China must move toward a market economy

In January, China's deputy prime minister Wu Bangguo (吳邦國) said that "to reform and build a market economy" is the PRC's policy, irrespective of whether China gets into the WTO or not. Now that the PRC is assured of WTO entry, the hard work of transforming China's socialist market economy into a free-market system must begin.

At the end of the day, if China is to develop real -- rather than pseudo -- capital markets, privatization is essential,which means a legal structure that protects private property and freedom of contract. As Zhao Zhijun, (趙紫陽) a member of the Economic Research Institute of the Chinese Academy of Social Sciences, has said, China needs to "create laws that protect the rights, interests and property of the private sector.

China has made significant progress since 1978 when it initiated its long march toward a market economy. Per capita income has increased more than fourfold, and millions of people have moved from the dying state sector to the vibrant private sector. But serious problems remain, especially in the financial services industry, where foreign competition has been narrowly limited.

The four large state banks continue to monopolize the allocation of scarce capital and restrict the flow of funds to the nonstate sector. Political factors, not profitability, largely determine who gets the funds. Indeed, state-owned enterprises (SOEs) receive more than two-thirds of the funds but account for less than one-third of industrial output value.

The inefficiency of SOEs has caused the state-owned banks to hold nonperforming loans totaling 25 percent or more of outstanding loans.

Recapitalizing the banks is not a panacea. Without institutional change and a hard budget constraint, the politicization of investment decision making will continue. Cheap credit will flow to favored SOEs that will waste scarce capital on low quality "pet"projects with little value to consumers.

Breaking up the large state banks might help increase efficiency if private owners specializing in risk taking and accountability for use of resources take the place of politically motivated state managers whose first loyalty is to the Chinese Communist Party (CCP).

Making asset values fully dependent on market forces and letting interest rates be freely determined would remove the last vestige of central planning and depoliticize the economy. These measures would end now rampant corruption and lay a sound basis for economic growth.

The party elders must know that privatization is the only logical way to change the incentives and the behavior of inefficient SOEs. But they also recognize that privatization would end the CCP as they know it. Thus, many party members are reluctant to sever ties with the old economy and jump into the sea of private enterprise. Yet, the new economy and global competition may force them to do just that.

It is not difficult to forecast that, with China's entry to the WTO, foreign competition will spur domestic competition and foster growth of the nonstate sector; freedom of choice will expand; alternatives to state provision will give people greater independence; and, as China becomes more open to the outside world and more liberal, the chances for peaceful interaction will increase and those for conflict diminish.

A modern economy requires the free flow of goods, services and ideas. China will have to allow greater freedom of expression and tolerate differences of opinion if it wants to be at the leading edge of the global economy. Pretending to create capital markets by debt-for-equity swaps, in which most of the shares are owned by the state, will not fool international investors.