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					“Market Economy, Hierarchy, and Single Party Rule:
How Does the Transition Path in China Shape the
Emerging Market Economy?”

Barry Naughton

International Economic Association, Hong Kong, January 14-15, 2004.

ABSTRACT: “Gradualist” transition strategies were intentionally adopted only by
governments in which control was maintained continuously by the Communist Party.
Early on, some argued that because of this, gradualist transitions would be incomplete,
and marked by slowed growth and market development in the long run. Instead, the
gradualist transition in China—as in Vietnam—has been thorough, but marked by the
survival of administrative hierarchies and Communist Party political control. The
administrative hierarchy was a relatively inexpensive and flexible institution that
substituted for more expensive specialized institutions adapted to developed market
economies. It has itself been adapted through phases of decentralization and re-
centralization, each with its own distinctive features, costs, and benefits. The emerging
market economy in China has been characterized by authoritative policy-making, which
has generally contributed to rapid growth, but also by insider privatization, deteriorating
income distribution, and continued uncertainty about the stability of property rights and
financial and legal institutions.

PRELIMINARY DRAFT of January 10, 2005: Please check with author for most recent

       The presence of an administrative hierarchy was an integral feature of the planned
(or “command”) economy. Today, in both China and Vietnam, although nearly all
transactions are carried out through the market, there is still an administrative hierarchy
that commands ultimate political, and in some respects economic, authority. In order to
survive, however, that hierarchy had to be adapted to dramatic changes in the overall
political and economic environment. In this paper, I organize some observations about
the nature of market transition around the simple fact of the continuity of an
administrative hierarchy. I use three building block ideas to gain perspective on three
larger questions: What does it mean that a continuously operating hierarchy has survived
in China and Vietnam? What changes had to be worked on the nature of that hierarchy to
keep it functioning in the dramatically different environment that emerged from
economic transition? And what difference does it make to post-transition society that this
hierarchy has adapted and survived? The first section covers the 1980s; and the second
section the 1993 through current period. The third section looks at SASAC as a specific
example of the hierarchical processes at work, and the fourth section concludes with six
suggestions of ways in which this perspective can help us understand contemporary
China and Vietnam.

       In the early phases of transition, everyone recognized that a command hierarchy
existed. “Big bang” transition strategies were adopted only when power at the top of the
hierarchy had been transferred, either by election or political collapse. In that case, new
leaders naturally destroyed as much of the old hierarchy as possible, because of its lack of
perceived political legitimacy, and because it was an obvious source of resistance and
opposition to change. Some observers argue that “big bang” transition were necessary
because the old hierarchies had collapsed. There is some truth to this, but the collapse of
the hierarchy was never the first stage in the “big bang” transition. Those hierarchies had
first been weakened by declining commitment from elites, drawn away by lack of belief
in the socialist system, and by alternative opportunities for individuals. Before Yeltsin
came Gorbachev. Gorbachev weakened the command hierarchy, intentionally and
unintentionally (Suraska). The experience in Russia leading up to the big bang showed

that when the strength of the incentives for individuals to comply and advance within the
hierarchy declined to a certain point, elite commitment to the hierarchical system
evaporated. In other words, there was a “tipping point.” Individuals began to “abandon
ship,” behavior changed; there was a scramble for assets; and the system collapsed with
remarkable speed. Nobody outside these systems anticipated such a remarkable outcome.
This observation sets the scene for the first of our three building block concepts: There is
a commitment problem among elites. As the option of personal enrichment becomes
more feasible along with the growth of the market economy, there must be some increase
in the overall level of incentives inside the hierarchy in order to sustain the same level of
commitment as before. Those incentives can either be career incentives or rewards for
specific performance. Gorbachev’s transition path did not provide either one, and so the
hierarchy collapsed.1

         The Chinese experience was essentially the opposite. China’s reforms during the
1980s were limited to the incremental changes feasible within the context of a continuing
hierarchy. In fact, this statement is too weak. Deng Xiaoping presided over a
rejuvenation of the hierarchy at a very early stage of transition, during the early 1980s.
He organized a comprehensive program to replace aging officials with younger, better
educated leaders, and selected a batch of fast track candidates, which included most of
the officials who have become the top leaders of China today. So, rejuvenation and
strengthening of the Party—and thus of the administrative hierarchy—came at an early
stage. Crucially, this meant that the career incentives within the Party-government
hierarchy were strengthened and were functioning reasonably well. Competent young
officials could anticipate promotion. Thus, Deng Xiaoping’s revitalization of the
administrative hierarchy meant that it was basically adequate for the next decade.

         The functions this hierarchy supervised, before reform, were wide-ranging.
Individual agents were also responsible for an extraordinarily broad range of activities
and outcomes. The Party managed everything, and therefore in practice agents had to

  Most readers will recognize that all three of these building block concepts come directly from multiple
task principal-agent models. See esp. Holmstrom and Milgrom.

respond to whatever specific commands came down from the center. They had to
balance many competing tasks and demands on their time. Agents were never rewarded
for achieving a specific task, because if they were agents might divert effort from other
important jobs and devote too much effort to that specific task. They were rewarded for
doing well everything they were told to do. They were employees, not contractors. This
is very much in line with pure incentive theory. Individual incentives were low powered.
This accorded with the socialist ideals of acting for the public good, but it was also an
efficient way of structuring incentives in a situation where agents had multiple tasks, and
there was little danger that they would be distracted from their jobs by the temptation of
any outside activities. Outside activities were easy to monitor under “transition despite
poverty.” If local economic development activities were successful, most agents were
implicitly required to turn over 100% of the surplus generated to higher levels of
government (with TVEs as an important exception even before reform).

         Again using the language of multi-task principal-agent analysis, once “economic
development” was adopted as the primary goal of the Communist Party, at the 3rd plenum,
one of the tasks became vastly more important than the others, and that was generating
local income. The economic environment was liberalized, so for the first time, there also
became an important danger that agents would direct their effort to “outside activities,”
i.e., to personal enrichment that bears no (or negative) relationship to local development.
In the earlier system, there had been relatively little problem with corruption simply
because monitoring of personal consumption was relatively easy.

         But the legitimation of economic development raised the problem of the
commitment of elites. How to make sure that local elites continued to be committed to
the common good of economic development?2 There are two complementary answers to
this question: the first has to do with the external environment in which income
generating activity could take place, and the second the incentives for compliance within
the hierarchy. Qian and Weingast have described the first well as “market-preserving

 Of course, part of the answer is that they aren’t, and that corruption is a serious problem. But at a
minimum the problem is contained enough to prevent economic development to go forward.

fiscal federalism,” including competition among jurisdictions in the presence of factor
mobility. This limited the supply elasticity of production factors (especially investment
capital), and made predation much more difficult. It aligned local official/s incentives
with the centrally mandated goal of economic development. The second answer is that
the administrative hierarchy was steadily “incentivized.” That is, local officials were
increasingly given high-powered marginal incentives to accomplish the core task of
economic development. Agents were turned into contractors who were allowed to keep
most of the increase in surplus generated in their locality.

        This brings us to our second building block. Agents managing multiple tasks
have a difficult job deciding where to allocate their effort. Incentives must be structured
in such a way that agents can balance the marginal return to effort in different activities,
in a way consistent with the preferences of the center. Among the different types of
incentives, the most important are career incentives and rewards for specific tasks. In the
case of China in the 1980s, overall career incentives were reasonably robust, as we’ve
argued above. “Incentivization” of the hierarchy meant rich specific task rewards for
improving income and profit in each locality.3

        The first phase of economic reform—from 1978 through about 1994—has
generally been characterized as one of decentralization (fangquan rangli). Many of the
important features of reform during this phase can be characterized simply and
parsimoniously. During this period, many levels of the hierarchy adopted incentive
contracts requiring a fixed payment and a low (including zero) marginal rate of taxation
on revenue (or surplus). Fixed payment incentive contracts provide high-powered
incentives on the margin; but require administratively complex formulae or negotiations
to set the fixed payment. In practice, Chinese reformers “grandfathered in” most agents:
their payments were set equal to the previous year’s payments. This gave them strong
incentives, shifted the economic system in the direction of marketization, and provided

  All of the important literature on this period is based on an understanding of the persistence of this
hierarchical structure. Blanchard and Shleifer make a special point of it in emphasizing that some kind of
central authority is necessary for market-preserving federalism to work. And Huang Yasheng has long
stressed the importance of central government oversight. These seem more like correctives to the various
popular wisdoms than criticisms of serious work, which is premised on some kind of hierarchical relations.

economic stability. Most of the other characteristics noted about the first phase of reform
can be deduced from this simple characteristic: the economy “grew out of the plan,”
(Naughton) it was a “reform without losers,” (Lau, Qian and Roland) reformers “played
to the provinces,” (Shirk) and power and resources shifted to lower levels.4

        Of course, a great deal of political and economic debate and competition took
place over the rules that governed what local agents could do with the resources they now
retained. The reform process gradually revealed important compromise solutions relating
to these rules: land was contracted to households in the countryside, and a “dual track”
price system was permitted in the cities. Still, what is perhaps most impressive, looking
backwards, is precisely how little rule change was required in the most critical areas of
the economy. The foundations of public ownership were unchanged. Bureaucratic lines
of subordination were weakened, but remained fundamentally unchanged. Agents were
permitted to benefit from successful investment of their local resources, but benefits
could only be indirect and position-dependent. Clearly, during the first decade of
Chinese reform, rebuilding the hierarchy, regularizing it, and above all, “incentivizing” it,
were effective in backstopping the economic transformation. The two great surprises of
the early phase of transition—and the fundamental core of debates about the transition—
were how far the hierarchy dependent, “gradualist” transition was able to go, and how
devastating the collapse of the Soviet hierarchy proved to be.

        But after this contrasting first step of transition, there were still many tasks to be
completed. How did the hierarchical system evolve next? Much of the Western
literature is shaped by the presumption that the objective of transition is obvious, that this
will mean a full market economy, the abolition of an administrative hierarchy, and the
creation of a democratic system. It seems so obvious that the Communist Party is
outdated, a relic of the past. Direct command and control relations will be replaced by
indirect market regulation; democracy replaces whatever systems of legitimacy regulated

 At one point in the late 1980s, explicit contracts specifying a fixed payment had been signed by most of
China’s farm households, over 80% of state-owned enterprises, all provinces, all provincial foreign trade
bureaux, and many, probably most, sub-provincial governments.

the hierarchical political system. But actual development is evolutionary, not teleological.
Our beliefs about where the system ought to go should not be allowed to obscure our
analysis of where the system actually is going.

       By the end of the 1980s, the Chinese system was trending towards something that
ultimately did not take place. We might call this a “Soft Bang.” If Zhao Ziyang had
maintained political control over the policy process, we might have seen something like
the following scenario: having separated government and party hierarchies, a fairly rapid
movement would have occurred to privatization, in waves and batches. There would
have been rapid progress, but also significant disruption and macroeconomic instability.
Insider privatization would have occurred in a situation in which China was still in the
very early stages of opening to foreign capital. Rapid creation of new interest groups
would have occurred, and legitimacy of new wealth would be called in question. But
given the foundations created by a decade of market reforms, there is no reason to believe
this would have been as disastrous as in the Soviet realm. Financial problems might have
been more tractable. In any case, this alternative reality can serve as a useful
counterpoint to what actually happened: China did not undergo either a Big Bang or a
Soft Bang.

       Instead, the hierarchy was used to perform new, economically productive tasks.
Frightened by the collapse of the Soviet party, and the deep divisions revealed in their
own system, Chinese leaders resolved to strengthen their own administrative hierarchy.
Important changes occurred in the structure of power at the top, and those changes led to
a more decisive and authoritative pattern of policy-making (Naughton; Yongnian Zheng).
In order for the hierarchy to perform the new functions required of it—indeed, in order to
survive at all—it had to be reshaped and adapted. In some respects, this was a
continuation of the 1980s pattern, because the hierarchy was constantly being reshaped;
but some new tasks were undertaken were new functions needed for a well-functioning
market economy.

       The mid-1990s turn-around in economic policy and reform strategy in China
affected nearly every aspect of policy. A significant recentralization of management and
regulatory power that enabled China to face a number of serious economic challenges,
and in most cases, overcome them. This change had extensive consequences for
corporate governance, foreign trade and investment, and fiscal and financial sector
reforms. The new policy regime achieved short-run financial and fiscal stability despite
numerous challenges, and laid the institutional foundation for diversification of
ownership and further reform, in particular through the Company Law. The implications
of this change for economic transition have been well described (Qian and Wu;
Naughton). Most of the existing accounts stress the shift in transition strategy and in the
governmental functions toward those of a regulatory state. Here, I look at it from the
standpoint of hierarchy. As part of the shift in strategy, the pervasive use of contracts
throughout the hierarchy was abandoned. “Incentivization” was dropped, in order to
move toward a level playing field in many areas.

       But at the same time, it is clear that the post-1994 reformulation of transition
strategy had a recentralizing component, and indeed that the shift in strategy could not
have been effected without substantial centralization. This is most strikingly evident in
trends of fiscal revenues in GDP. Not only did trends for overall fiscal revenue reverse
strikingly after 1995, but among fiscal revenues, the central government sharply
increased its share of initial revenue collections from just under 30% of total revenues to
significantly over 50% of total revenues. The central government thus sharply increased
its initial control over a steadily rising share of GDP. Moreover, the central government
clarified its control over most large enterprises, which, especially in the mid-1990s, were
much larger and more profitable than small enterprises. Between 1994 and 1997, small
and medium industrial enterprises, in the aggregate lost substantial sums of money, while
large enterprises in the aggregate earned around 60 billion yuan in profits annually (about
1% of GDP).

       How did Chinese leaders carry out a recentralization, while also foreswearing the
use of one of the most powerful task incentives they had (the contracting system)? There

are basically two answers to this question. First, they increased the strength and
predictability of the career incentives governing pay-offs to agents (i.e., to government
and Party officials at local levels). That is, they strengthened the Communist Party and
its control of the personnel system to provide clearer and direct links between overall
performance and political careers. The Communist Party was not the only instrument
that could have been used to achieve this outcome, but it was by far the most readily
available. Its choice was essentially one of short-run pragmatism, dictated by the needs
of a challenging, immediate situation. Second, they began to sharply redefine—and
generally narrow the scope—of the tasks that Party and government officials were
expected to perform. To put it simply, they began to move the hierarchy in the direction
of a “regulatory state.”5 This brings us to our third building block: When agents face
difficult trade-offs among multiple tasks, a fundamental way to manage the hierarchy is
to group together and separate tasks according to their incentive characteristics (i.e., are
the outcomes easily monitored, and what is the appropriate level of reward?).
Specialization and professionalization are desirable not just because they contribute to
accumulating skills, but also because they make it more feasible to adjust incentives to
appropriate levels.

         Strengthening career incentives, given Communist Party’s management of
personnel throughout the economy (and certainly in the government sector), was
equivalent to a strengthening of the Party’s role in economic personnel. Of course, this
was also inseparable from a re-assertion of the Party’s role in general. The general
direction of political reform in the 1980s—separating the Communist Party from direct
management of the economy (dangzheng fenkai and dangqi fenkai) was abandoned. The
Party’s indispensability in personnel management was re-emphasized, and a more
intrusive role for Party decision-making was legitimated. Consistent emphasis on the
Party’s direct role has continued with little or no interruption since the early 1990s, and

  It could also be argued that the center provided side-payments to local actors to purchase their compliance
with the changing rules. Side payments were made to ease adoption of specific centralizing policies.
Especially worthy of note are the agreements made to guarantee local governments they would not be made
worse off by fiscal reforms (Xu Shanda 2002); distribution of listing quotas on the stock market to each
province; permission to consolidate urban credit cooperatives into city-run commercial banks; etc. Some of
these side payments have significant economic consequences, but in general they are less important than
the division of responsibilities between center and locality.

arguably has been furthered by the recent (September 2004) Fourth Plenum of the 16th
Party Central Committee, which stressed the necessity of increasing the Party’s
governance capability. The center used a strengthened Communist Party to create a more
centralized hierarchical system.6

        The changes were evident throughout the political and economic system. A
significant change occurred in the relationship between central and local jobs. As Cheng
Li (2004) explains, advocacy of local interests by local leaders became increasingly overt
and legitimate, and regional representation in central Party congresses became
regularized and quantitatively more significant. At the same time, a series of norms
became institutionalized, that governed rotation among provinces of provincial Party
Secretaries and Governors, and set term limits and age limits. Finally, it became clear
that the path to ultimate power in Beijing led through the provinces: eight of the nine
Standing Committee members today had extensive provincial management experience,
rotating through a series of provincial posts before being brought back to Beijing. (Wen
Jiabao, the Premier, is the exception that proves the rule.) Whether these changes
strengthened or weakened local power vis-à-vis the center is debatable; what is
unambiguous is that they knit provincial personnel into a career ladder, the apex of which
is in Beijing. Moreover, the steps to promotion are reasonably well specified and
predictable (Bo 2004).

        Party personnel control was also strengthened with respect to the top management
of SOEs. As part of the transition to a regulatory state, the industrial ministries were
down-sized, and then generally abolished in 1998. The ministries, and their Party
committees, had previously appointed managerial personnel, creating career paths within
specific industrial systems that crossed lines between enterprises and functional
bureaucratic systems. With the ministries gone, how would this appointment power be

  Of course, the re-emphasis of the Party’s role coincided with dramatic changes in the character of the
Party itself. At the top, the power fragmented among revolutionary elders and next generation leaders
throughout the 1980s was reunited following the gradual passing of the revolutionary generation (Naughton
2001). At the bottom, the Party was drained of virtually all ideological content, abandoning any serious
commitment to social transformation, appointing itself instead the representative of “advanced social
forces.” These were important changes, but outside the scope of this paper.

exercised? During the 1998 administrative reform itself, Premier Zhu Rongji was able to
vest control of personnel appointment for the largest state firms in a government agency,
but subsequently most of the personnel power was brought directly back under the
Communist Party. The Central Committee’s Organization Department took charge of
appointments of large central enterprises, down to the vice-director level.

       Party reassertion was also evident in the specific reforms in the financial sector.
Most obviously, the Financial Work Small Group was an extraordinary Party body
created in 1998 to oversee the appointment of personnel in the re-organized banking
system. The Small Group (not to be confused with Leadership Small Groups) ensured
that the administrative recentralization of the banking system into regional banking
districts (to remove the banks’ subordination to provincial leaders) would be staffed in a
highly centralized fashion. In this way, it was made clear to whom the new regional bank
heads owed allegiance. It was the reassertion of latent central power through the Party
and personnel system that implemented the recentralization of the banking system
(Heilmann 2004). We will return to this point below.

       The second essential change was to narrow the scope of what the government
hierarchy tried to accomplish. This moved government (especially central government)
in the direction of the regulatory state, and de facto granted local governments increased
authority to manage their own economies, including permission to begin, at first
gradually, substantial privatization. The shift of transition strategy—and particularly the
implementation of the Company Law in 1995—began a gradual, incremental process by
which local agents are given increasing authority and “ownership” rights over public
assets. The Company Law provided a general legal framework that permitted sales of
stakes in state-owned companies; diversification of ownership stakes, even if all owners
were themselves state-owned entities; and distribution of ownership stakes to managers.
On the basis of this legal framework, the central government took a number of important
steps. The policy of “focusing on large firms, and letting small firms go [zhuada
fangxiao] amounted to almost a non-compete agreement with local governments. This

policy was gradually adopted in the mid-1990s, and formally ratified in 1997 at the 15th
Party Congress.


        Many of these issues of hierarchical control and definition of responsibility have
been played out in the creation and operations of a powerful new government body, the
State-Owned Assets Supervision and Administration Commission (SASAC). SASAC
was authorized at the 10th National People’s Congress in March 2003 and set up
operations in June. The mission of SASAC is to “fully realize [the government’s role as]
investor and owner [tixian chuziren daowei].” SASAC was mandated by the 16th Party
Congress in November 2002 to establish a “new state asset management system in which
authority, duty, and responsibilities are united, and in which management of assets,
personnel, and affairs is unified.”7 This mandate should mean that the SAC would
assume a combination of powers previously dispersed among different ministries and the
Communist Party. The “Implementing Regulations” of May 13, 2003, specified that
“rights and interests [quanyi]” are among the attributes of ownership that the State Asset
Commission is supposed to exercise.8 SASAC, then, is not a regulatory body. Quite the
contrary—the SASAC is designed to be a powerful and authoritative body that will
exercise ownership rights.
        SASAC is in a special position, relatively privileged and authoritative, and
reporting directly to the State Council. But it has no broader legal warrant. It is not part
of the government administration, being classed instead as a “special public non-profit
organization [tebie shiye danwei],” so that its establishment does not require approval by
the National People’s Congress. In fact, the NPC has been struggling to pass a law on
State Assets for over a decade, so far without result. The drafting committee was

  “Li Rongrong tan guoziwei jigou shezhi yu zhineng” (Li Rongrong discusses the creation of the State
Asset Commission structure and capabilities), Xinhuawang (New China net) (transcript of press
conference), May 22, 2003,
  PRC State Council, “Qiye guoyou zichan jiandu guanli zhanxing tiaolie” (Temporary regulations on the
supervision and management of state-owned enterprise assets), State Council Order 378, May 13, 2003,, hereafter referred to as “Implementing Regulations.”

reorganized in spring of 2004, presumably because of SASAC’s input.9 Without explicit
legal warrant, even the most important regulations coming out of SASAC are issued out
of the Director’s Office, but co-signed by the Minister of Finance.10
        In fact, SASAC lacks important pieces of most of its core ownership functions.
Although it theoretically enjoys all the privileges of ownership, it does not in fact harvest
any profits from the firms under its control. Its relationship with the Party authority is
amgibuous and problematic. Within SASAC, although the head, Li Rongrong, was
initially given unambiguously higher ranking than the Party Secretary, Li Yizhong, the
authority relations between the two seems less clear at present. Most important is the
division of authority of personnel decisions in subordinate enterprises, and this is
discussed in the following section.
        SASAC is extremely active in trying to ensure that the state gets full value for its
assets. It passed regulations on the transfer of state assets at the end of 2003 that are
designed to protect the interests of government owners, by making the transfer of assets
as transparent as possible.11 It has attempted to channel sales of government assets
through Property Rights Transactions Centers (chanquan jiaoyi zhongxin), initially three
such centers for national firms, but now expanding to regional centers as well. SASAC
promulgates a series of standards, rules, and procedures for the transfer of state assets.
Moreover, it reports significant activity. According to their most recent report, from
1998 through the end of 2003, the number of state-owned and state-controlled enterprises
(in all sectors) declined from 238,000 to 150,000. But SASAC is not a regulatory body,
so its status in passing standards and rules is not entirely clear. Fundamentally, SASAC
is simply providing guidance to the local-level SASACs that are engaging in state asset
        For its own firms, SASAC tries to maintain as much discretionary authority as
possible. Recently, SASAC posted an acknowledgement of problems in privatization

  Hu Yifan, “国资 10 年求法 [Ten Years of Trying to Pass a Law on State Assets]” Caijing, May 2003,
accessed at; Yi Lin, “非部门的立法尝试[The
Attempt to Establish Laws without a Departmental Sponsor], Caijing, April 2004, accessed at
   SASAC, “企业国有产权转让管理暂行办法 [Provisional Methods for the Transfer of Enterprise State-
owned Property]” December 31, 2003, accessed at
   SASAC, “Provisional Methods.”

combined with a defense of its work and the current system. Obviously a response to
Larry Lang and the recent public discussion about management buy-outs, the response is
interesting in what it does and doesn’t reveal.12 The document, like all of SASAC’s work,
uses lots of politically inoffensive circumlocutions, such as “gaizhi [改制]” and “adjust
the economic distribution of state ownership [调整国有经济布局], while also calling for
transparency and “sunlight.” But it always insists on the need for active, discretionary
interventions on the part of the state “owner”:
                 It is one-sided to interpret the “adjustment of state ownership’s
         distribution and structure” to mean that the larger the state share the better; and to
         only talk about “advance,” never “retreat;” but it is also not correct to interpret it
         as “the state withdraws as private ownership advances,” and to advocate “the
         withdrawal of the state economy from all competitive sectors,” to just talk about
         “retreat” and never “advance.” You have to fully understand the policies laid
         down by the center, uphold the idea that you have advance and retreat, there are
         things you do, as well as things you don’t do….You can’t “cut with a single
         knife,” and you can’t use administrative commands to carry out enterprise re-
         systeming (p. 3)

However, there is one area where SASAC is quite unambiguous, which is the dividing
line between central and locally owned enterprises. With the establishment of central
SASAC, local governments fully owned their enterprises for the first time. As of May
2004, only ten provincial level SASACs had been established, but according to SASAC’s
timetable, even municipalities and prefectures below the province level were to set up
local SASACs by September 2004.13 Provinces and cities scrambled to set up local
SASACs during the summer and fall 2004. Regardless of what progress is made on the
regulatory front, the establishment of a clear dividing line between firms owned by
different levels of government clearly gives local government enormous leeway in
continuing with a wide range of restructuring and privatization efforts.14

  “SASAC: Maintain the direction of State Enterprise Reform; Regularize and Advance the Reorganization
of SOES [国资委:坚持国企改革方向 规范推进国企改制]” September 29, 2004, at
   “The 189 Centrally controlled Enterprises will Become 100,” Caijing Shibao, May 2004 accessed at
   Central SASAC has always been careful to specify the firms under its direct control. Originally, a list of
196 was promulgated but this was reduced by mergers and specific circumstances to 189 by May 2004.
Reportedly, another twenty or so firms were being prepared for merger or acquisition, and the plan was to
continue to amalgamate the central firms to form 30-50 trans-national conglomerates, and 100 firms in total.

        In other words, SASAC has been unable to establish clear authority to exercise
the combined aspects of government ownership, as envisioned in its charter. It has not
been able to establish clear rules and principles for its own operation, nor for the process
of restructuring and privatization going on at local levels. In a sense, this failure by
SASAC parallels that of, for example, the China Securities Regulatory Commission
(CSRC) in imposing an unambiguous regulatory framework on circulating shares since
2001. Part of this failure is to do with the nature of the personnel process, to which we
now turn. The specific issues relating to SASAC involve the more general issues relating
to personnel power and career paths.

        When it was established, SASAC was assigned with the power to appoint and
remove the managerial staff in its supervised state enterprises. In the hope that new
personnel would bring in new management style, SASAC launched some campaigns to
recruit qualified professionals publicly from both domestic and abroad to upgrade the
overall managerial level. Improved compensation packages for executives have also been
provided in the hopes that high-level managerial staff will be dissuaded from inside deals.
But in fact SASAC has not achieved unambiguous control of the personnel appointment
process. In the first place, there are 46 central enterprises for which SASAC was unable
to wrest the personnel appointment power from the Politburo, and these undoubtedly are
the biggest and most important firms. Moreover, even when SASAC has and exercises
appointment power, it is unclear whether it is acting as an agent of the CP, or has some
kind of autonomous will. Even Li Yizhong recognizes this ambiguity:
        The current situation of Party building in central firms doesn’t fully correspond
        with the demands of the new situation…..We need to speed up our exploration of
        the paths and methods that can organically unify the principle that the party
        manages cadres, the party manages human resources, with the legal right of
        managers to employ people.15

“The 189 Centrally controlled Enterprises will Become 100,” Caijing Shibao, May 2004 accessed at

  Li Yizhong, 李毅中, “Realize the raising the Party’s governance capability in
enterprise party building [把提高党的执政能力体现到企业党建工作中],” August 2004,
accessed at

As mentioned in an earlier section, the strengthening and regularization of Communist
Party control over career paths has been a consistent feature of the post-1994 period in
China. Although SASACs at all levels nominally exercise personnel authority over their
subordinate enterprises, there is a strong likelihood that SASACs will serve simply as
channels for Party authority. Recent party decisions seem to have encouraged a new
model of the role of the Board of Directors. In this model, members of the Board will be
full-time appointees, without other posts. There will be limits on the number of senior
managers on the Board, and a clear line separating managerial personnel and other
Directors. By some accounts, the new Board of the Huijin Corporation, the holding
company that owns the Bank of China and Construction Bank, is a model of this kind of
structure. Newly appointed Board Members are said to have resigned from all other

           In fact, the Party’s control of this process is at least in tension with, and perhaps in
contradiction with, the Party’s simultaneous effort to centralize and regularize career
paths in the government as a whole. The Party increasingly seeks to rotate people
through a series of different types of positions, and different regions, as it promotes the
best people to higher rank. Rotation and avoidance have obvious benefits, in restraining
the growth of local interests, and keeping agents incentives aligned with the principal.
But for precisely that reason, career paths of this type make it crystal-clear to the
personnel being managed that their careers are being evaluated according to the complex
basket of objectives which are important to the Communist Party. Becoming the
representative of the owners’ interest will not have a large impact on corporate
governance if the “owner’s interest” continues to reflect the whole heterogeneous range
of political and social concerns that motivate the Communist Party.

     21 Shiji Jingji Baodao, September 2004.

Figure 1: Telecom Reshuffle
China Mobile      CEO Zhang Ligui         retired        CEO Wang Jianzhou
                  EVP Wang Xiaochu

China Telecom     CEO Zhou Deqiang        retired        CEO Wang Xiaochu
                  EVP Chang Xiaobing

China Unicom      CEO Wang Jianzhou                      CEO Chang Xiaobing
                  EVP Shang Bin                          President Shang Bin

       We see many examples of these cross-company career paths in China today. One
type was exemplified by a recent shuffle among top executives of the big three (state-run)
airlines in China. All three chiefs were retired at the same time, and new heads appointed,
sometimes from different airlines. Clearly, all three managers answer to the same
principal, and at the same time. Another type is the development of a political-financial
career path. Capable managers such as Liu Mingkang move from the Bank of China, to a
vice-governorship of Fujian, to the China Bank Regulatory Commission, and most
recently was rumored to be returning to a top provincial post. Several other prominent
examples from the financial sector could be named. At the same time, the heads of a
number of large state-owned companies are now members of the Central Committee of
the Party, almost on an ex officio basis (like the provincial leaders). This inter-weaving
of professionals from various sectors into a single national career path is deeply
embedded in the Party’s strategy for the current period. They are not isolated personnel
choices for particular challenges.
       From the enterprise standpoint, this type of ownership representation is unlikely
to be successful. Perhaps in cozy monopoly sectors, such a blending of company and
social goals in the manager’s objective functions would be acceptable. But in a highly
competitive environment marked by entry of private and foreign firms, such an approach
is simply not likely to succeed. The economic and political implications of a couple
score reorganized but not fundamentally restructured national corporations failing a
decade from now are not pleasant to contemplate.


        How does the reconstitution of a centralized hierarchy effect the economy of
China today? What difference, after it all, does it make to have a hierarchical political
and administrative system? In this final system, I suggest six ways in which the
persistence of the hierarchy shapes China’s contemporary economic trajectory.

        First, we need to take seriously the role of the Communist Party and the
hierarchical system in China’s economy, politics and society. As Communist Party
ideology has become hollowed out, there is a natural tendency to underestimate the role
of the party in other respects. This would be a mistake. Indeed, recent moves tend to
indicate a strengthening of direct Party management as a way to resolve ambiguities and
contradictions in the present system. On the positive side, the emphasis of the 2004
Fourth Plenum on the Party’s governance ability certainly indicates a willingness to move
forward in making Party personnel decisions somewhat more open, more competitive and
more professional.17 But this willingness seems to be coupled with a determination to
exercise Party control of the personnel process more directly and explicitly. The
resolution of the Fourth Plenum is couched in generalities, but it certainly seems to
envisage continued and strengthened Party control of the personnel process.18

        Second, there is a tension between job specialization, and stronger unified career
incentives. Recent evolution is toward a stronger unified Party-government hierarchy,
which weakens the development of separate specialized regulatory and management
functions. Specialization in administration is important because it builds skills, and it
creates functional differentiation that is an important underpinning to a modern economic
system. But in addition, specialization creates commitment by managerial groups to
particular, independent objectives appropriate to that group, which strongly supports the
necessary functional differentiation. Moreover, it permits the overall structure of

   Indeed, one observes in China a far greater willingness to acknowledge and discuss the Party’s role in
many decisions. We should be careful not to take the greater openness about the Party’s role for a more
important role for the Party. In fact, it appears that both are occurring simultaneously.
   Particularly in the final section, Article 9. Chinese Communist Party Central Committee, “Decision on
Strengthening the Construction of the Party’s Governance Ability,” September 19, 2004, Xinhua
September 26, 2004 report.

incentives to evolve in a way that allows high-powered incentives to be adopted for
important tasks, without worrying that effort will be drawn away from other, equally vital
tasks. This flexibility can be carried out either with stronger career paths (this is often the
solution for high-skilled regulators, who exercise significant discretion and can have high
morale), or powerful task-related rewards.

       As the Chinese system evolves and opens up, the hierarchy must evolve into
either stronger unified career incentives, or into stronger specialized career paths. One of
these needs to be implemented, because otherwise the diversion of managerial effort into
“outside activities” will undermine government and enterprise functions, and ultimately
economic growth. But there is a trade-off between them—you can’t do both
simultaneously—and the clear trend is toward unified control.
       Third, this unified system has its own logic, which is “political” as well as
managerial. The primary meaning of “political” in this context is that leaders making
personnel choices must be sensitive to their need to promote individuals who will be
supportive of their person and policies. In other words, personnel appointments must be
made by “patrons,” promoting their “clients.” This is inescapable because of the system
of “reciprocal accountability,” (Roeder, Shirk) in which government and Party elites
check and elect each other (but are not accountable to outside social forces). The logic of
the system may also be “political” in the sense that objectives other than profit
maximization enter objective functions.

       Fourth, the overly unified system tends to concentrate ultimate decision-making
authority at the top, in a single person. China has been remarkably effective at delegating
almost all economic decision-making into the hands of the Premier, keeping the Party
head in a consensus and approval role. This worked well in the early years of Zhu Rongji
(when the polity needed much more decisive decision-making), and in the early years of
Wen Jiabao, when he presided over an important rationalization of the government
structure. But this type of system leads to too many important decisions being made by a
single person, and no individual is capable enough to make all those decisions. For

example, how is macroeconomic policy decided in China today? It is too centralized and

       Fifth, the current system prevents the emergence of powerful national business
and financial groups. This has both good and bad sides. There will not be extremely
powerful oligarchs in China in the foreseeable future, not Khodorkhovskys to rise and fall.
Holding back the power of large national business groups is reminiscent of Taiwan’s
policy through the 70s. Guomindang suspicion of independent business power kept
Taiwan’s economy small-scale for decades. In Taiwan, extremely efficient markets
allowed small-scale firms to overcome most of the supposed limitations of their size; but
whether this will also be true in China is not certain.

       Sixth, finally, with the hierarchical system being used to perform so many
important functions, there is no clear path toward further democratization. Consultation
and checks and balances are being built into the authoritarian system, which is certainly
positive. However, it is difficult to see where the next stages of opening, capacity
building, and free competition will come from. And these are needed to move China to
the first rank of world economies.


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