What Japan Can Learn From China's Reform Experience

Senior Fellow, RIETI

Since the end of the 1970s, China has taken the path of gradual reform with the aim of shifting from a planned economy to a market-oriented one. During this time, the performance of the Chinese economy, which has sustained high economic growth averaging 9% annually, has sharply contrasted with that of Japan, which fell into and has remained in a long period of stagnation since the 1990s. China's experience over the past 25 years suggests that steps such as proceeding in an orderly fashion from experimentation to full-fledged implementation, respecting vested interests to the greatest extent possible, and focusing on the creation of a new system rather than reforming the old one are effective as a reform strategy. These lessons should serve as a reference for Japan, which is currently undertaking its own structural reforms.

Fostering a new system rather than revamping the old regime

China's reforms have proceeded along the path of least resistance by refraining, as much as possible, from damaging vested interests. At the same time, authorities have repeatedly conducted experiments and taken their time to nurture markets and the non-state-owned enterprises that form their backbone. There may have been concerns that reforms would hit an impasse if they are implemented in order of easiness, since the most difficult tasks would have remained left over. However, as the new order takes shape, this issue can be overcome by having those who benefit from the reforms compensate those who are hurt by them.

The first characteristic of China's gradual style of reform is the sequence of steps that have been taken from its experimentation to its implementation. First, reforms are launched on an experimental basis in designated areas and companies. When they are successful, the reforms are introduced on a nationwide scale. For example, market-opening policies were first implemented at "points" - the four economic zones established in 1980, such as Shenzhen. They were then expanded to create a "line" - the coastal regions - and then to a whole "surface" that covered virtually the entire nation. As for corporate reforms, experimentation began in 1978 with the granting of autonomy to six state-owned enterprises in Sichuan Province. Since then, at every new stage of reform, such as the introduction of a contracting system and a stockholding system, authorities have experimented using a select group of firms. Not only does this keep the risk of failure at a minimum, it can also have a demonstrative effect on the old system if successful.

The other characteristic of China's gradual style of reform is the fashion in which the range covered by the new system expands step-by-step while at the same time preserving the old regime. During the transition toward a market-oriented economy, a planned economy and a market economy exist side by side for a long period of time in both the economic system at large and in each subsystem (corporations, price formation, trade, foreign exchange, etc), creating a two-tier structure (the so-called dual-track system). The coexistence of state-owned enterprises and non-state-owned companies, the double pricing for the same product (planned price and market price) and the dual exchange rate policy (different rates applied to state-owned enterprises and non-state-owned firms such as foreign affiliates) that existed until the end of 1993 are typical examples of this.

In order to implement economic reforms smoothly, benefits must be given to as many people as possible while keeping the number of people who suffer losses to a minimum. If compensation can be awarded in the form of income transfer from beneficiaries to victims, resistance to reforms can be reduced. For example, under the dual-track system of prices and foreign exchange, state-owned enterprises can obtain raw materials and hard currency at cheap planned-economy prices, even if they are traded at a higher price on the market. In this way, a system that guarantees vested interests is built into the dual-track system.

However, simply respecting vested interests and delaying reform of the old system will increase the risk of further economic decline and force authorities to implement radical reforms in the end. For gradual reforms to be successful, the growth of the new system must create conditions to reform the old system. In China's case, non-state-owned enterprises are in fact providing the conditions under which state-owned enterprises can be revamped. When market-opening reforms were launched, state-owned entities made up 80% of total industrial output, but that figure has fallen to below 30%, and the non-state-owned sector, comprising foreign firms and private companies, is becoming the main player in the Chinese economy. In this process, non-state-owned enterprises are not only providing new employment opportunities for workers who have lost their jobs as a result of reforms at state-owned enterprises, but also frequently purchase state-owned enterprises. In this way, the expanding new regime (non-state-owned enterprises and market economics) forms a sea that will eventually overwhelm the isolated island of the old regime.

Getting around the usual story of support "in theory but not in practice"

While China is achieving results through its reforms, the Japanese economy has entered a phase of maturity and remained in a long state of stagnation, especially after the start of the 1990s and collapse of the bubble economy. This is not simply due to cyclical factors. Much of it is the result of structural factors that have come about because reforms have been put off despite the fact that the various systems that have so far supported the Japanese economy no longer match the new environment, and Japan is being pressured to completely overhaul its systems. In order to respond to such demands, various proposals have been made, from the 1986 Maekawa Report to the "reforms without sanctuaries" advocated by Prime Minister Junichiro Koizumi. It appears that deregulation and the creation of an environment where competition principles work are the consensus in all of these reform proposals. However, it seems that reforms are seeing little progress because they are meeting resistance from vested interests when it comes to their planning and implementation. Even if everyone is aware that a wonderful world awaits them once reforms are carried out, there is a lack of analysis regarding what kind of path leads to the finish line.

Reforms are extremely difficult to implement in any country. Even if reforms do increase effectiveness and enlarge the overall economic pie, this does not ensure their implementation. This is because the benefits will not necessarily be distributed evenly and there will be people who benefit and those who will not. Owing to this, as the phrase "in theory but not in practice" goes, relevant parties may support the reforms in principle, but when it comes to specific issues, those who have something to lose will oppose them. This is the reason why structural reforms such as the privatization of the postal services and Japan Highway Public Corporation that the Koizumi administration is tackling are not proceeding as planned.

As this shows, while the "theory" is an argument based on the benefits of society as a whole, the "practice" of it are arguments based on partial benefits from the viewpoint of individual interest groups. While economists, who place priority on efficiency, always support reforms, there are many politicians who are passive toward change out of consideration of income distribution, including respect for vested interests. People who oppose reforms are criticized as being resistant forces, but when we consider that interest groups and the politicians who represent them are only acting, just like other economic players, to maximize their own interests based on institutions such as existing laws (in other words, the rules of the game), it is not necessarily appropriate to conclude that they are "bad."

Reforms that do not harm anyone and bring benefits to all are the easiest to implement because no one will object. These are called "Pareto Optimal" reforms, or reforms without pain. Therefore, it is not an exaggeration to say that respect for vested interests is a fundamental rule for carrying out reforms smoothly. Such respect may seem to be the enemy of economic reforms, but respecting vested interests and reforming the economy can be consistent with each other if those who are put at disadvantage through the reforms are compensated for their losses. While this can be done in a clear-cut manner through the state budget, it may also be achieved by making efforts to foster a new system while preserving the old regime.

China's experience shows us that in order to make reforms a success, the most important thing, from the strategic point of view, is to foster a new regime rather than break down the old one. Also, as in the case of China's non-public sector, even if the new regime is weak and imperfect in its fledgling stage, its potential for development should not be ignored. When applying these hints to Japan's reforms, we should turn our eyes to up-and-coming industries rather than mature ones, and venture businesses rather than major companies. In addition to this, more active use should be made of direct investment by foreign firms. The inflow of direct investment can invigorate the Japanese economy through the introduction of technology and business management know-how, development of job creation and skills, and the improvement of productivity and consumer benefit through increased competition.

On the other hand, as measures to reduce the opposition of vested interests, it would be effective to provide compensation for those affected. There are two ways of going about this - income transfer by such means as fiscal policy and income transfer through negotiations between relevant parties. In Japan, an example of the former would be the ¥6.01 trillion in agriculture-related outlays made in line with the liberalization of rice imports under the Uruguay Round of trade talks, while an example of the latter would be the early retirement programs adopted by some firms (following their alteration of the tacit contract of lifetime employment they had with their employees). Also, while there is debate over the need to stop the practice of "amakudari" - the rehiring of senior-level bureaucrats at private or quasi-governmental bodies - because it leads to collusion between administrators and the private sector, it would probably be more realistic to pay losers some form of compensation from state coffers should such a policy be implemented (the purchase of amakudari rights).

The distribution of public works spending (by project type or ministry of jurisdiction) in Japan's fiscal outlays is so inflexible that it may be called virtually fixed. This signifies that the protection of vested interests is built into the budget system. As a result, project allocations are always concentrated in traditional areas and there is no way to respond to the needs of the new era. To correct this, ideally, radical reforms should be pursued without paying any heed (so as to maximize efficiency) to existing budget frameworks (the status quo), but from the viewpoint of receptivity, it would be more realistic to implement gradual reforms that apportion as much as possible to new areas from the overall increase in the budget for general expenditures, while maintaining the budget scale of areas that should be downsized.

Up until now, reforms have not made headway in Japan because the government paid too much respect to vested interests. As a matter of fact, more than ¥100 trillion in public funds has been pumped into faltering industries one after another in the name of economic stimulus measures. The return on the nation's investments as a whole is increasingly worsening, while there has been no progress in the advancement of industry. What we should learn from China's experience is that while some form of protection of vested interests is inevitable, at the same time the fostering of a new system must be vigorously pursued.

January 27, 2004

January 27, 2004