value
of agricultural output (GVAO)-as had been the case.
When the 1985 State Statistical Communique was
released, however, the output totals presented first
were calculated according to the old system. Because
village industries were the most rapidly growing
sector in China's economy, their inclusion in the
GVAO statistic made agricultural and industrial
growth appear better balanced. In other press reports,
statistics for GVIO have been presented without
qualification as to whether village industries are
loosening of central controls, they may have been
startled by the extent of the problem. During the past
year, the Chinese media have reported numerous
examples of illegal price hikes, fraud, bribery, smug-
gling, and black market trading of foreign currencies.
Three of the most egregious cases uncovered by
Beijing were:
? The Hainan Island Case. Island authorities took
advantage of development policies that allowed
Notwithstanding the potential problems with Chinese
accounting methods, we report official statistics for
the following reasons:
? We believe Chinese leaders base decisions on the
official data that is released publicly. Although
leaders undoubtedly receive confidential reports on
economic performance, we believe the government
does not have a separate data set that is markedly
more accurate than the information released by the
State Statistical Bureau. Changes in the values of
official economic statistics often provide us a means
to predict accurately changes in Beijing's economic
policy.
? We believe growth rates give accurate qualitative
indicators of economic performance. For instance,
Chinese price indexes probably understate inflation,
but changes in the indexes may generally reflect the
inflation trend.
? Sometimes we are able to verify official statistics
indirectly. Reported gains in oil production, for
instance, correspond with increases in Chinese oil
exports (which can be verified from partner trade
data).
economic trends in China.
We believe official statistics, when interpreted with
some caution, provide a generally accurate picture of
tariff-free imports of some products to purchase
Japanese cars, television sets, and other consumer
durables and illegally resell them in the interior of
China. Before central authorities stepped in, Hai-
nan entities had arranged to import almost $1
billion worth of cars. On the basis of reports by the
Hong Kong media, we believe that broad elements
of the party, government, and military forces took
part in the scheme.
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? The Fake Medicine Case. In one prefecture in
Fujian Province, 45 enterprises manufactured coun-
terfeit brand-name medicines, which were marketed
throughout China. According to press reports, local
officials protected the counterfeiters for over two
years. The case was judged to be so serious that it
was mentioned in a major speech at a national party
conference in September 1985.
? The Liu Haoran Case. An itinerant ex-convict set
up a dummy trading company and, in less than six
months, signed fraudulent contracts worth 7.85
billion yuan (almost $2.5 billion) with Chinese orga-
nizations. Promising to deliver scarce goods in re-
turn for a down payment, Liu collected more than
19.7 million yuan (over $6 million).
Last year Beijing also combated a proliferation of
companies established by party and government
officials. Chinese media reported that these officials
used their influence to obtain goods in short supply
and reaped windfall profits by marking up prices. In
one case, local officials threatened a bank manager
with loss of party membership if he did not lend them
money for their company. Recently, the Hong Kong
press has reported that children of senior officials
have been involved in illegal dealings while managing
large Chinese trading companies
Party conservatives-with Politburo Standing Com-
mittee member Chen Yun the rallying point-took
advantage of economic problems to press Deng
Xiaoping to slow the pace and narrow the scope of
reforms. In May 1985, a party newspaper for intellec-
tuals published a series of articles that drew parallels
between the rapid growth China was experiencing and
the 1958-60 Great Leap Forward-which Chen had
opposed. Two months later, the party theoretical
journal published an incendiary article that praised
Chen's leadership of the economy in the 1940s and
1950s and disparaged current decisionmaking on eco-
nomic policy. Chen delivered a sharp public criticism
at a party conference in September, warning that the
fall in grain production threatened economic stability.
Chen also rebuked reformers on theoretical grounds,
arguing that "market regulation involves no planning,
blindly allowing supply and demand to determine
production ... planning is the essence of macroeco-
nomic control." In a broader sense, Chen's argument
implied that economic reforms were progressing too
rapidly and that there are limits on how far economic
decentralization can go without threatening social
disorder.
Although Deng was able to weather the storm-at the
September party conference, in fact, he was able to
make sweeping personnel changes that strengthened
his reform coalition-conservative criticism clearly
was a factor in the marked slowdown of the pace of
reform. Premier Zhao stated in January 1986 that no
major price reforms would be implemented this year,
and in his speech to the national party conference in
September 1985 suggested that Beijing might need a
two-year readjustment period to perfect macroeco-
nomic control techniques. Other leadership state-
ments and press reports indicate that through the end
of this year the Chinese will:
? Adjust agricultural policies to boost grain produc-
tion. Beijing will increase state investment in agri-
culture and make subsidized fertilizer and fuel
available to peasants who grow grain.
? Widen slightly the scope of managerial autonomy.
Firms that produce goods for export, for example,
will be encouraged to retain a portion of their
foreign exchange earnings for use in improving
production technology.
? Promote efficiency and profitability through spe-
cialization and interenterprise trade.
? Make minor price adjustments. Policies linking total
wage funds and enterprise profitability probably
will be delayed pending further price reforms.
We believe this period of adjustment will be smoother
than the 1979-80 cycle of reform and readjustment
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restore economic stability.
that led initially to a surge of imports, investment
spending, and inflation-and later to arbitrary can-
cellations of import contracts for industrial plants and
sharply reduced spending for important infrastructure
projects. First, central leaders are now more knowl-
edgeable about how China's economy operates and
what is economically feasible. Second, production of
agricultural, and light and heavy industrial products
is much better balanced than before, the government
has a budget surplus, and foreign exchange holdings
are much higher. Finally, Beijing can use indirect
economic levers, as well as administrative controls, to
Impediments to Future Stability
economic dislocations last year still exist.
Beijing's ability to reestablish economic stability in
1986 will weigh heavily in determining reform plans
for the rest of the decade. Managing an economy that
is being transformed from a centrally planned system
to one that mixes planning and market elements, is
difficult, however, and the factors responsible for
makes similar mistakes almost inevitable.
Policy Errors
Major sources of economic instability in 1985 were
the 50-percent increase in currency in circulation and
loans to industrial enterprises that were made in 1984.
In our view, the money supply surge was caused by
errors in the implementation of new banking reforms.
Although a period of consolidation may allow Beijing
time to plan the next steps in reform, the pragmatic,
trial-and-error nature of China's reform process
capital construction and wage payments.
One-Sided Enterprise Autonomy
Although managers have more flexibility in using
enterprise revenues, reforms have not progressed far
enough to allow market forces to discipline managers
who make poor choices. Beijing still subsidizes state
enterprises that lose money, and a working group was
formed only recently to draft bankruptcy legislation.
Until the industrial reform program is implemented
fully, a further relaxation of administrative controls
over enterprises probably will cause another surge in
Local Interests
Reports in national and provincial media suggest that
enormous pressure by workers, managers, and local
officials for rapid growth is a continuing source of
economic instability. Promotion of "10,000 yuan
households" by the media in 1984 and exhortations to
get rich through hard work have generated rising
expectations among workers for an improved standard
of living. Rising food prices have intensified worker
demands for raises, while the relaxation of state
controls over some enterprises has weakened the
ability of managers to resist them. Given years of
emphasis on meeting quantitative targets, many man-
agers still believe that they must prove their compe-
tence by rapidly expanding enterprise production.
Chinese leaders have made clear they will increase the
powers of the central bank and make greater use of
taxes to maintain economic stability while implement-
ing reforms. But because they lack experience in
managing a partially decentralized economy, and
because pressures for rapid growth exist throughout
the country, we expect China to experience periods of
rapid growth and inflation-followed by government-
induced retrenchment-as Beijing implements its re-
form program! The fluctuations in China's economic
growth, in turn, probably will impart a "stop and go"
character to Beijing's reform program during the next
five years.
Because of China's large overall trade deficit and
declining foreign exchange reserves, Beijing probably
will push hard for increased exports this year-
including greater sales to the United States of oil,
light manufactures, and textiles. China may restrain
domestic consumption and try to increase exports of
corn and soybeans-primarily to Japan, South Korea,
B The difficulty of managing China's economy is compounded
because the responsiveness of enterprises and consumers to econom-
ic levers probably is changing as the reforms proceed. 0
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and the Soviet Union. We believe China will continue
to make noticeable-but minor-inroads into tradi-
tional markets for US grain in 1986.
this year, Premier Zhao
indicated that Beijing will try to slow the growth of
imports while changing the composition of China's
purchases. According to Zhao, Beijing will strictly
control imports of consumer durables and production
lines that process foreign-supplied components. Re-
strictions already are in place for consumer durables
that China can produce domestically, including color
televisions, refrigerators, radios, and motor vehicles.
These restrictions will probably have a greater impact
on sales by East Asian trading partners than on sales
by the United States. Despite the lower harvest in
1985, grain reserves and increased production this
year probably will be sufficient to prevent Beijing
from increasing grain imports by much in 1986.
Beijing's ability to cut back overall imports is some-
what limited, however, by the continuing need for raw
materials and technologically advanced equipment for
Chinese industries.
Faced with the prospect of a trade deficit in 1986,
Beijing is attempting to be more selective in expend-
ing foreign exchange reserves. For instance, Beijing
apparently has decided to slow or postpone major
infrastructure projects-such as construction of a
nuclear power plant near Shanghai-for which US
firms expected to compete. Increased restrictions on
the use of foreign exchange may make joint ventures
with China less attractive to US investors.
Beijing seems resigned to covering part of the expect-
ed trade deficit with increased commercial borrowing
from the world financial market. At a March meeting
with US Embassy officers in Beijing, Chinese banking
officials stated that the government was willing to
increase China's debt service ratio from the current 5
to 7 percent to 15 percent by 1990-implying that
China could potentially borrow more than $25 billion
in the next five years.10 In 1985, China issued over
$800 million of foreign-currency-denominated bonds
for public subscription outside of China, and we
expect Beijing to step up these sales this year. In-
creased Chinese commercial borrowing will provide
new opportunities for US banks to benefit from
Beijing's opening to the West, as well as greater
competition for international investment funds.
In the long run, commercial opportunities for US
businesses are linked to Beijing's success in imple-
menting its ambitious reform program, and, therefore,
to its ability to prevent the instability that plagued the
economy last year. Prospects for increased US sales to
China are dependent to some extent on China's ability
to earn foreign exchange. Improved Chinese export
performance, however, ultimately must be achieved
through improvements in industrial efficiency elicited
from reforms of production and industrial manage-
ment systems. Controversial price reforms are neces-
sary to improve resource allocation in China and are
the keys to allowing China and its trading partners to
benefit from increased specialization according to
comparative advantage. 0 in March, Chi-
nese officials hinted that they eventually plan to make
China's currency freely convertible, and thus elimi-
nate foreign investors' concerns regarding repatriation
of profits. Beijing probably anticipates, however, that
currency convertibility can be allowed only after the
reform program has been implemented fully.
10 Some of the borrowing, of course, would be noncommercial
borrowing from international organizations and other governments.
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Appendix
A Report Card on Economic Reforms
The Third Plenum of the 12th Party Congress, which
met in October 1984, approved a general set of
guidelines for expanding China's economic reform
program to urban areas. During the first half of 1985,
Beijing announced initial steps toward price and wage
reforms, while promoting increased autonomy for
industrial enterprises. In 1985, Beijing also took a
major step toward commercializing agriculture. We
believe the economy has responded strongly to the
reforms, but not always in ways that Beijing antici-
pated.
Second-Stage Agricultural Reforms
Seven years ago Beijing introduced the "household
responsibility system," which gave peasant families
effective control, but not ownership, of farmland. The
system allowed peasants to lease land for a fixed
period-now 15 years for most uses-and gave them
leeway to manage the land as they wanted. Peasants,
in return, had to meet production quotas but could sell
overquota output to the state at premium prices. To
encourage greater production, in the spring of 1979
Beijing raised procurement prices of all major farm
products (but maintained retail prices at previous
levels)
The success of the reforms probably surprised
Beijing-grain production increased at an average
rate of over 6 percent per year from 1979 to 1984.
The agricultural policies, however, began to impose a
financial burden. Beijing had to lay out increasing
amounts of budget revenues to purchase the bumper
harvests, while produce rotted in overflowing state
granaries.
To reduce the financial burden of successful reforms,
Beijing implemented policies in 1985 that broadened
the influence of market forces on agriculture. Instead
of setting mandatory purchase quotas for peasants to
fulfill, the state now signs production contracts for
grain (and cotton) with individual farmers. The con-
tracted amounts generally are less than the previous
quotas, and peasants are expected to sell surplus
production on the free market. The state has dropped
its former commitment to purchase all overquota
production at a premium price, and will now purchase
excess grain only if the free market price falls below
the set procurement price. In addition, the state no
longer purchases nonstaple products such as vegeta-
bles, fruit, or meat-but state-owned marketing units
in cities are being encouraged to sign contracts with
peasants to improve supplies of nonstaples in urban
areas. Finally, rural industry is being promoted to
absorb some of the excess labor created by increasing-
ly efficient agricultural production.
Beijing hoped the new policies would promote the
development of a diversified agricultural sector and
encourage peasants to produce better quality products
and make more efficient use of land. The policies,
however, elicited a stronger response than Beijing
intended. Peasants were quick to switch to more
profitable crops, such as oilseeds and vegetables.
Strong consumer demand and readily available funds
spurred the development of rural industries. Accord-
ing to one Chinese journal, workers on average made
three times more in rural industries last year than in
traditional agricultural pursuits-and some peasants
left their land idle to take jobs in industry. We believe
that about 60 percent of the 1985 decrease in grain
production can be attributed to the new rural policies.
Reforms of Enterprise Management
China's reform leaders believe that granting enter-
prise managers increased decisionmaking autonomy is
the key to reducing the waste and inefficiency that
have traditionally plagued Chinese industry. On one
hand, Beijing is diminishing the scope of central
planning. Only about 60 major industrial products-
such as steel, petroleum, and chemicals-are to re-
main under mandatory state production quotas. Most
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goods eventually will be produced under "guidance"
plans that are set by the state but are flexible enough
to enable enterprises to adjust to changing market
conditions. Although individual managers will have
an element of choice under guidance planning, the
state intends to maintain overall compliance by ad-
justing economic levers such as enterprise taxes and
interest rates on loans. Some consumer items and
many agricultural products will be traded in essential-
ly open markets.
On the other hand, Beijing is attempting to reduce the
control of party and government officials over eco-
nomic decision making in factories. Enterprises now
retain a larger share of their revenues, and managers
have more leeway to develop production and market-
ing strategies and decide how to use retained earnings.
In 1984 enterprises were given the right to sell
overquota industrial production at prices above state-
set levels. Enterprises are encouraged to compete, and
managers increasingly are held accountable for losses.
Chinese media claim that output has increased mark-
edly in some factories in which managers have been
given enhanced decisionmaking authority. We believe
that the right to market overquota production has
been a particularly strong lever for increased efficien-
cy and production. Embassy and press reports, how-
ever, suggest that the implementation of increased
enterprise autonomy has been uneven. In many fac-
tories, party officials or higher administrative units
still make the important decisions. Moreover, when
managers have decisionmaking authority they are
sometimes hesitant to use it. For instance, managers
who have the right to fire unproductive workers
almost never do.
Price Reforms
China's price system is irrational in that prices of
many goods do not reflect relative market scarcities or
the costs of production. State-set prices have been
changed infrequently since the 1950s, and some goods
are piled up in inventories while others are in chronic
shortage. Within the next five years, Beijing plans to
establish a more rational, three-tiered price system.
Prices of key products, such as coal and steel, will still
be set by the state, but at levels that better reflect
relative scarcities in the economy. Prices of many
other products, including most manufactures, will
fluctuate in response to market conditions within
bounds set by the state. Supply and demand alone will
determine the prices of minor consumer goods-for
instance, some clothing products, cosmetics, and vege-
tables-and overquota production of most industrial
goods.
Beijing took a cautious approach to price reform in
1985. The key reform implemented was the removal
of controls on retail prices of vegetables, meat, and
other nonstaple farm products. Beijing also removed
price controls on sewing machines, watches, and some
brands of bicycles, and-to encourage greater use of
highway transport-raised short-haul railroad rates
for passengers and freight.
Although Chinese media report that the reforms have
prompted gains in efficiency, higher prices-particu-
larly for food-have sparked widespread complaints.
Because the planning system generally kept inflation
low in the past, consumers and Chinese leaders are
sensitive to price hikes. Reform leaders realize that if
they relaxed price controls on additional products the
current excessive demands for consumer and invest-
ment goods would boost the inflation rate, so they
have postponed major price reforms until after 1986.
Wage Reforms
Chinese reformers, recognizing that Maoist egalitari-
anism eroded labor productivity, are encouraging
enterprise managers to reward workers for superior
skills and performance. Last year, some industrial
enterprises, on a trial basis, were allowed to float their
total wage funds upward or downward on the basis of
the amount of profits earned and the amount of taxes
delivered to the state. In July 1985, Beijing an-
nounced a wage-reform package for teachers and
government workers in which wages are to be based
on the employee's position, seniority, and perfor-
mance.
Wage reforms ran into serious snags last year. Unau-
thorized across-the-board wage hikes for factory
workers contributed to inflation and undermined ef-
forts to link remuneration to performance. Wage
a
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reforms for teachers and government workers fell
almost a year behind the original timetable, delayed,
we believe, by budget concerns and resistance from
employees, who fear they will lose out if skills and
positions are rated over seniority as salary criteria.
tivity rose.
Reformers discovered that the policy of allowing an
enterprise's wage fund to float on the basis of profit-
ability was seriously flawed by China's irrational
price structure. Enterprises selling goods at high
state-set prices were able to make large profits in
1985, even if their efficiency was low, while enter-
prises required to sell goods at low state-set prices had
difficulty earning profits, even if their labor produc-
sation trade operations.
Foreign Trade Reforms
Beijing significantly reduced central control over for-
eign trade in 1984. City and provincial governments
were given greater authority to deal with foreign
firms, and Chinese foreign trade enterprises were
allowed to operate as commissioned agents for manu-
factures and importers of most products. Some of
China's key state enterprises were granted indepen-
dent authority to sign contracts for technological
transformation projects, joint ventures, and compen-
strictions on foreign exchange use.
We believe Beijing hoped the reforms would increase
the stake that Chinese enterprises have in the trade
process and thereby improve the timeliness and quali-
ty of imports and exports. The relaxed controls,
however, caused the trade balance to deteriorate
sharply last year, and competition among local trade
organizations caused a decline in the export prices of
some Chinese goods. Since April 1985, Beijing has
recentralized its trade apparatus and tightened re-
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