Sun, Nov 06, 2016 - Page 6 News List

China’s incomplete contracts issue

By Andrew Sheng and Xiao Geng 沈聯濤,肖耿

This year’s Nobel Prize in Economics went to Harvard University’s Oliver Hart and the Massachusetts Institute of Technology’s Bengt Holmstrom for their pioneering work on the economics of property rights and contracts. At a time when China is attempting the difficult transition from a system of incomplete contracts to a strong property-rights regime, the real-world importance of these contributions could not be clearer.

No contract can specify every eventuality. So instead, contracts must spell out the allocation of “control” rights — who can make decisions in which circumstances. For a centrally planned economy attempting to allocate more authority to the market, such contracts are invaluable — at least at first.

This has not been lost on Chinese reformers. From the mid-1980s to the early 1990s, they introduced both the “rural household responsibility system” and the “enterprise contract responsibility system” for state-owned enterprises (SOEs). Those systems essentially delegated more decisionmaking rights, as well as certain profits, to farmers and workers, so that they had a stronger incentive to work more efficiently within state-owned communes and firms.

A similar approach was adopted in China’s 1994 fiscal reform to handle tax sharing between the central and local governments, with control rights relating to land and local economic development delegated to local officials, particularly at the municipal and county levels. This helped to advance development, although it also created space for local officials to take advantage of fringe benefits — a practice that later morphed into outright corruption.

More recently, the incomplete contract approach has also been used in the area of shadow banking. Regulators allowed innovations in incomplete contract-based financial intermediations, such as trust companies and Internet-based platforms, while maintaining tight control over the formal banking sector.

By defining partial rights to both decisionmaking and benefits, China’s leaders gave stakeholders incentives to compete efficiently with their peers, without giving up full authority. In that sense, these incomplete contracts laid the foundation for market-oriented competition in China, before it was possible — owing to institutional and ideological barriers — to achieve clearly defined private property rights.

However, while the incomplete contract approach was necessary during the transition to a market economy, it is not a long-term solution. More clearly defined and securely protected property rights, underpinned by an effective legal and judicial framework, are still needed. In fact, the loopholes in the incomplete contracts are undermining progress.

For example, one of the lingering issues of the rural household responsibility system was unclear property rights relating to farm land, which is still legally owned collectively by local farmers, even though land use rights were contracted to the individual households for 30 years.

Without privatization, farmers could not sell their land at market value for urban development, creating space for abuse and corruption, as well as social instability, particularly because urban and rural land values widened substantially during China’s high-growth period.

Likewise, the enterprise contract system failed to move the SOEs to sustained profitability. Unlike farmers, who did not borrow at all, SOEs borrowed heavily from state-owned banks. When they generated profits, the proceeds were shared with managers and employees.

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