Report No. 7267-CHA

ChinaRural Industry: Overview, Issues, and ProspectsMarch 1 1989

China Country DepartmentAsia Region

FOR OFFICIAL USE ONLY

Document of the World Bank

This document has a restricted distribution and may be used by recipientsonly in the performance of their official duties. Its contents may not otherwisebe disclosed without World Bank authorization.

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OPP,*, - # FOR OFFICIAL USE ONLYCHINA

RURAL INDUSTRY: OVERVIEW, ISSUES, AND PROSPECTS

Table of Contents

Page No.

SUMMARY AND CONCLUSIONS ............................................... i

I. BACKGROUND AND RECENT DEVELOPMENTS ............................. 1

China's Changing Strategy for Industrial Development. 1Evolving Patterns of Rural Industrialization. 3Institutional Framework. 4Different 'Models' of Local TVE Development. 7Recent Growth Performance .11Overall Dimensions of China's TVE Sector .14Conduct of Business and Market Interactions .19Industrial Structure ....................... .................. 21The Question of Relative Efficiency .24

II. MACROECONOMIC ISSUES AND INTERSECTORAL RELATIONSHIPS .26

Macroeconomic Impact .26Competition and Integration with State Industry .29Relationship with Agriculture .30Urbanization and Migration .33Foreign Economic Relations .34

1II. LEGAL AND REGULATORY FRAMEWORK .36

Legal Framework for TVP Business Activities. .36Regulatory Environment .38Treatment of Private Enterprises .40Discriminatory Treatment vis-a-vis the State Sector .41

This report, prepared by the World Bank, is based on a collaborative researchproject (RPO 674-05) between the World Bank and the Institute of Economics ofthe Chinese Academy of Social Sciences and other Chinese research institu-tions. The project involved in-depth fieldwork in four counties, each repre-senting a different level and pattern of rural industrial development inChina. As part of the project, survey data on a sample of 122 rural indus-trial firms, 1,174 employes, and 67 rural townships were collected andanalyzed. Aggregate statistics at county, provincial, and national levelsalso were utilized. The main research output of this project is a bookentitled China's Rural Industry: Structure, Development, and Reform (inprocess), from which many observations and ideas, contributed by Chinese andWorld Bank researchers, have been incorporated in this report. Two fieldworkmissions occurred as part of this project (in June-July 1986 and February-March 1987), for which the World Bank team consisted of the following persons:William Byrd (mission leader), Alan Gelb, Josephine Woo, Jan Svejnar (con-sultant), and Christine Wong (consultant). The Chinese research team for thisproject consisted of Lin Qingsong (team leader), He Jiacheng, Luo Xiaopeng, DuHaiyan, Du He, Gu Xiulin, Li Hanlin, Meng Xin, Song Lina, Wang Hansheng, WangTuoyu, Wang Xiaolu, Wu Quhui, Xu Xinxin, Yang Xiaodong, and Yang Xiaodong.Research assistance was providr l vy 7hu Ning, Hong Wei, and Liang Xuefeng.

This document has a restricted distribution and may be used by recipients only in the performanceof their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

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Page No.

IV. FINANCIAL ISSUES ............................................... 42

Current Situation and Problems ................................. 42Enhancing Capital Mobility ..................................... 43Enterprise and Community Risk Management ....................... 47Capital Structure of Larger PEs ................................ 48The Future Role and Structure of the Banking System ............ 49

V. INDUSTRIAL STRUCTURE, LOCATION PATTERNS, AND SUPPORTSERVICES .................................................... 51

Enterprise Size and Economies of Scale ......................... 51Community Industrial Structure and Subsectoral Composition ..... -3Technology ..................................................... 54Industrial Location and Spatial Patterns ....................... 55Industrial Support Services .................................... 56

VI. LABOR AND HUMAN RESOURCES ...................................... 59

Current Wage Practices and Labor Relations ..................... 59Workers' Role and Protection ................................... 60Wage/Incentive Systems and Pay Differentiation ................. 61Development of Rural Nonagricultural Labor Markets ............. 62Mobility and Nurture of Human Resources ........................ 63

VII. PROBLEMS OF BACKWARD AREAS ..................................... 66

Ameliorating Fiscal Predation .................................. 68Human Resource Development in Backward Areas ................... 69Greater Population Mobility and Rural Industrialization ........ 70

VIII. PROSPECTS FOR THE FUTURE: INSTITUTIONAL AND POLlCY ISSUES ...... 72

Fiscal Incentives Related to TVE Development ................... 73Future Role of Community Governments ........................... 74Community Orientation of CEs ................................... 75Role and Importance of Private Enterprises ..................... 75Diversified Ownership in the TVE Sector ........................ 76Legal and Regulatory Environment ............................... 77Competition and Market Structures .............................. 77Government Industrial Policies ................................. 79The Faciliteting Role of Government ............................ 79

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TABLES IN TEXT

1.1 TVE Ownership Structure in Four Counties, 1985 .................. 8

1.2 Growth Performance of TVE Sector, 1978-87 ....................... 12

1.3 Growth and Ownership Structure of TVE Gross IndustrialOutput Value, 1978-87 ........................................ 13

1.4 Composition of Rural Gross Output Value, 1978-87 .141.5 Structure of Rural Labor Force, 1978-87 .151.6 Ownership Structure of Chinese Industry, 1971-871 .171.7 Subsectoral Composition of GVIO, 1982 and 1985 .181.8 Capital Structure of Large TVEs ................................. 23

2.1 Bank Credit to TVCEs, 1980-87 ................................... 27

2.2 Use of TVCE Profits to Support Agriculture, 1978-87 ............. 32

5.1 Average Sise of TVCEs, 1980-87 .................................. 52

7.1 Economic Indicators ic rour Counties, 1985 ...................... 67

7.2 Economic Indicators !n Two Townships ............................ 67

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GLOSSARY

TVE - Township and village enterprise (including all kinds of rural non-agricultural firms, both private and community-owned)

CE - Community enterprise - TVE owned by a community government (town-ship, village, or producrion team)

PE - Private enterprise

TYCE - Township- or village-owned CE

TE - Township eiterprise

VE - Village enterprise

CG - Community government (township, village, or production team)

TG - Township government

TIC - Township industrial corporation

ABC - Agricultural Bank of China

RCC - Rural Credit Cooperative

PRS - Production responsibility system in agriculture

SE - State enterprise

CPE - Centrally planned economy

GVIO - Gross value of industrial output

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SUMMARY AND CONCLUSIONS

China's TVE Sector

1. The last decade has seen a tremendt,us growth of rural indtustrial andother nonagricultural activities in China, accompanied by large increases inrural personal incomes and major shifts in the structure of the rural laborforce (see Chapter I). Rural GVIO increased at over 231 p.a. in real terms in1978-86, while employment in rural nonagricultural activities (industry,construction, transport, and commerce) jumped by 1242 (or by over 30 millionpeople) during the same period.l/ Millions of new firms have beenestablished, new activities and technologies have become operative, and asizable group of industrial entrepreneurs, managers, technicians, and skilledworkers has emerged. China's TVE sector has become both an integral componentof the rural economy and the most dynamic, rapidly growing part of Chineseindustry.

2. Though China had achieved a certain degree of rural industrializationprior to the late 1970s, this is dwarfed by the burst of growth and develop-ment which has occurred since then. The Government's reversal of previousideological and political prohibitions against large-scale involvement innonagricultural activities by the rural population, starting in 1978, played acrucial facilitating role.2/ The production responsibility system (PRS) inagriculture (implemented in 1980-83) also was e- remely important because ittransformed hidden surplus labor under the old commune system into visiblesurplus labor, which generated great pressure to create new nonagriculturalemployment opportunities. In the more developed areas, the PRS preventedlocal labor supply conditions from constraining TVE development for a while(permitting annual growth of TVE GVIO of 30-100% for two or more years in arow). Rising rural incomes and sharp increases in credit provided to TVEs bythe banking system, along with TVEs' internal accumulation (generated in partby concessional tax treatment) were able to finance the rapid expansion of thesector. Perhaps most important, the release of human energies and talents in

1/ This figure is based on China's official labor force statistics, whichappear to underestimate the number of people involved in part-time orseasonal off-farm actJvities and those employed by very small firms.The total number of nonagricultural TVE employees including part-timeand seasonal workers rose from 22 million in 1978 to 77 million in1986, an increase of 55 million.

2/ The prereform emphasis on "division of labor' between urban and ruralareas, with the former engaging in industry and other nonagriculturalactivities and the latter forced to specialize in agriculture (withemphasis on grain production), created an institutional and policyenvironment generally inimical to rapid TVE development. Only the fewareas where local government eubverted national policies (like southernJiangsu Province) achieved a reasonable degree of success in ruralindustrialization before the late 19709.

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China's rural population brought on by rural reforms was extraordinary, withits most dramatic manifestations in the burgeoning TVE sector. In thiscontext, the progressive liberalization of Government policy toward ruralprivate enterprises (PEs) was most helpful.

3. Dramatic changes in rural policies and institutions unleashed the TVEsector on the supply side, but the demand side also played a critical role.The state sector had left numerous "vacuums", where it did not meet existingdemand, providing an opening for TVEs. Rising personal incomes in both urbanand rural areas generated strong new demand for many consumer goods (as wellas for building materials for rural housing). Enterprise reforms, whichallowed firms to procure inputs outside the plan, also generated considerabledemand for many goods that could be produced by TV'Es. High investment demandthroughout the economy meant more opportunittes for TVEs. In responding todemand from all these sources, the TVE sector generally seems to have beenquiCKer and more flexible than state enterprises (SEs).

4. The institutional structure of China's TVE sector is intimatelylinked with the three-level system of rural community governance structures inplace since the late 1950s (the township, the village, and the productionteam). Chinese rural communities are characterized by fixed memberships (dueto population immobility), various forms of income-sharing within the commu-nity, and a considerable degree of financial self-reliance in external rela-tionships. Community governments (CGs) at the township level functior- in manyways like "mini-states", and they also serve as profit-oriented businessentities supervising community-owned TVEs (CEs). In the prereform period, allTVEs were owned by CGs (mainly townships and villages); this "traditional"form of ownership survives and remains entrenched in some parts of the countrywhere it has achieved great successes. Since the early 1980s, private formsof TVE ownership have emerged, ranging from individual proprietorships topartnerships to a tiny handful of genuinely "cooperative" firms and to jointvent-,res among different types of entities. There is thus considerable diver-sity in ownership structure, along with great variation across localities inthe relative importance of different types of enterprises as well as inpolicies adopted by local governments and CGs.

5. TVEs are characterized by great dynamism (rapid growth, ability totake advantage of opportunities, and flexible adjustment), competitivenessvis-a-vis the state sector, "hard budget constraints" (at the community levelif not always at the enterprise level), diversity in institutional arrange-ments and development models, outward orientation in terms of product markets(with respect to the locality the producer operates in), and strong localcommunity ties (through community ownership as well as other linkages). Manycharacteristics of the TVE sector appear to have been conducive to its rapidgrowth and development since the late 1970s. The outward orientation of TVEstoward product markets seems to have been crucial in this respect, along withrelatively "hard" budget constraints for CGs. The interaction with CG fiscalincentives and local employment needs generated a potent stimulus for nonagri-cultural development in virtually all localities and communities (though ruralindustrialization did not succeed everywhere).

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6. Despite their impressive recent growth performan-ce, TVEs facenumerous problems. Though these have not prevented the TVE sector fromgrowing extremely rapidly so far, they may become a more serious hindrance inthe future.

7. As in the Chinese economy as a whole, factor mobility in the TVFsector is limited. This is a source of rigidity which may not be so importantif output, investment, and employment are all growing very fast. But asgrowth slows, and as diffusion and adaptation of relativelv advanced techno-iuies and practices become more important determinants of TVE perrormance,immobility could become an increasing handicap. A major cause of factor immo-bility, as well as a problem area in its own right, is the weak legal frame-work governing TVE activities. Though much codification has taken place inrecent years, enforcement of laws and adjudication of cases are stillproblematic.

8. The TVE sector is now facing increasingly severe competiti- andmarket saturation in many industries. Though in part merely reflecting marketadjustment, this does result in numerous investment failures and financialproblems. Problems of backward, inefficient technology and poor productquality plague TVEs in many localities. In some industries, TVEs' ability tocompete in changing circumstances may be hindered by continuing small firmsizes--due mainly to the strong community orientation of enterprises combinedwith factor immobility. Still another weakness is the inadequate network ofsupport services for rural industrialization. This mirrors the neglect of theservice sector in the Chinese economy as a whole, but it could well be agreater problem for the TVE sector since self-provision is less feasible forsmall firms. Scattered, dispersed locstion patterns for TVEs may be asignificant source of static inefficiency at present, and may become anincreasingly severe problem in the future. Like the limitations on firm size,these are largely the result of community orientation, which dictates that thebulk of TVEs are located in their home communities, and factor immobility.

9. Though the role of %Gs has been highly beneficial in some regionswhere TVE development has prospered, i.s many of the more backward areas CGshave been a hindrance. Given their own tight resource constraints and thelack of other sources of funds to tap, CGs in backward areas may make exces-sive levies on their CEs, which the latter are for.ced to financd through addi-tional borrowing from local banks or drawing on their depreciation funds.This makes it harder for TVE development to get off the ground. Due to unevenendowments, particularly of human resources, and factor immmobility, spatialpatterns of TVE development have been highly uneven. To some extent this is anatural consequence of rapid growth in the TVE sector cverall, but spatialimbalances are more oE a problem than they might be in many other countriesbecause the population of the poorer localities is not permitted to leave themen masse. Finally, remaining ambiguities and discrimination in the treatmentof private firms may still be a significant problem.

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The Need for an Improved Legal and Regulatory Framework

10. TVEs suffer from the inadequate 'egal framework that characterizesthe Chinese economy as a whole, and from an unstable, sometimes discriminatoryregulatory system (Chapter III). Though a great deal of business and economiclegislation has been promulgated during the past several years (including acontract law, a bankruptcy law for SEs, a state enterprise law, and others),enforcement and adjudication still appear to be somewhat uneven, with apparentbiases against "outsiders" in legal cases handled by local economic courts(which are organs of county governments). There are also indications thatTVEs, and within the TVE sector PEs, are sometimes discriminated against bythe legal and regulatory systems. The community orientation of TVEs may inlarge part be due to the inadequate legal framework and poor treatment ofoutsiders, rather than to any inherent "community consciousness" in China'srural population.

11. Though additional legislation is needed in some spheres, furthercodification will not solve problems of inadequate enforcement and unevenadjudication. In this respect, one option would be to move toward enforcementand adjudication mechanisms that cut across localities and communities, atleast for legal disputes between economic entities from diZferent communitiesand localities. Traditional methods might for some time to come continue tobe used in disputes within communities. To improve the regulatory environmentof the TVE sector, greater separation of the regulatory and ownershipfunctions of government agencies would be desirable (indeed, this is a criti-cal aspect of Chinese economic reforms as a whole). As in the case of thelegal framework, it would make sense for regulatory functions to be carriedout at a level of government higher than that of enterprise ownership (e.g. atthe provincial level for regulation of the TVE sector). In addition, greatersimplicity and transparency in regulatory processes is needed.

12. A better legal and regulatory framework may require new governmentinstitutions of certain kinds, like court systems that cut across localities.Alternatively, it may be possible to strengthen and improve existing institu-tions like the Industrial and Commercial Administration Bureaus so that theycan provide adequate recourse in cross-community and cross-locality disputees.Evenhanded treatment of economic disputes that cut across localities andregions is an important part of the Government's efforts to foster free inter-locality trade and a unified national market. Finally, the temptation toestablish a ministry or similar government agency to provide administrativesupport and supervision for the TVE sector should be avoided. One of the mainreasons behind the successful performance of TVEs may well be their lack ofpowerful "mothers-in-law", so to create such an entity would be counterproduc-tive.

Ownership and Institutional Structure

13. China's TVE sector is characterized by diverse, evolving patterns ofownership combined with a cor.tinuing strong community orientation (see ChapterI). The "traditional" system from the prereform period, based on ownershipand supervision of TVEs by township and village governments, has been highlysuccessful in a few of the better-off areas like southern Jiangsu Province.

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Where entrenched, it appears to have considerable staying power. On the otherhand, in many parts of the country wholesale privatization uf the traditionalCE sector has occurred in various forms (contracting and leasing of firms toindividuals, outright sales, abandonment of failing CEs, etc.). In theseareas (often the poorer, more backward ones), due to difficult conditions thetraditional system never got well-established in the prereform period, andexisting CE assets were often divided or sold off when the PRS wasimplemented. New enterprise creation and incremental growth come largely fromthe private sector. In still other parts of the country like southernGuangdong Province, a diverse, multi-level ownership pattern has emerged, withnumerous joint ventures among different entities adding to the diversity.

14. Diversity of ownership in the TVE sector has more advantages thandisadvantages, and there is no need to impose uniformity (Chapter VIII).However, strengthening and clarification of the property rights of owners(whatever kinds of entities these may be) with respect to their firms would bedesirable. Evenhanded treatment of different forms of ownership by the legaland regulatory systems also is needed (Chapter III). In particular, anyremaining discriminatton against PEs should be reduced to the extent possible.At the same time, the ownership rights of communities in CEs that are under-going various forms of privatization should be recognized and appropriatelyrecompensed.

15. Fiscal incentives have played a major role in promoting TVE indus-trial growth. While these linKages will likely weaken over time, as part ofthe separation of regulatory from fiscal functions in CGs, it is important toensure that CGs and their officials continue to have adequate incentives topromote TVE development. In this context, the uniform nationwide pay scalefor township leaders may be counterproductive given the great differences inaverage per-capita income levels across regions and localities (in the mostdeveloped rural areas, a township leadet's base pay is lower than that of anordinary TVE worker). To enhance their incentives, abolition of the uniformnationwide pay scale for township leaders could be considered, along withdevelopment of appropriate performance-related bonus systems geared to localconditions and needs.

Capital Mobility 3/

16. Immobility of capital leads to inefficiency in resource allocation,but more important it hinders the rapid growth of successful TVEs and therebythe attainment of larger firm sizes where this is desirable. There is a needto facilitate movements of capital to the investment opportunities withhighest returns, within localities. But capital flows across provinces andregions raise complex issues because of the continuing immobility of otherfactors. For example, large outflows of funds from the backward areas to earnhigher returns in more developed localities would further exacerbato theproblems of the former.

3/ Options for enhancing capital mobi'.ity in the TVE sector are discussedin a-re detail in Chapter IV.

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17. In addition to encouraging greater capital flows within the ruralbanking system, one possible way to enhance local capital mobility and improvethe efficiency of investment would be through emergence of new financialinstitutions in rural areas. These could improve the provision of financialservices to TVEs and ,enerate competition with the existing state-owned (butat lower levels largely community-oriented) banking system. To realize thebenefits from greater institutional diversity, many of the new institutionsshould cut across community/locality lines (up to now, most of them appear tobe community-based). Some financial institutions could be structured as jointventures among different CGs and local governments. Cross-community jointventures among TVEs are another possible means of concentrating scatteredrural capital and directing it to high-return uses.

18. Still another possible option for enhancing capital mobility is forwell-performing rural communities to issue financial instruments to attractcapital and spread risk. These "income bonds" could involve a combination offixed and variable, profit-related returns and could be marketed through thebanking system. Secondary trading could emerge gradually over time, andincome bonds could eventually evolve into more equity-like instruments. Sincethere is no international experience and little past Chinese experience toprovide guidance on how well the income bond concept would work in practice,and moreover massive, possibly destabilizing flows of capital across regionsand provinces should be avoided in the short run, experimentation with incomebonds probably should start on a small scale, in a few of the more advancedareas.

Capitalization of Large Private Enterprises

19. Many iarge PEs depend heavily on bank credit, and property rightswith respect to firm equity are still vague and ambiguous (founders' originalcontributions are typically "repaid" once the enterprise is financiallyviable). While private property rights need to be further strengthened andclarified, these firms' capital structure could be improved by allowing banksto make nonvoting equity investments in larger PEs (Chapter IV) This wouldrequire a change in orientation and practices on the part of the rural bankingsystem, and it wouJ4 also require careful monitoring and regulation ofemerging linvestmer banking" practices. The increased risk from equityparticipation shoul be manageable because this would occur only in the caseof larger, rapidly growing, and successful PEs. Bank equity participationwould allow communities to reap a larger portion of the returns from theactivities of PEs that they now finance through credit, enhance PEs' ac:ess tobank funds, and partially socialize their ownership in a way that shouldpreserve the incentives and autonomy of private proprietors.

The Need for More Concentrated Location Patterns

20. The strong community orientation of China's TVE sector has resultedin highly dispersed location patterns, with factories dotting the countrysidein many areas (see Chapter V). As a result, infrastructure is costly or isinadequately provided; it is harder for a dense network of services to emergebecause of scattered clients; advantages of "economies of agglomeration" are

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largely lost; transport costs are high; wasteful patterns of land use arepervasive, in particular occupation and pollution of high-yield agriculturalland; and more generally, industrial pollution is spread widely in thecountryside, with consequent difficulties and high costs for pollutioncontrol. Since the root cause of dispersed location patterns is the communityorientation of the TVE sector, any solutions to this problem must address thefirm-community nexus. But a more efficient location structure is urgentlyneeded in the short tun and cannot await gradual weakening of community orien-tation over time.

21. One possilble option for promoting more concentrated location patternsis for local government authorities at county or higher levels to estRblish'industrial parks" at which all types of TVEs could set up operations. Thesewould not be under the jurisdiction of any particular rural community, andwould offer (on a fully costed basis) infrastructure, public utilities, andservices for TVEs which locate there. International experience indicates thatthere are numerous pitfalls to be avoided if the industrial park concept is towork well; most such schemes in other countries have not been very successful.Thus industrial parks need to be well thought-out and carefully designed, andin the Chinese context particular care would need to be taken in determiningpolicies toward movement of people into them. Moreover, the attractions oflocating in industrial parks should if possible be complemented by measures todiscourage location of firms in the old dispersed manner. Appropriate land-use and land-conversion fees, cost-based utility charges, and meaningfulpollution control standards and pollution fees might help encourage relocationto industrial parks.

Support Services for TVEs

22. The network of services supporting rural industrialization(commercial. financial, 4-ansport, and technical, among others) is for themost part inadequate (Chapte- V). This reflects similar problems in Chineseindustry as a whole and in the et-tire economic system, but the problems forTVEs are exacerbated by (1) their relative lack of access to services providedby state institutions and (2) the greater need of small firms like TVEs forspecialized services (since it is herder for them to engage in self-provision). The focus on gross value of industrial and agricultural output asa performance indicator may have resulted in relative neglect of opportunitiesin the service sector by CGs. Price distottions also may have been important,and the community orientation of the TVE sector and inadequate legal frameworkmost likely have played a role.

23. Part of the solution is to improve the access of TVEs to existingurban, state-oriented service institutions, which is already beginning tooccur as the latter become more profit-oriented. This does not mean thatlarge government programs for provision of support services to TVEs should beestablished. On the one hand, TVEs should pay the full cost of any servicesthey obtain from government institutions, while on the other, these agenciesshould not take advantage of their monopoly position or administrative powerto gouge the TVE sector. The critical need is for development of industrialsupport services within the TVE sector itself, on a profit-oriented, commer-

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cially viable basis. This is not only essential for the healthy futuredevelopment of rural industry, but it can also be an important source ofgrowth and employment in its own right. Many services are most efficientlyprovided by small firms, so they represent a great opportunity for the TVEsector.

24. Among the measures which might help encourage rapid development ofTVE services are (a) greater freedom for professionals and skilled workers toleave their firms and set up their own service businesses;4/ (b) greaterconcentration in TVE location patterns, which would also concentrate demandfor services; (c) improvements in the legal and regulatory environment for PEs(since the relative importance of services is greater for them); and (4)shifting the evaluation of CG and local government leaders by higher levelsfrom a narrow focus on production to a broader assessment of local economicdevelopment, with an appropriate emphasis on services.

The Role of Workers

25. Lower labor costs and better labor motivation are among the mostimportant sources of TVEs' competitive advantages vis-a-vis SEs (Chapter VI).Though TVE workers play virtually no role in firm-level decisionmaking, theyare members of the rural communities to which most sizeable TVEs belong.Moreover, nearly universal use of performance-based wage systems (piece rates,firm-level workpoints, bonuses, year-end "dividends", etc.), combined withgreater ease of firing poor performers, provide potent incentives for hardwork and long hours. Smooth labor relations in the TVE sector are facilitatedby its community orientation and by the fact that most workers are "firstgeneration" and have spent at most a few years outside of agriculture.

26. As the community orientation of the TVE sector weakens over time, asin at least some areas more and more workers are hired from outside the commu-nity (often on a short-term basis), and as the TVE labor force becomes moreaware of its group interests, this largely beneficial pattern may change.Carefully designed institutional and policy measures will be needed to preventa possible deterioration in labor relations from becoming a drag on the effi-ciency and growth of the TVE sector in the future. Regardless of how the roleof workers and labor relations evolve in the future, basic legislationdelineating acceptable labor practices in the TVE sector would be desirable.This should not be overly restrictive, but it would be helpful both inprotecting workers and in protecting employers (especially privateproprietors) from arbitrary charges of "exploitation". These regulationswould have to be widely perceived as appropriate and fair, and they would needto be backed up by meaningful sanctions and an enforcement mechanism.

4/ This could also have some negative effects, like reduced identificationwith firms by these personnel, weaker incentives for TVEs to providetraining for their employees, and sharply rising wage levels as aresult of competition among enterprises for highly-qualified personnel.Nevertheless, the benefits most probably outweigh these costs.

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Improving Prospects for Backward Areas 5/

27. The degree of spatial inequality in rural incomes, economic develop-ment, and industrialization is considered a problem by many in China. This iscaused mainly by the combination of highly uneven endowments of human andother resources and immobility of population and other factors of production.Problems of backward areas are exacerbated by the "fiscal predation" many CGsengage in, which sucks resources away from local TVEs and alienates thebanking system. Redistribution through the national fiscal system is signifi-cant but does not address the fundamental causes of uneven development. More-over, "aid" from higher levels of government is often wasted or mainly goes tofinance local government and CG payrolls.

28. The counterproductive role of CGs in many backward areas needs to bechanged. A two-pronged approach can be envisioned, including major reductionsin the size of local and community governments in backward areas and, aftercareful evaluation, financing some key public and social services through thestate budget (rather than with CG extrabudgetary funds as at present). Thesemeasures would reduce the need for fiscal predation by easing the constraintson CGs in backward areas. Certain other actions at the local level also mayhelp ameliorate fiscal predation, but these are unlikely to work well unlessthe resource squeeze on CGs is reduced.

29. Augmenting the human resource base in backward areas could helpstimulate rural industrialization in them. This can be furthered by trainingand other measures to improve the quality of the indigenous human resourcebase (though a serious "brain drain" may arise), as well as by establishmentof a regulatory and policy environment conducive to an inflow of theseresources from elsewhere. Attracting outside entrepreneurs, who can thenbring in the other skills needed to organize production and marketing success-fully, is crucial. Though international experience suggests that it is verydifficult to promote regional development in backward areas where it has notoccurred spontaneously, the strongest possible efforts have to made in thisdirection (in ways that are not costly to the Government), as long as popula-tion and labor remain largely immobile. How3ver, over the longer term,considerable exit of population from the backward areas may be the only meansof pulling up their average income levels and bringing labor force into linewith local resource base.

Labor Markets and Mobility

30. One of the most difficult issues for the future faced by the TVEsector (and indeed by the Chinese economy as a whole) is the extent to whichopen labor markets should emerge and there should be freer mobility of laborand population (see Chapter VI). Mobility of 'high-quality human resources"(entrepreneurs, managers, engineers, marketing personnel, technically skilledworkers, etc.) is a highly effective means of diffusing technology, bestmanagement and other practices, and industrial experier.Ze throughout theeconomy. Thus the costs of immobility of this kind of labor are very high.

5/ See Chapter VII for more details.

i~~~~~~~~~~~~~~

On the other hand, large-scale population movements generate substantialshort- and medium-term social costs, particularly if they involve excessivemigration into large cities.

31. Chinese reality may dictate sul)stantial restrictions against massivepermanent movements of population and ordinary labor into major urban centersor from poor to rich rural areas, at least in the short run. But large-scale"temporary" movements of workers (t-'thout their families) are already occur-ring, in some ways reminiscent of the "guest-worker" phenomenon in Europe.This at least temporarily provides employment and income to people from back-ward areas. It also helps check the rise in labor costs in the more advancedareas, and provides on-the-job training and experience, which augments thehuman capital of backward areas if the temporary laborers return home. Thelong-term impl_cations are still unclear, however, particularly whether thesemigrants will return home or eventually will view themselves as permanentresidents of the localities they work in. Even if mobility of population endordinary labor remain restricted, measures to increase the mobility of high-quality human resources may improve efficiency and growth prospects in the TVEsector.

The Evolving Role of TVEs in the Chinese Economy

32. The future role and share of the TVE sector in the Chinese economydepends on many hard-to-predict factors. But from all indications, its impor-tance will continue to grow over the short and medium term. TVEs representthe only hope for achieving the Government's ambitious goals for shifting alarge part of the rural population from agriculture to nonagricultural activi-ties over the next several decades, and for transforming the countrysidethrough "urbanization in small towns". Great hope is also invested in the TVEsector as a future generator of exports and export earnings. More generally,competition from the TVE sector may well serve as a potent source of pressureto stimulate the state-owned industrial sector to reform itself and improveefficiency.

33. The TVE sector will need to further evolve and develop if it is tocontinue to be a highly dynamic "leading sector' in the economy, pErticularlyif urban reforms are successful in drastically improving the efficiency andcompetitiveness of the state sector (see Chapter VIII). The barriers againstreasonably large firm size in the TVE sector will have to be overcome, butthis can only occur gradually as institutional, administrative, and otherconstraints are removed over time. As part of this process, the communityorientation of larger TVEs will need to weaken, and oGs should gradually sepa-rate their local government/fiscal functions from their corporate businessdevelopment role. Diversified ownership patterns may be appropriate forlarger TVEs. Closer and more organic forms of integration with state industrymay become more and more desirable, even necessary, for smaller TVEs. The TVEsector will likely continue to be characterized by a great deal of localvariation and, for some time to come, experimentation.

34. The future development of the TVE sector does not call for massiveGovernaent support, financial or otherwise, or for large new goverument agen-

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cies, major, costly new programs, or detailed administrative regulation andpromotion. Nevertheless, the role of government will be crucial in somerespects. More important than any positive measures to support the TVE sector(though some of these may be called for) is the need to avoid policies andrestrictions which do major harm to TVEs, based on the mistaken notion thatTVEs are sources of problems elsewhere in the economy.61 The TVE sectorshould not be made a scapegoat for the problems of Chinese agriculture,serious as these may be; fundamental solutions must lie in agriculturalpolicies and reforms. Similarly, TVEs should not be held back becausecompetition from them is rmaking life harder for many SEs; obviously it isnecessary to move toward a "level playing field" on which enterprises of alltypes can compete with each other on an equal basis, but this should beaccomplished by freeing restrictions on other sectors rather than by tighterrestrictions on TVEs. Finally, the TVE sector is not the main source ofmacroeconomic instability in the Chinese economy; hence it should not bedisproportionately affected by any credit squeezes or other restrictivemacroeconomic policies to deal with "overheating" of the aconomy. The long-term prospects for the TVE sector are bright, as long as it is allowed tocontinue to develop, evolve, and adapt to the changing economic andinstitutional structure of the Chinese economy.

6/ Macroeconomic issues and intersectoral relationships involving the TVEsector are discussed in detail in Chapter II.

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I. BACKGROUND AND RECENT DEVELOPMENTS

1.1 This chapter will first briefly review China's overall industrialdevelopment strategy as it has evolved during the past several decades, aswell as changing patterns of rural industrialization. Then it will look atthe institutional framework within which the TVE sector functions, particu-larly the organizational structure of rural communities. The impressiverecent growth performance of the sector will be described, and the ove-alldimensions of the TVE sector in terms of output, employment, income, and otherrelated aspects will be outlined. The conduct of business in TVEs and thecharacteristics of markets they face will also be discussed. Finally, thechapter will look at salient features of the industrial structure of the TVEsector and at its changing role in Chinese industry as a whole.

China's Changing Strategy for Industrial Development

1.2 Prereform industrialization. Between the late 1950s and the late1970s, a distinctive pattern of industrialization took shape in China, basedon an evolving industrial strategy and a unique combination of institutional,demographic, political, and ideological constraints. Chinese industry on theeve of reforms was characterized by problems and weaknesses that in manyrespects resembled those of other centrally planned economies (CPEs). Butthere were some important differences, which in part explain subsequentdevelopments and in particular the extraordinarily rapid growth of ruralindustry since the late 1970s.

1.3 China's prereform industrial policies and industrialization strategyvery much followed the Soviet model. Industrialization relied on a very highinvestment rate (often over 30Z of GDP), with most industrial investmentfinanced through the government budget. Heavy industry, particularly basicgoods like steel, was emphasized at the expense of light industry and consumergoods production. Production, resource allocation, and investment were allsubject to planning and administrative direction, exercised through a hierar-chical system of industrial administration based on ministries and bureaus,and backed up by state ownership of all sizeable industrial firms. Enter-prises had little autonomy in business decisionmaking, and all of theirprofits were turned over to the government.

1.4 But industrialization in China departed from the Soviet model inimportant respects even before the late 1970s, and evolved its own distinctcharacteristics. These differences were related to China's initially very lowlevel of development, its huge rural population still at a low level of sub-sistence and relying primarily on agriculture, transport and other bottleneckswhich fragmented the domestic market, and elements of Maoist ideology andeconomic strdtegy. Among the most striking deviations from the Soviet modelwere (a) elimination of material incentives (no bonuses for workers, no profitretention by enterprises); (b) a much cruder and less comprehensive planningapparatus; (c) a territorially decentralized system of industrial administra-tion, with even large enterprises nominally "reporting to" provinces andmunicipalities rather than the center; (d) similar partial administrativedecentralization of planning and control over goods allocation; (e) a tendencytoward provincial and even local self-sufficiency and autarchy; (f) immobility

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of population, enforced through the household registration system and ration-ing of basic consumer goods in urban areas; and (g) a clearcut "division oflabor' between urban and rural areas, with the latter largely prevented fromengaging in nonagricultural activities, particularly industry.

1.5 There was also an important regional dimension in China's prereformincustrialization strategy. Each province was supposed to develop its own'complete industrial system". Massive investments in industrial developmentwere made by the central government in some of the interior provinces. Thiswas motivated partly by military considerations, partly by the ideology ofprovincial and local "self-sufficiency" in industry. High-cost and oftenhighly capital-intensive state-owned industrial firms were nurtured in thecities of interior provinces. This generated a more balanced pattern ofindustrial growth across provinces, but at very high cost.

1.6 These features greatly affected the pattern of industrialization inChina. In addition to vertical insulation between ministries, there was agreat deal of horizontal insulation between provinces and localities. Theseparation between city and countryside brought about a sharp polarizationbetween the urban and rural population. The former were guaranteed employ-ment, for the most part in the state sector, and were entitled to a comprehen-sive set of subsidies and benefits, whereas the latter were not, had lost thebulk of their productive assets (land and implements), and were largelyprohibited from engaging in nonagricultural activities. This resulted in adualistic economic structure, with urban areas engaging in capital-intensiveindustrialization while hidden surplus agricultural labor accumulated in therural areas with very little outlet. Overall, inefficiency and waste werepervasive, and growth was generated primarily by the high investment raterather than by improvements in factor productivity.

1.7 Changes since the late 1970s. China's industrial landscape haschanged dramatically as a result of reforms, but the legacy from the prereformperiod is still evident in many spheres. Bonuses for w%.rkers and profitretention for enterprises were reinstated relatively early (the former in 1978and the latter, for most large enterprises, by 1980). Markets have becomeincreasingly important in the distribution of industrial goods. In contrastwith the past predominance of state ownership, a variety of different owner-ship forms (including collective and community ownership, partnerships, indi-vidual proprietorships, and joint ventures among different types of firms) nowflourish. But perhaps most important from the perspective of this report,China's rural population is now allowed, even encouraged to move into nonagri-cultural activities, as a means of soaking up surplus labor from agricultureand augmenting personal incomes. As a result of this fundamental change inorientation, there has been an explosion of rural industrial development.Industry in the countryside has now reached the point where it is an importantdeterminant of the overall pace of China's industrial development andinteracts in complex ways with urban industry.

1.8 A strong element of continuity is the immobility of China's popula-tion and labor force, despite some loosening in the system at the margins.Thus there is still considerable separation between administratively designa-ted urban and rural areas, even though many of the latter are industrializingand urbanizing (without the traditional urban privileges and subsidies) at a

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rapid pace. Territorial decentralization of the industrial administrationsystem has been carried even further than in the prereform period, withoutcompletely freeing enterprises from local control. Except in the privatesector (where the bulk of firms are still relatively small) every Chineseindustrial enterprise still reports to a government supervisory body, usuallyan industrial bureau. Finally, "investment hunger" continues to pervade thesystem, and the aggregate investment rate has climbed to near 40Z in the lasttwo years.

1.9 It is this combination of change and continuity which has generatedChina's current industrial structure, strategy, and policies. Unlike what hasoccurred in some developing countries, massive migration tc the large citiesand consequent social problems have been avoided. The burst of rural indus-trialization has been at least in part the result of administrative rigiditieswhich prevent the population from leaving rural areas. The continuing insula-tion between many facets of the urban and rural economies also partly explainswhy the inefficient urban/state industrial sector has only slowly been"awakening" in response to competition from rural industry. Despite nearly adecade of reforms, state enterprises (SEs) still face great obstacles intrying to improve efficiency and instill dynamism in their activities.

Evolving Patterns of Rural Industrialization

1.10 Rural industrialization in China before the late 19709 occurred in anadministrative straitjacket, albeit one which was loosened on occasion. Thepressures of surplus agricultural labor and the desires of the country'sleaders to promote rapid industrialization led to several "waves" of ruralindustrial development. One occurred as part of the Great Leap Forward move-ment of 1958 and was a disastrous failure. The bulk of rural factories andworkshops created at that time were shut down in the early 1960s. A secondwave of rural industrialization occurred as part of the campaign to promoteagricultural mechanization launched in 1970. It resulted in rapid ruralindustrial growth, but only in some parts of the country, like southernJiangsu Province, and in the peripheries of large cities. Though rural areasin principle were only allowed to develop industries directly supporting agri-culture (e.g. agricultural machinery and fertilizer), some of them moved intcmore profitable activities, ranging from machine building to subcontractingparts and products for urban factories. This prereform rural industrialdevelopment laid the foundation for a subsequent "take-off' in the lowerYangtse valley (Shanghai environs, southern Jiangsu, northern Zhejiang), itthe Pearl River delta, and in a few other rural areas with conditions condu-cive to industrialization (proximity to urban markets, technology, and infor-mation, a rich agricultural base, a core of entrepreneurs and skilled workers,etc.). In the prereform period, rural industrialization occurred entirely onthe basis of community government (CG) ownership of firms.

1.11 Since the late 1970s, China's rural industrialization strategy anddevelopment patterns have undergone a remarkable transformation, much greaterthan the corresponding changes in the urban industrial sector. Ideologicaland political prohibitions against rural nonagricultural activities were

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erased starting in 1978.1/ Moreover, private industrial and other nonagricul-tural activities are now permitted, even encouraged. Most recently, in 1987limits on the size of private firms (a ceiling of seven non-householdemployees) were formally lifted. As a result, new patterns and "models" ofrural industrialization have arisen. The production responsibility system inagriculture (PRS) transformed hidden surplus labor under the old communesystem into visible surplus labor, which generated great pressure to createnonagricultural employment opportunities and may have facilitated theemergence of new, private forms of ownership. The PRS also eased local laborsupply constraints in some of the most rapidly growing areas. Rural industryhas thrived by taking advantage of the increased scope for market activitiesand the slower response of the state sector to new opportunities. It also hasbenefitted from tax advantages and, since 1984, enhanced access to credit fromthe state banking system. But the underlying institutional structure retainsmany features from the prereform period.

Institutional Framework

1.12 China's rural economy since the late 1950s has been organized under aframework of rural community governance structures, linked to higher levels ofgovernment primarily through the Communist Party hierarchy. Recent reformshave changed this pattern somewhat, by restoring the township as the lowestlevel of government in rural areas and allowing much greater scope for eco-nomic activities and asset accumulation by private individuals, but neverthe-less, rural community organizations retain their cohesiveness and a major rolein the local economy. Rural communities in China exist at three levkls:(a) the township (formerly the commune), which is now the lowest level inChina's government hierarchy and has an articulated government structure--thetypical township has 15-30,000 people; (b) the village (formerly the brigade),which is not a separate level of government but has governmental functions anda community structure--villages generally have a population of 1-2,000; and(c) the production team (sometimes referred to as 'villagers' smsll group"),which is purely a community structure and has lost most of its administrativefunctions as a result of the PRS--a team on average has about 30 householdsand 150 people. There are substantial variations in size and economic poweramong communities in different parts of the country.2/

I/ Though applied unevenly and never fully enforced in some parts of thecountry, the prereform emphasis on "division of labor" between urbanand rural areas, with the former engaging in industry and othernonagricultural activities, the latter forced to specialize itlagriculture (with emphasis on grain production), created aninstitutional and policy environment generally inimical to rapid TVEdevelopment. Only the few areas where local government subvertednational u?olicies (like southern Jiangsu Province) achieved areasonable degree of success in rural industrialization before the late1970s.

2/ For example, in Nanhai County, Guangdong Province, the average townshiphas over 50,000 people and a gross industrial output value of more thanY 35 million. In Shangrao County, Jiangxi Province, by contrast, theaverage township has only 20,000 people, and gross industrial outputvalue averages only Y 393,000.

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1.13 The most important characteristic of China's rural communities istheir largely fixed membership (population), due to the household registrationsystem which has prevented any substantial rural-urban or rural-rural m.gra-tion for three decades. Most people born into a rural community stay therefor their entire lives, and their children also will belong to the samecommunity. Immobility of population implies immobility of human resources,though "temporary" migration to cities and other rural areas to seek jobs isincreasingly common.

1.14 Another key feature is the combination of income-sharing within thecommunity and a considerable degree of financial 'self-reliance' in relationswith other communities and higher levels of government. Income-sharing hasoccurred in various ways over time and in different parts of the country.Before the PRS, the workpoint system in production teams assured relativelyequal distribution of income within them. Allocation of jobs in enterprisesowned by townships and villages (TVCEs) also has been a means of balancingfamily incomes in areas where TVE development occurred relatively early. EvenCG decisions on establishment and location of new enterprises have had income-sharing considerations in mind. Finally, the equal distribution of agricul-tural land when the PRS was implemented contributed to a relatively equaldistribution of income within most rural communities. To some extent income-sharing has been weakened by the rapid growth of private economic activitiesand the abolition of the commrune system.

1.15 On the other hand, the degree of self-reliance of rural communities,particularly at the township level, has if anything increased since the late1970s. Fiscal revenue-sharing systems have gradually been extended down tothe township level, and the township has been established as a separate levelof government administration and public finance in 1984-86. Most townshipsdepend heavily on extrabudgetary revenues--primarily from TVEs, in the form ofprofit remittances to the CG and various "management fees" 3/ --to meet publicexpenditure needs. Even for poorer, more backward communities which receivefiscal subsidies, incremental financial resources at the margin depend largelyon the efforts of the CG and its subordinate economic entities. Reforms inthe local banking system have made lending ceilings in a township to a large

3/ Management fees do not represent payment for services provided; rather,they are often ad-hoc levies by CGs, which occur ot;tside the budget.TVEs also generate the lion's share of budgetary tax revenues in themore industrially developed rural communities.

extent dependent on deposit generation within tne township.4/ Givenimmobility of human resources, rural communities must largely rely on the"human capital" of their own members.

1.16 CGs have complex, often conflicting roles and responsibilities. Inthe first place, they function essentially as "mini-states", providing a wholerange of public and social services and (especially at the township level)setting policies and regulations within their jurisdictions. The instrumentsavailable to CGs include establishment and ownership of CEs, decisions on CGexpenditures, a considerable degree of influence over the lending decisions ofthe local banking system in many areas, encouragement and support of differenttypes of private enterprises (PEs), etc. CGs cannot use certain policyinstruments normally available to states, however. They cannot engagedirectly in deficit financing: their expenditures cannot exceed availablefunds (including transfers from higher levels of government and from TVEs andthe portion of locally collected taxes allocated to them). Hence CGs face arelatively 'hard" budget constraint. CGs cannot effectively impose barriersto trade in goods, so they cannot meaningfully "protect" their enterprisesfrom outride competition. In any case, rural communities, even at the town-ship level, are too tiny markets to be of much use to local TVEs in mostindustries.

1.17 In addition to being local governments, CGs are profit-orientedeconomic entities akin to holding companies, investment corporations, or evenheadquarters of loosely controlled multidivisional corporations. CGs tend tobe intimately involved in major investment decisions for CEs, decisions toestablish or dismantle firms, changes in product lines, appointment of enter-prise management, managerial compensation (sometimes wages as well), andbonuses. CGs also can play a crucial role in risk absorption for subordinateCEs, investment financinp 'both directly and through arranging other sourcesof funding like bank loais), and more generally by representing their CEs inan often hostile administrative environment.

1.18 There are serious conflicts inherent in this dual role of CGt, whichwill be explored i:i subsequent chapters. But the combination of strong fiscaland employment incentives for CGs, their business development role, and themarket environment for outputs and material inputs TVEs function in (seebelow) has generated an extremely powerful 'push" for TVE development.

1.19 TVEs consist of all nonstate, nonagricultural urdertakings in ruralareas, as well as some agricultural activities organized as (nonstate) firmsrather than on a household basis. They fall into a number of main categories.Traditional TVCEs are owned and controlled by township or village authorities.Firms at the production team level often were not independent accounting unitsand instead put their proceeds into the "pot" of collective distribution toteam members. Many team firms were privatized during or in the aftermath ofthe PRS. Some township enterprises (TEs) and especially village enterprises

4/ Though there are large gaps between the two (positive or negative) inmany localities, incremental loans to a large extent depend onincremental deposit generation.

(VEs) have been "contracted" or leased to individual management.5/ PEsinclude both individual firms and partnerships owned and managed by severalpeople. Many of them are based on family or kinship ties. Close personalrelationships with CG officials are often necessary for sizable PEs to allowthem to navigate the complicated administrative environment. Only a few TVEsare owned cooperatively by all or most of their workers.6/ Finally, there arean increasing number of joint ventures between different forms of ownership,within the TVE sector as well as including urban state and collective enter-prises. Joint ventureq with foreign partners are still very rare, but inplaces like Guangdong Province, many TVEs have cooperative relationships withforeign firms short of equity participation.

1.20 China's rural communities have been profoundly affected by the PRS,which gave peasant households partial rights to land which had previously beenvested in the production teams and greatly reduced direct supervision of agri-cultural production by CGs. Moreover, it abolished the system of communityworkpoints and collective distribution of income, reverting to primarilyhousehold-based personal income generation and distribution. The communeswere abolished and replaced by townships [xiarig], now the lowest level ofgovernment in rural areas. Another important policy change already mentionedwas the relaxation of previous restrictions against large-scale expansion ofnonagricultural activities by rural communities. Similarly, removal ofrestrictions against household nonagricultural activities and, more recently,against sizable PEs stimulated a great spurt of TVE development. Finally,related to the PRS was a crucial cnange in wage systems. In the past many

; TVCEs paid workers' wages directly to the production teams or which workerswere members--workers received workpoints and participated in year-end collec-tive income distribution in their teams. This greatly dilvted incentives,since any fruits of harder work were shared not only with other workers in theenterprise but also with all the members of the production team. Even in TVEswhere workers were paid directly, fixed time wages were the norm. With thePRS, TVEs shifted to direct payment of workers, and moreover, performance-based pay in a variety of forms became the norm (enterprise-based workpoints,year-end dividends, profit-related bonuses, and above all, piece-rate wages).This had a great impact in improving incentives and efficiency.

Different 'Models" of Local TVE Development

1.21 China's TVE sector shows a remarkable degree of local and regionalinstitutional diversity, despite the basically uniform overall framework.This is the result of both exogenous and endogenous factors. The formerinclude the traditional resource base (most importantly in terms of humancapital and agricultural land); proximity to markets and to urban industry;pre-1949 industrial and commercial traditions; delivery requirements for grain

5/ These contracts typically involve remittance targets or sharing ratesfor the enterprises, with extra profits being kept by the contractor.

6/ But community ownership has some of the characteristics of cooperativeownership in small communities where the employees of the mainenterprise make up a significant proportion of the communitypopulation

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and other crop& under the agricultural planning system; and prereform rurasindustrialization. On the other hand, local authorities and CG leaders havesometimes influenced the path and pace of ruLal industrialization as well asthe local institutional structure. One example is the decision of Wuxi Countyauthorities in the early 1970s to support continued development of TVEs,despite the prevailing national trend against this at the time.7/ Authoritiesin Nanhai and other counties of southern Guangdong Province permitted andprotected "undergrotnd" private firms even in the prereform period. Innumerous other localities, authorities did not promote development of TVEsuntil very late, handicapping rural industrialization.

1.22 A key dimension of variation is ownership. In the four countieswhere extensive field research was conducted, striking differences wereencountered. Table 1.1 shows shares of different types of TVEs in GVIO inthese four counties in 1985. The share of PEs ranged from a low of 3Z in WuxiCounty to a high of 51Z in Jieshoi County. The relative weights of TEs andVEs also varied considerably, with the share of TEs nearly three times that ofVEs in Jieshou and close to twice as high in Shangrao but roughly equal toeach other in Wuxi. Only in Nanhai County did team-run firms account for asubstantial part of total industrial output.

Table 1.1: TVE OWNERSHIP STRUCTURE IN FOUR COUNTIES, 1985(I of total gross industrial output value of TVEs)

Wuxi Nanhai /a Jieshou Shargrao China

Total (Y million) 3,705 ..421 127 31 175,008

TEs lb 48 43 36 43 45

VEs 47 31 13 22 38

Team firms 2 16 - - 9

PEs 3 10 51 35 8

/a Shares in gross revenues of industrial TVEs.

/b Including town-run firms.

Source: Fieldwork information; Table 1.3.

7/ Jiangsu Province as a whole several times successfully ignored nationalcampaigns to shut down and "readjust' TVs, which gave it a commandinglead in rural industrialization on the eve of reforms in the late19709.

1.23 Another important but more subtle dimension of variation is thedegree to which lower-level communities are under hierarchical control bytownships. In Nanhai, villages and teams have been relatively independent,whereas in Wuxi, the township government (TG) rules with a stronge- hand. Thedegree of administrative control over wages, the degree to which workersreceive profit-related bonuses, the methods of appointment of TVE managers,labor allocation, and a host of other practices can differ greatly acrossregions, localities, and even communities within a locality. There is alsoconsiderable variation in policies followed by local and community authori-ties. In southern Guangdong, some counties promote large enterprises owned bytownships, others village and team firms, others PEs, still others outside orforeign entrepreneurs. Wuxi has an administrative climate which makes itvirtually impossible for large PEs to emerge. Jieshou County authoritiespersonally sponsor some of the more successful private entrepreneurs, support-ing them with bank loans and administrative help.

1.24 The most important dimension of variation is in levels of developmentand industrialization (see Chapter VII). The richest and most industrializedcounties like Wuxi and Nanhai already have in large measure achieved theequivalent of "middle-income status", whereas the most backward areas, anorder of magnitude poorer and often hundreds or thousands of zimes lessindustrialized, are nowhere near the "take-off" stage. The former face issuesof how to organize, finance, and furtl.er develop the TVE sector mostefficiently, while the latter are striving merely to get nonagricultur3ldevelopment started. Local diversity in the TVE sector can be illustrated bya brief look at the four counties that were subjected to intensive fieldwork.

1.25 Wuxi County in Jiangsu Province for a long time has been the mostindustrialized rural county in China, even though it is by no means the mosturbanized. Wuxi is also the quintessential example of the "traditional" TVEsystem based on TVCEs, integrated under the supervision of TGs. This isespecially evident in wage determination and labor allocation. Industry inWuxi is highly efficient in the Chinese context; TVCEs are relatively large;many of them use relatively advanced technologv; and they compete effectivelywith state industry. Industrial PEs are severely hampered by administrativerestrictions. Neither labor nor land markets have developed, though largeamounts of financial capital have been brought in from other parts of thecountry by local banks to support local TVE development, and many TEs or town-ship industrial corporations (TICs) have issued bonds to employees ar.d localresidents. Labor is not encouraged to flow in from other parts of thecountry.

1.26 Nanhai County in Guangdong Province is also highly industrialized,but more urbanized than Wuxi. Its TVE sector is "open" to the outside worldin terms of foreign trade and business relationships (most notably extensiveprocessing arrangements between Nanhai TVEs and Hong Kong firms). Nanhai hasa diversified structure of rural communities, with much greater independenceat the lower levels (villages and teams) than is the case in Wuxi. This hasspawned a variegated pattern of TVE ownership, in which TVCEs are importantbut by no means dominant, and production team enterprises, PEs, and variouskinds of firms "contracted" to private management, "Joint ventures", and even

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'cooperative' entities have emerged. There is a relatively open labor market,which has stimulated a large influx of migrant workers from poorer areas out-side the county. As a result, wage controls are largely ineffective. Capitalflows from outside appear to be less important, mainly because the county iswell-endowed with local bank savings deposits.

1.27 Jieshou County in Fuyang Prefecture of Anhui Province represents amore-or-less "average" level of TVE development for China as a whole, but itspolicies toward the TVE sector are unusual. It is much less industriallydeveloped than either Wuxi or Nanhai, and its average rur-al per-capita incomein 1985 was somewhat below the national average. The most distinctivefeatures of Jieshou are a lively market in land and the emergence of asubttantial ntumber of large PEs, under the personal sponsorship of county andCG authorities. The county has encouraged relocation of PEs to Jieshou Town(the county seat), where infrastructure and support services are more readilyavailable. PEs in Jieshots Town are vulnerable to "creeping collectivization"in various forms, however. In the rural areas ottside the county seat thelevel of industrialization remains extremely low, and most CEs have eithergone out of business or have been "privatized" in one way or another."Specialized villages" engaged in handicraft production have emerged inJieshou and neighboring counties as a new mode of rural nonagriculturaldevelopment.

1.28 Shangrao County in Jiangxi Province represents a level of ruralindustrialization and TVE development significantly below the nationalaverage. Even though the county is endowed with substantial mineralresources, rural incomes depend primarily on agriculture, industrial firms aresmall and mostly unprofitable, and industrial development has not yet been puton a self-sustaining basis, despite an infusion of capital from the centralgovernment. The ownership and management of TVCEs is in the 'traditional'mode, but unlike in Wuxi this has not been successful. TVEs are plagued byproblems of excessive levies by CGs to meet public expenditure needs, wide-spread overmanning, poor management, lack of contact with markets outside thelocality, etc.

1.29 These four counties to a certain extent exemplify forr different"models" of TVE development in China. One other important "model" is that ofWenzhou Prefecture in Zhejiang Province. A poor and remote area, Wenzhou hasachieved great success in TVE development by permitting almost completely freedevelopment of PEs; a thriving "informal" financial market, based largely onprivate financial institutions; and extensive commercial relationships withdistant parts of China. Wenzhou is different from Jieshou because thedevelopment of PEs may be somewhat less related to personal support by CG orlocal government officials, and because of the much greater emphasis onprivate service sector development, especially in finance. Like Nanhai,Wenzhou has a well-functioning labor market, with large flows of workers frompoorer, mountainous parts of the prefecture into the booming tcrwns. It alsohas a market in land.

1.30 The diversity of the TVE sector means that reforms and policymeasures which work well in some areas may be unsuccessful in others. For

example, the turn to PE-based industrialization in many poorer areas is basedon a recognition that the traditional CE system (epitomized by Wuxi) cannot besuccessful in the more backward areas, for a variety of reasons. It isimpossible at present to assert unequivocally that any one model of local TVEdevelopment is better than the rest under all conditions and circumstances.Over time, the relative advantages and disadvantages of different models willbe tested during the process of market competition, and the TVE sector as awhole may gravitate toward one or more of the most successful and efficientmodels. But this is a natural process which should not be rushed by prematureGovernment decisions and administrative directives.

Recent Growth Performance

1.31 The growth of the TVE sector since the late 1970s and particularlysince 1983 has been spectacular, whether measured in terms of output, employ-ment, assets, or profits (see Table 1.2). Nominal gross output value of allTVEs increased at an average annual rate of 25% in 1978-87. GVIO rose by over262 p.a. in nominal terms during the same period. Real growth rates are hardto calculate due to lack of accurate price deflators, but even with generousassumptions about inflation (which was low until the mid-1980s), real outputgrowth has been in the 202 p.a. range. The nonagricultural labor force inrural areas (industry, censtruction, transportation, and commerce) grew by 13?p.a. in 1978-86, for a total increase of 124% (over 30 million people).8/TVCEs' total wage bill, assets, profits, and tax payments all increasedrapidly in line with the growth of output and employment. Profits have risenmuch more slowly than other indicators, however, suggesting that profitabilitydeclined in the TVCE sector. Average wages in TVCEs rose by nearly 132 p.a.in 1978-87, considerably faster than the rate of inflation.9/ Though thenumber of TVCE firms has increased only very slowly, new enterprise creationin the PE sector has been tremendous in recent years.10/

8/ These calculations are based on China's official rural labor forcestatistics, compiled by the State Statistical Bureau, which appear toseriously underestimate the number of people involved in part-time orseasonal off-farm activities and those employed by very small firms.According to figures compiled by the Ministry of Agriculture's TVEBureau, the total number of nonagricultural TVE employees (includingpart-time and seasonal workers) rose from 22 million in 1978 to 77million in 1986, an increase of 55 million.

9/ Average wages in TVCEs rose far more rapidly than in SEs in 1978-83(12X p.a. versus 6% p.a.), but this pattern was reversed in 1983-86,when TVCE wages increased by 141 p.a. and SE wages by 162.

10/ The number of PEs reportedly rose from 4.2 million at the end of 1984to 10.4 million at the end of 1985, 13.4 million at the end of 1986,and 15.9 million at the end of 1987.

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Table 1.2: GROWTH PERFORMANCE OF TVE SECTOR, 1978-87(X p.a.)

1978-68 1988-87 1984 1986 1986 1987 1976-87

Output*lural nonagricultural output

value (nominal) t 16.6 36.4 84.9 46.8 80.2 84.8 25.0Industrial output valuo (nominal) 19. 41.6 56.2 45.7 82.1 84.4 26.4

EmploymentNonigricultural labor force 6.2 19.9 38.6 20.1 16.1 8.1 12.1Rural lndustrlal labor force 3.1 16.9 20.0 18.2 14.6 5.0 7.4

Number of FirmsMrTVs -2.5 4.1 22.6 -4.9 -8.8 4.0 0.4

Industrial TVCEs -1.8 6.8 21.1 -5.1 2.7 10.6 2.2

Financlol Indicators (TVCEs only)Fixed assets 15 16.7 26.7 20.9 80.5 26.2 29.6 20.6Profits /c 7.4 14.1 18.4 81.6 -2.1 16.0 10.8Taxes L/ 21.8 80.0 34.4 87.2 26.9 22.0 25.3Bank loan. 84.7 55.9 102.6 40.8 47.0 41.4 48.8Orose revenues 17.8 88.8 86.6 44.1 21.7 82.0 24.2

Employment 2.7 9.8 18.9 7.9 5.8 7.1 5.8Wage bill 15.2 24.9 86.1 26.0 17.9 20.8 19.4Average wage 12.1 18.7 14.5 16.7 11.4 12.8 12.9

Averago wage, state units 6.1 15.6 19.5 17.8 16.6 9.8 10.2

/a Oross output value of rural nonagricultural materiale-producing *sctors (industry,construction, transpor', and commerce).

b Value of fixed assets at original cost, without subtracting depreciation.Gross profits before payment of income tax (but net of Indirect taxes).

tc Includes both direct and Indirect taxes.

Sourcoe: Statistical Yearbook of China 1981, 1986, 1986, 1987; China Rural StatisticalYarbook, 1985, 198s, 1987.

1.32 Growth in China's TVE sector has been highly uneven over time(Table 1.2). There was a sharp acceleration in 1983-87 as compared with1978-83, with GVIO rising by 202 p.a. in the earlier period and 42Z p.a. inthe later period. Growth in 1984 and especially in 1985 was substantiallyhigher than in 1986 and 1987. TVE growth has also been unbalancedgeographically, with some areas, particularly more advanced coastal regions,experiencing more rapid growth than backward, less industrialized interiorprovinces. Between 1980 and 1985, TVE nominal GVIO rose by 4152 in Zhejiang

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Province, by only 372 in Inner Mongolia. In eight provinces the increase wasgreater than 2502, in seven it was below 120Z. Many though not all of thefast-growers were more industrialized from the beginning, and a number ofbackward provinces in terms of rural industrialization slid further intorelative backwardness. Provincial growth rates mask great differences acrosscounties within provinces.

1.33 Table 1.3 provides a more detailed picture of industrial outputgrowth for TVEs under different forms of ownership. TVCE GVIO has grown at23Z p.a. in 1978-87 and was especially high in 1984-85. GVIO of PEs(including production team firms) has risen sharply, starting from a iiny basein 1980. Some of this may reflect incorporation of economic activities whichpreviously escaped the statistical network, but most of it represents realgrowth. Differential growth rates have led to substantial changes in thecomposition of TVE industrial output. The shares of TEs and VEs havedeclined, while that of PEs jumped from negligible levels in the late 19708 to21? in 1987.

Table 1.3: GROWTH AND OWNERSHIP STRUCTURE OFTVE GROSS INDUSTRIAL OUTPUT VALUE, 1978-87

(Z p.a. and Z of total)

1978-83 1983-87 1984 1985 1986 1987 1978-87

Annual Growth Rates

TVCEs 18.4 34.7 36.8 40.9 27.6 34.1 23.1

PEs /a 54.6 95.7 328.7 68.0 50.0 35.6 63.5

TVE sector 19.7 41.5 55.2 45.7 32.1 34.4 26.4

Shares in Total (1978) (1983)

Township firms 56.8 53.5 45.9 43.7 42.3 42.0

Village firms 40.9 40.2 36.7 36.2 34.9 35.9

Team firms } n.a./b n.a.tb 2.0 }

Partnerships 12.3 6.3 8.1 10.5 8.2 123.1

Individual firms } } 9.4 9.7 12.7

/a Including production team firms.lb Many production-team firms were "privatized' in the early 1980s. In 1984

and 1985, they seem to have been included in the category of partnerships.Since 1987 no PTEs have been reported in the statistics.

Sources: Statistical Yearbook of China, 1981, 1984, 1985, 1986; China RuralStatistical Yearbook, 1985, 1986, 1987; and China Economic Yearbook,1981, 1985.

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Overall Dimensions of China's TVE Sector

1.34 Given the rapid growth documented above, the overall dimensions ofthe TVE sector have been changing substantially. For example, measured interms of real GVIO, China's industrial TVE sector was roughly four times aslarge in 1986 as it was in 1980. Thus any attempt to describe the size anddimensions of the TVE sector can only be a snapshot of a rapidly changingsituation, which may quickly become out-of-date.

1.35 Table 1.4 shows the dramatic changes in the composition of grossoutput value in China's rural areas. The share of crop cultivation droppedfrom somewhat over half in 1980 to less than one-third in 1986; the share ofother agricultural activities remained more-or-less constant; and industryrose from less than one-fifth to nearly equal the share of crop cultivation in1986 and surpass it in 1987. Construction, transport, and commerce rosemodestly as a share of the total, indicating there is still much potential forfuture gains.

Table 1.4: COMPOSITION OF RURAL GROSS OUTPUT VALUE, 1978-87

1978 1980 1983 1984 1985 1986 1987

Rural total gross socialproduct /a 203.8 279.2 412.4 506.8 634.0 755.4 943.2

Shares in Total

Crop cultivation 52.6 49.3 47.1 43.3 36.0 33.1 30.1

Forestry, livestock,fishery, and sidelines 16.0 19.5 19.6 20.1 21.1 20.0 19.5

Industry 19.4 19.5 20.0 22.9 27.6 31.5 34.8

Construction, transport,and conmerce 12.0 11.7 13.3 13.7 15.3 15.4 15.6

/a In current prices. Includes gross output value of the five "materials-producing" sectors (agriculture, industry, construction, transport, andcommerce), excluding nonmaterial services.

Sources: China Rural Statistical Yes..book, 1986; and Statistical Yearbook ofChina, 1987, 1988.

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1.36 Shifts in the structure of the rural labor force have also beensignificant, as is shown in Table 1.5. Cultivation declined sharply in 1984and 1985, but much of the slack was taken up by agricultural sidelines, whichmore than doubled their share. The proportion of the rural labor forceengaged in industrial activities rose only modestly (from 6Z in 1978 to 8Z in1986). Construction, transport, and commerce more than quintupled theirshare, however, rising from 12 in 1978 to 6Z in 1986. Overall, the movementof labor out of agriculture in rural areas has only begun. Nearly four-fifthsof the rural labor force is still engaged primarily in agriculture andsideline activities.

Table 1.5: STRUCTURE OF RURAL LABOR FORCE, 1978-87(million persons and Z of total)

1978 1980 1983 1984 1985 1986 1987

Total Rural Labor Force /a 306.4 318.4 346.9 359.7 370.7 379.9 390.0Shares in Total

Agriculture (cultivation) 83.8 82.8 81.5 70.9 67.3 }

} 80.2 79.2Forestry, livestock, side- }lines and fishery /b 5.9 6.4 6.4 13.3 14.6 }

Industry 5.7 6.1 5.8 6.7 7.4 8.3 8.5

Construction, transport,and commerce /c 1.2 1.6 2.5 4.4 5.5 6.1 6.7

Other /d 3.4 3.1 3.8 4.7 5.2 5.4 5.6

/a At year-end. Does not include labor force of state farms./b The industrial portion of sidelines labor force has been included under

industry./c Commerce includes storage, catering, and other related personal services./d Including real entate administration, public utilities, residential

services, consultancy, public health, education, sports, social services,scie:utific research, technical services, banking and insurance, govern-ment, Party, etc.

Sources: China Rural Statistical Yearbook, 1985, 1986; Statistical Yearbook ofChina, 1987, 1988.

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1.37 The TVE sector has become increasingly important as a generator offiscal revenue ir. rural areas and a major provider of personal incomes forrural inhabitants. Total tax payments by TVEs in 1985 (including both profittax and indirect taxes) were nearly Y 14 billion, accounting for only 7.7? oftotal national budgetary revenue but the lion's share of tax collected inrural areas (the stagnant agricultural tax generated only Y 4 billion). Taxpayments by TVEs have been rising sharply as earlier exemptions are graduallyphased out, though "special treatment" remains common and PEs in particularcan evade much of their tax liability. The TVE sector probably is still some-what more lightly taxed than the state sector (though the difference isreduced if extrabudgetary remittances of TVEs are factored in), but on theother hand its tax burden is much heavier than that of agriculture.

1.38 In 1985, wage payments and distributions to community members byTVCEs totalled Y 31 billion. This represented Y 40-50 per member of the ruralpopulation, or about 15Z of average per-capita rural income. PE wages addsignificantly to these figures. But nevertheless, the share of the TVE sectcrin personal income generation is far less important than its role in produc-tion. This is partly due to much lower net/gross output value ratios inindustry and especially commerce than in agriculture. Moreover, most TVCEprofits go into investment and thus affect personal incomes only indirectly.

1.39 Extrabudgetary remittances of TVEs to CGs are very important,especially in the more developed areas. In 1985 TVCEs turned over Y 6.8 bil-lion in profits to their supervisory CGs, not including management fees whichmay have totalled as much as Y 2 billion or even more. These figures comparewith total tax payments by TVCEs of Y 10.9 billion. More than half of TVCEremittances to CGs were ploughed back into reinvestment in them, but substan-tial amounts were used by CGs for supporting agricultural production, forsocial services, for covering the CG's payroll, and a considerable amount (Y620 million) was distributed to community members.

1.40 The TVE sector has become the most dynamic part of Chinese industry,an important actor in most subsectors and dominant in a few. Its share intotal national GVIO has risen sharply, from only 3Z in 1971 (when the movementto promote commune- and brigade-run enterprises was getting underway) to 9Z onthe eve of reforms in 1978 and then, rising very rapidly starting in 1984, toover 23? in 1987 (Table 1.6). The state sector's share has declined consider-ably (from over four-fifths in 1975 to three-quarters in 1980, five-eighths in1986, and under 60% in 1987), while that of urban nonstate enterprises hasrisen moderately. All parts of the TVE sector have seen their shares inChinese industry as a whole increase, but PEs have shown the most spectaculargrowth, rising from negligible levels in the late 1970s to account for nearly5Z of China's total GVIO in 1986.

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Table 1.6: OWNERSHIP STRUCTURE OF CHINESE INDUSTRY, 1971-87(X of total Industrial output value) /a

1971 1976 1978 1980 1981 1982 1983 1984Tb 198 1986 1987

state 86.9 81.2 77.6 76.1 74.8 78.8 72.6 67.6 75.9 62.8 69.7

Urban collective 10.9 13.7 13.7 14.4 14.1 14.3 14.4 15.9 15.9 165. 14.6

Urban IndividualsC - - - 0.0 0.0 0.1 0.1 0.2 0.8 0.4 0.6

Urban other - - - 0.6 0.6 0.7 0.8 1.1 1.2 1.6 2.0

Rural nonstat. 3.2 6.1 8.7 10.0 11.0 11.2 12.1 16.2 17.7 20.8 28.1

Of which:Township 1.6 2.6 4.8 6.4 5.9 6.0 6.8 7.7 7.8 8.8 9.8

Village ) ) } } } } 6.0 6.8 7.6 8.41.6) 2.6 8.9 4.6 5.1 6.2 6.8

Below village } } } } } } } 1.6 8.1 4.5 6.4Of which:Individual fires 1.6 2.6 8.8

/a Percentage. for 1971-80 are bascd on Industrial output value figures In 1970 constantaccounting prices, for 1981-88 in 1980 constant prices, and for 1L84-87 In currentprices. Since these figures are based on data compiled by the Stat. StatisticalBureau, they show slightly lower TVP shares than Ministry of Agriculture statisticswould Imply.

/b In the absence of current price data for ownership forms other than rural nonstat.industry, the shares of different urban ownership forms were calculated on the basisof their constant-price shares. There may be some inconsistencie between 1984 dateand earlier and later data, which are from different sources.

/c Includes partnerships.

Sources: Statistical Yearbook of China, 1988, 1986, 1986, 1987, 1988; China RuralStatistical Yearbook, 195, 1986, 1987; Statistical MaterialseonCR'isIndustrial Mae rla i, 1949-84, 1986.

1.41 TVEs are active in virtually all the broad subsectors of Chineseindustry, as can be seen from Table 1.7 (which due to data limitations pro-vides information on TVCEs only). Only in one of the 14 major subsectors(petroleum) is the share of TVEs truly negligible. The most important TVCEindustrial subsectors are machinery, construction materials, textiles,chemicals, and food (in that order), which together account for nearly three-

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quarters of TVCE gross industrial output value. Among these major subsectors,however, only the share of construction materials is far higher than it is forindustry as a whole--otherwise shares tend to be no higher than or moderatelylower than in industry as a whole. The composition of TVCE industrial. outputhas remained reasonably stable over time, with gradual rather than abruptchanges in relative shares.

Table 1.7: SUBSECTORAL COMPOSITION OF GVIO, 1982 AND 1985(Z of total)

1982 1985Industry Industryas a whole TVCEs as a whole TVCEs

Metallurgy 8.7 2.4 8.0 3.4

Electric power 3.7 0.7 3.3 0.4

Coal and coke 3.0 5.5 2.5 3.8

Petroleum 5.2 0.1 4.5 0.1

Chemicals 11.8 8.2 11.2 8.4

Machine building 22.0 24.8 26.9 25.5

Construction materials 4.0 20.7 4.2 18.9

Forestry 2.0 2.5 1.6 3.0

Food 13.5 8.3 11.5 7.9

Textiles 15.5 11.6 15.3 12.5

Garments 2.5 3.8 2.4 3.7

Leather 1.0 1.3 0.9 1.6

Paper 3.6 1.6 1.3 2.4

Cultural/educational n.a. 2.6 2.6 3.0

Other 3.5 5.9 3.8 5.4

Source: Statistical Yearbook of China, 1983 and 1986.

1.42 TVE sector shares irn the output of particular industrial productsvary greatly, but again, the coverage is rather broad. TVEs produce nearly80Z of all bricks in China, but perhaps more surprising, they are responsiblefor almost 20Z of total national cement production, three-eighths of nationaloutput of silk textiles, nearly a quarter of paper qnd cardboard, around 30Zof phosphate fertilizer, and 262 of coal. The share of metal-cutting machinetools is under 42, but TVEs are increasingly important in electronics (where

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they accounted for 6Z of total national output value in 1986), consumer dur-ables of many kinds, and even some more sophisticated industries. Onlycertain basic industries using process techniques with substantial economiesof scale (e.g. petroleum refining) are impervious to entry by TVEs.

1.43 All in all, the TVE sector has established its importance in a numberof crucial spheres of the Chinese economy. It has been responsible for thebulk of incremental output and income in rural areas, and it represents theonly hope for moving rural labor into productive employment outside ofagriculture, particularly as long as restrictions against permanent migrationinto large cities are kept in place. Without TVE development, much of theefficiency gains from agricultural reforms could not be realized. At the sametime, the TVE sector is increasingly important in Chinese industry as a whole,both in terms of meeting rising demand for the whole range of industrial goodsand as a competitor/partner to state industry.

Conduct of Business and Market Interactions

1.44 There is ample quantitative as well as anecdotal evidence that TVEsfunction primarily in a market environment for their outputs and nonfactorinputs. The share of government mandatory or "guidance" plans in the totaloutput of most TVEs is minuscule, usually zero. Moreover, in most cases whereplanning is reported to account for a substantial share of total enterpriseoutput, plans are either merely reference targets or more in the nature ofmarket-based procurement orders by state agencies. On the input side, TVEsrely primarily on the market mechanism. the only major exception is electricpower, but even here, the market is playing an increasingly important role atthe margin. Unlike many SEs, the bulk of TVEs buy and sell goods for moneyrather than through barter-like exchanges.

1.45 A striking feature of the TVE sector is the outward product marketorientation of firms with respect to their home communities. This is onlynatural given the relatively small size of rural communities and their limited"home markets". CGs have little or no ability to 'protect" local TVEs fromoutside competition anyway. Outward orientation is most striking in the moreindustrialized localitiess in Wuxi County in 1984-85, for example, only 42 ofthe gross sales of all industrial TVCEs occurred within the home township ofthe producer. Eighty-two percent of a sample of firms in Wuxi sold less than202 of their output within the county in 1985, while large majorities ofsimilar samples of enterprises in all four counties subjected to intensivefieldwork sell at least 40% of their output outside the home province. Formany of the larger, more successful TVEs, the relevant sphere of salesactivity is the national market. The combination of outward orientation andinability to rely on CG protectionism in large part explains the dynamism andcompetitiveness of the TVE sector.

1.46 In contrast, the TVE sector is heavily community-oriented withrespect to factor markets and investment and location decisions. TVEs of allforms of ownership (including PEs) must obtain key factors of productionthrough the good offices of CGs. This is especially true of land and capitalfrom the banking system, but in some areas CEs also get labor allocations .rom

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CGs. Moreover, numerous different CG permits and approvals are needed tostart a TVE business and stay in operation, whether CE or PE. Virtually allof China's TVEs are rooted in particular rural communities, obtain factorinputs from within them, and do not consider relocation (particularly outsidethe county) as an attractive option.

1.47 TVEs to a surprisingly large extent do their own procurement andmarketing. This is due to the relatively "thin" commercial network in ruralChina, as well as TVEs' relative lack of access to state plan distributionchannels and their need to penetrate new, often hostile markets. Therelatively large purchasing and marketing staffs of TVEs and nigh marketingexpenses are undoubtedly essential in the environment in which TVEs currentlyoperate. Similarly, TVEs cannot rely on a well-developed network of otherindustrial support services and instead often must engage in self-provision ordo without them (see Chapter V).

1.48 The markets for industrial goods that TVEs operate in were justemerging in China in the late 1970s, so they have been to a large extentshaped by TVEs. The state sector left many gaps of unfilled demand, and thesharp rise in urban and rural personal incomes starting in the late 19709generated additional demand which SEs were often initially not well-placed tomeet. There were many opportunities to earn extraordinarily high profits atthe outset, and hence early entrants (mostly from the richer areas which hadalready undergone TVE development to a certain degree) benefited greatly, andcould grow rapidly through internal accumulation.

1.49 However, as competition became .aore severe due to widespread entryinto the industries concerned, prices and profit margins tended to fallsharply, squeezing the later entrants. in markets where entry by TVEs isrelatively easy, the typical pattern has been erosion of initially highprofits as widespread new entry occurred (which sometimes overshot the appro-priate long-run industry capacity). Of course new opportunities have beengenerated by the growth of the TVE sector itself, but these often requirebetter skills and more advanced technology.

1.50 There is considerable variation across industries and products in themarket structure and nature of competition faced by TVEs. For a few indus-trial goods, markets are essentially nationwide in scope and competitorsinclude SEs as well as TVEs. Specialized machinery produced by many firms inWltxi falls into this category, and Wuxi TVEs have often emerged successful';om competlsion wIth the state sector. In some industries, the competitiveadvantages of TVEs are so great that most SEs have already exited or are inthe process of doing so (usually by changing their product lines); competitionmay be quite severe, but it is entirely within the TVE sector. In still otherindustries, transport costs or other restrictions may result in segmentedmarkets along local or provincial lines. Even so, there may be considerablecompetition among TVEs and with SEs within provinces and localities. Thereare at most only a few TVE industries c.iaracterized by very weak or non-existent competition.

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1.51 Overall, TVEs face a relatively "hard" and generally highly competi-tive market environment. This puts great pressure on many of them to performwell and is relatively unforgiving of mistakes, undoubtedly contributing in amajor way to the efficiency, dynamism, and flexibility of the TVE sector.Unlike SEs, TVEs have no "captiver markets for their products. They are alsoless constrained by price controls, making it less likely that they will facechronic sellers' markets for their outputs. TVE product markets have beenhighly unstable, which is only natural given their recent emergence andadministrative and economic "shocks" which have occurred at times.ll/ TVEshave shown impressive ability to adjust successfully in the face of adversecircumstances, through measures ranging from changes in product lines todownward adjustments in wages, replacement of management, major restructuring,privatization, and to a lesser extent et the extreme, going out of business.12/

1.52 There are some problems, however. Many TVEs produce shoddy, poor-quality goods using backward techniques which waste materials or energy andoften generate considerable pollution as well. Sometimes these shortcomingsreflect the weakness of competition from the state sector (combined with limi-tations on the size of the bulk of TVEs). More generally, the "overheating"of the Chinese economy generates an overall environment of high demand, inwhich firms and production techniques (both inside and outside of the TVEsector) which otherwise would fall by the wayside can survive and evenprosper. Further improvements in the functioning of markets for industrialgoods in China, a more competitive state sector, and some cooling off in themacroeconomic demand environment would all help ameliorate these problems,though they might also result in a slowdown in the TVE growth.

Industrial Structure

1.53 The average TVE is a relatively small concern, and most ruralcommunities are still largely nonindustrialized. The average industrial TE in1985, for example, had 56 employees and a gross output value of a little overY 300,000, while VEs were only about one-third as large. Many rural townshipshave only a handful of TVEs and GVIO of less than Y 1 million, generatingprofits of only Y 100,000 or so--perhaps Y 5 per member of the community onaverage. Although average size of firms and number of firms per community aremuch larger in the more advanced areas like southern Jiangsu and GuangdongProvinces, there are very few large TVEs and virtually none with annual GVIOof over Y100 million. This is related to the fact that all TVEs are closelytied to rural communities, even the most economically developed of which havelimited resources, and factors of production cannot be freely acquired fromelsewhere.

1.54 The more industrialized rural communities tend to have a mixture of'specialized' and "conglomerate" industrial structures. There is usually somespecialization in a broad industrial subsector or two (for instance machinebuilding in Wuxi County or textiles in Xiqiao Town of Nanhai County), but

ll/ For example, the tight national credit policy imposed in early 1986 hadan immediate and severe impact on TVEs.

12/ In NanhRi County in ;986, for example, about 4Z of CEs and about 15Z ofPEs went out of business.

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typically there is also some spreading of firms in a community across indus-tries. Such diversification serves as a mears by which communities can spreadrisks from market fluctuations, in the absence of financial instruments forthis purpose.

1.55 There is great regional variation in industrial structure, just asthere is in firm size, financial performance, and TVE development itself. Themore backward areas tend to have a high share of resource-based industries and"transport-protected" activitiea (like construction materials), along withbasic food processing. Manufacturing in general, and more 3pecifically thedynamic industries with potential to stimulate rapid output growth and laborabsorption, tend to be concentrated in the more advanced coastal regions.Despite their increasingly higher wages, these areas still offer a betteradministrative and economic environment for industrial development.

1.56 Turning to financial structture, industrial TVEs on the whole are muchmore highly leveraged than SEs. This partly reflects their recent rapidgrowth and relative lack of reliance on state and CG grants of funds. Thecapital structure of a sample of 200 larger TVEs (nearly all of them TEs) ispresented in Table 1.8. CG contributions are very important in providing"seed" capital for CEs at time of founding (contributing close to 30Z of thetotal), but their share declines sharply as successful firms expand. The twomost important sources of funds for established, growing CEs are internalaccumulation and bank loans, though arrears to other firms have grownconsiderably in recent years (partly reflecting the tight credit situation).Capital from individuals (whether the firms' own workers or other communityresidents) accounts for only a small part of the total.

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Table 1.8: CAPITAL STRUCTURE OF LARGE TVES(2 of total)

At End- End- End-Junefounding /a 1984 1985 1986

Government grants and loans 4.0 1.8 1.6 1.7CG contributions /b 29.4 6.3 6.0 4.4Enterprise's own funds /b - 41.0 40.7 43.2Bank loans 38.2 28.9 24.1 23.4Capital from other firms Ic 13.0 14.8 19.1 19.8Capital from individuals td 6.5 3.5 4.6 4.0Other 8.9 3.7 3.9 3.5

/a This represents different points in time for different firms./b The share of CG contributions is somewhat understated and that of internal

accumulation is overstated because capital provided by the township gov-ernment on a nonrepayable basis is included in the latter rather than inthe former. However, given rapid growth of the firms concerned, the orig-inal contribution of CGs would account for a much smaller share of totalcapital than at founding.

/c Mostly payables (possibly including some to government agencies), but alsoincluding small amounts of explicit loans and "investments" from otherenterprises.

Id Including bonds purchased by workers (jizi), wages payable to workers, andcapital provided by individuals outside the firm.

Source: Zhou Qiren, 'The Macroeconomic Effects of Debt Management--A Policy-Oriented Analytical Report on an Investigation of 200 Large Townshipand Village Industrial Enterprises in 10 Provinces," Draft Report,May 1987, pp. 11, 20.

1.57 PEs rely primarily on household capital (from founders, friends,relatives, workers getting jobs, etc.) when they first get started. Like CEs,if successful in their business activities they can rely to a large extent oninternal accumulation to finance expansion. But beyond a certain point, manylarger PEs exhaust these two sources of capital and try to get loans fromRural Credit Cooperatives (RCCs) or (less commonly) Agricultural Bank of China(ABC) offices. Some of them may also turn to new nonbank financial inter-mediaries which are emerging in certain parts of the country. Overall,balance sheets of relatively large and successful PEs might not look toodifferent from those of CEs.

1.58 Declining profitability in the TVCE sector is evident from Table 1.2,though profit rates on sales and assets are still considerably higher onaverage than in state industry. This trend reflects (a) exceedingly highprofits initially; (b) increasing competition in many TVE markets, which has

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put downward pressure on prtces and squeezed profit margins (especially sinceprices of many raw materials have been rising); (c) rising average capitalintensity of TVE production (though even now, it is still far below that instate industry); (d) disproportionately rapid rises in prices of investmentgoods, which overstate the increase in capital stock and hence the decline inprofitability as well; end (e) possibly concealment of profits for tax evasionpurposes, as previous exemi1ptions are phased out and the effective profit taxrate rises.

1.59 Poor financial performance is a problem for some TVEs, and there arecertain inhibitions against exit by failing TVCEs, though not as strong as inthe case of SEs. The need to maintain employment is obviously important inlocalities where there is still substantial surplus labor. In the moredeveloped areas where surplus labor may not be a problem, local banksgenerally try to force CGs to take responsibility for bank debts of defunctCEs. As a result, there is no incentive to shut down an enterprise unless ithas negative cash flow, since CEs cannot reduce their debt obligations bygoing bank.upt. In 1985, 41,000 TEs (9.8Z of the total number) made lossestotalling Y 600 million, while a smaller number of VEs (24,000, or 2.1Z of thetotal number) made losses totalling Y 250 million. Though much lower than thecorrespcnding figures for SEs, these losses are nevertheless substantial.Going downward through the ownership spectrum of the TVE sector, exit becomeseasier and hence there are fewer chronic loss-making firms in existence. PEssimply fold, effectively goirg bankrupt, in the face of severe financialproblems.

The Question of Relative Efficiency

1.60 It is extremely difficult to assess the degree to which the TVEsector is more or less efficient than the state sector, in terms of productioncosts and factor usage. Finding comparable firms in the two sectors withcomparable raw data is a major exercise in itself, but ascertaining thereasons behind observed differences in performance would be even harder, giventhe numerous distortions in the economy and a generally weak accounting systemfor the TVE sector. Input costs for TVEs may be higher than those of SEs, forexample, not because the former are less efficient but because the latter haveaccess to inputs at lower controlled prices through the plan. TVEs may alsobe able to inflate their costs to a greater extent than SEs, in the interestof tax avoidance. On the other hand, many SEs are still forced to sell alarge part of their output through the plan, at plan prices, which would makethem appear less profitable than TVEs. Similarly, the social expenditures ofTVEs (on workers' welfare, pensions, housing, etc.) are much lower than thoseof SEs, which would allow them to incur lower costs and earn higher profitsthan SEs even if production efficiency happens to be the same. In view ofthese considerations, any comparison of costs and profitability between TVEsand the SEs must be undertaken with great caution.

1.61 At the aggregate level, TVEs use somewhat more labor and much lesscapital than SEs per unit of output value. Hence any comparison of factorproductivity which gives a substantial weight to capital would indicate thatthe TVE sector is more "productive". But these kinds of estimates are biased

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by distortions on both the input and output sides, and in any case, there isvariation across products and industries. It would not be surprising if byand large, the TVE sector is more efficient than the state sector in theindustries where it already accounts for a large share of total output. Onthe other hand, "sellers' markets" and "two-tier" plan/market pricing systemsmay allow high-cost TVEs to survive in some industries like cement and steel-rolling.

1.62 The question of relative efficiency is perhaps not as important asthat of market orientation, dynamism, and competitiveness in the TVE sector.To the extent that these characteristics are present, they will move thesector in the direction of lower costs and greater efficiency, regardless ofprecisely where it happens to find itself at any particular point in time.Thus the crucial issues concern the functioning of markets faced by TVEs, thedegree to which TVEs can flexibly respond to market opportunities, theiradjustment to changing market conditions, and their overall competitiveness.In these respects, the TVE sector so far seems for the most part to have donemuch better than the state sector, though it will need to continue to evolveand develop in order to maintain a competitive edge in the future.

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II. MACROECONOMIC ISSUES AND INTERSECTORAL RELATIONSHIPS

2.1 This chapter looks at the broader macroeconomic and intersectoralissues facing the TVE sector, whereas those that follow will concentrate onissues more "internal" to the TVE sector itself. The increasing importance ofthe TVE sector in China's rural economy, in industry, and in the economy as awhole has given rise to questions in China about its impact on macroeconomicstability. Has the TVE sector contributed in a major way to demand pressuresand "overheating' of the Chinese economy? If so, how should demand pressuresfrom TVEs, for bank credit and other resources, be restrained? The TVEsector's interactions with the state sector and with Chinese agriculture alsoraise certain policy issues of concern to Chinese authorities. Are TVEs"inappropriately' competing resources away from state industry on the one handor from agriculture on the other? Are financial flows from TVEs to agricul-ture a heavy burden on the former, and how effectively are these funds beingused? Still another concern is the role of the TVE sector in foreign trade.The dynamism and flexibility of TVEs make them poten-ially successfulexporters, but to expand exports they need contacts with foreign businessmen,access to foreign exchange resources, better market information, etc. Thenature and implications of urbanization generated by TVE development formanother crucial set of policy questions. Related to this are the types andmagnitude of rural labor and population flows in the future, both rural-ruraland rural-urban (discussed in Chapter V). A fundamental issue underlying allof the others is the future role of the TVE sector in the Chinese economy. IsTVE development just a transitional phase, or will TVEs still be prominent inthe Chinese rural economy and in Chinese industry 20 years from now? Acomprehensive assessment of this last issue must encompass the analysis of'internal" TVE topics in subsequent chapters, however.

Macroeconomic Impact

2.2 Due to its rapidly increasing size and importance, the TVE sectornaturally has become a significant source of demand for bank credit, rawmaterials, energy, intermediate inputs, and other resources in the Chineseeconomy. But its role in causing the 'overheating' of the economy as a wholein 1984-85 and subsequently should not be overrated. In the first place, theshare of national credit and other resources taken by TVEs has not been largein relation to the increasing size of the sector (Table 2.1). The share ofTVCEs in total national loans outstanding was very low in the early 1980s:even after more than doubling to 52 in 1986, it is still quite modest inrelation to the share of TVCEs in China's gross social product (122 in 1985,142 by 1987). The share of TVCEs in incremental credit creation was only 7-81even in the boom period of TVE development in 1984-85. Finally, it appearsthat the :ratio of bank loans outstanding to GVIO is much lower for TVCEs thanit is for SEs (222 versus 382 in 1986, according to rough estimates).13/ Thusoverall, the TVE sector's role in credit inflation, a primary source of macro-economic instability in the Chinese economy, is modest.

13/ Because of much lower capital-output ratios in the TVCE sector than instate industry, bank credit may well be more important in relation tototal sources of capital for TVCEs than for SEs.

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Table 2.1: BANK CREDIT TO TVCEs, 1980-87(Loans outstanding at year-end, Y billion, and Z)

Total nationalbank and rural Share Share of TVCEs

Loans to credit coop- of loans in incrementalTVCEs erative loans to TVCEs credit creation

1980 5.600 249.594 2.2 -

1981 7.000 286.105 2.4 3.8

1982 8.200 317.342 2.6 3.8

1983 9.770 359.479 2.7 3.7

1984 19.796 477.409 4.1 8.5

1985 (1)/a 27.780 576.580 4.8 8.1

1985 (2)/a 27.780 630.547 4.4

1986 /a 40.825 815.873 5.0 7.0

1987 57.713 980.37 5.9 10.3

/a Before 1985, aggregate loan statistics do not include credit by thePeople's Construction Bank of China. The 1985 (2) data and 1986/87 infor-mation do include the Construction Bank. Loans to TVCEs presumablyinclude credit from all state banks as well as from rural creditcooperatives.

Sources: Statistical Yearbook of China, 1981, 1984, 1986, 1987, 1988; ChinaStatistical Summary, 1987; China's Finance, various issues.

2.3 Caveats and qualifications slightly weaken but by no means nullifythe above conclusion. Loans to PEs have not been factored in because of thedifficulty of separating them from loans to individual peasant households (foragricultural, sideline, or consumption purposes). Though they have risensharply, these still comprise a tiny portion of total credit. In 1986 totalloans to individual peasants were Y25.8 billion, only 3X of total nationalloans outstanding, and only part of this was loans to nonagricultural PEs.Some loans to TVEs may have been hidden in various agricultural loan cate-gories, but the amounts must be small in relation to total credit. Somecredit to SEs also has been transferred (voluntarily) by the enterprisesconcerned to TVEs through subcontracting and other arrangements. Finally,after tighter national credit policies were imposed starting in 1985, TVEsresorted to short-term bond issues to finance their continued expansion.Purchasers of these bonds may have drawn down their bank deposits to pay forthem, possibly enlarging aggregate demand.

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2.4 Overall, TVEs clearly have not taken a disproportionate share ofnational credit or government financial resources. Most CGs face a relatively"hard budget constraint', which appears to be effectively communicated totheir subordinate CEs, and PEs do not face problems of a "soft budget con-straint" in the first place. Hence TVE demand for economic resources largelyreflects legitimate economic and business concerns, and any distortions inthis demand for the most part are due to distortions in the market and other"signals" TVEs respond to. If the state sector generates very high demand forcertain kinds of goods, which the TVE sector then steps in and produces, thismay exacerbate problems of overall macro control. But the source of theproblem is not the TVE sector, which is merely responding to perceived effec-tive demand, and solutions should lie in restraining demand by the statesector.

2.5 More generally, while naturally a growing source of demand for inter-mediate and capital goods, the TVE sector has generated a tremendous increasein supply of goods demanded by SEs as well as by the urban and rural popula-tion. This has been done with overall capital-output ratios much lower thanin the state sector. Thus it is misleading to look only at the demand side--on balance the TVE sector has if anything contributed to macroeconomicstability through huge increases in supplies of goods that are in demand. Forexample, it has greatly expanded production of building materials, which helpsatisfy investment demand by all sectors of the Chinese economy.

2.6 There are two factors which may inflate TVE demand for resources,however. One is the enormous pressure CGs are under to increase nonagricul-tural employment, which may cause them and subordinate CEs to demand largeamounts of investment funds and take imprudent risks. This could be a problemparticularly in the backward areas with more surplus agricultural labor and aweaker base of TVEs, entrepreneurs, market opportunities, etc. But the macroimpact should not be exaggerated: leaving surplus labor in agriculture sapsthe vitality of that sector, with adverse consequences. A second factor whichmay inflate TVE demand is the ambiguous relationship between CGs and localbanks and credit cooperatives. In some of the more developed areas, symbioticties have evolved: CGs recognize that bank funds represent the community'sown accumulation and should not be wasted, and there is a clear assignment ofresponsibility for bad debts of CEs to their CG owners. But in many otherlocalities, particularly backward areas, CGs may use the local banking systemas a means of obtaining "deficit financing", weakening their hard budgetconstraints and opening the way for inefficient use of funds. This may fueldemand for credit above what is economically appropriate.

2.7 The immediate policy question is whether additional quantitativecredit controls should be applied to TVEs beyond those implied in the linkagebetween deposits and loans at the township level.14/ The latter, along withredeposit requirements, imposes some limitations on total credit in rural

14/ Under current Chinese banking practice, lower-level bank branches arelimited in the amount of credit they can provide to their clients bythe amount of deposits they generate locally--if they can attractadditional deposits, they can grant a similar amount of additionalloans (less required redeposits).

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communities. It is doubtful whether further quantitative limits on credit toTVEs should be instituted, unless the national macroeconomic situationrequires severe stringency, and other parts of the economy (most notably thestate sector) are being subjected to equally severe credit controls.

2.8 TVE demand for other resources (e.g. raw materials and energy)follows a broadly similar pattern to credit. It would not appear to be"excessive" in economic terms, though certain distortions in the system maymake it higher than otherwise or may give TVEs an advantage in bidding forresources against SEs. The key point is that the remedies to these problems,to the extent that they are serious, lie in removing or ameliorating thedistortions that give rise to them, not in direct restrictions on TVE activi-ties or growth. The TVE sector is the most dynamic and market-oriented partof Chinese industry, and it has been highly successful so far in generatingemployment opportunities for China's vast rural labor force. Hence directadministrative restrictions against TVEs would most likely harm the overallefficiency of the Chinese economy, and in particular they might weaken compe-titive pressures on SEs to improve efficiency.

Competition and Integration with State Industry

2.9 Closely related to the macroeconomic impact of the TVE sector is itsinteractions with state industry. These fall into the following main catego-ries: (a) competition in product markets; (b) competition for material inputsand energy; (c) competition for factors of production, particularly humanresources; (d) subcontracting by SEs to TVEs; (e) joint ventures, licensing ofSE brand names, etc.; and (f) relations between TVEs and state distributionagencies. One central issue is whether and to what extent there is "unfair'competition, which prevents SEs from fully making use of their econol.lic advan-tages (like large scale and more advanced technology), thereby allowing exces-sive expansion of TVEs. Another key question concerns the integration of theTVE sector into Chinese industry as a whole.

2.10 Precisely assessing the relative advantages of TVEs and SEs in acomplex, fragmented administrative and regulatory system still riddled withdirect controls is extremely difficult (see Chapter I). TVEs may gainconsiderable benefits from their greater freedom from price controls, abilityto spend large amounts on marketing and procurement, and tax advantages, buton the other hand SEs have access to material inputs through the plan, tostate marketing channels, to advanced technology and foreign exchange, etc.TVEs have lower labor costs than SEP. not so much due to lower wages butbecause SEs must provide a whole set of mandated welfare benefits to theiremployees (see Chapter VI). The situation may be radically different indifferent industries and markets. For example, the "two-tier" system in theiron and steel industry allows high-cost small producers (many of which arelocal state-owned enterprises rather than TVEs) to survive, but they mightvanish if a unitary pricing system is implemented and large complexes arepermitted to compete freely. On the other hand, in the textile industry TVEswill remain and if anything grow in importance. Increasingly, these outcomeswill be determined by economic factors rather than by administrativedecisions.

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2.11 A "level playing field" needs to be established for competition amongall kinds of industrial firms (see Chapter III), but this will be a long-termtask. In the interim, the temptation to impose direct restrictions againstTVEs to ease competitive pressures on the state sector should be avoided.There are many industries, particularly those in which labor costs are adominant factor, where TVEs could come to play an increasingly important role.Though adjustments by the state sector will be painful, they will lead toimprovements in aggregate efficiency. In other industries, where economies ofscale are significant, most TVEs may eventually exit, except perhaps for a fewof the largest ones, if they are allowed to grow to competitive size.

2.12 The most pervasive form of cooperation between SEs and TVEs is sub-contracting of parts production, assembly, ancillary activities, etc. to TVEsby SEs. This is usually motivated by the need of the latter to get access tocertain factors of production which they cannot obtain easily otherwise, mostnotably land and labor, and by their desire to take advantage of lower laborcosts in TVEs. Sometimes TVEs merely obtain (for a price) SE brand names tohelp sell their products. TVEs can even serve as a dumping ground for oldequipment of SEs. The benefits to TVEs from these arrangements include accessto more advanced technology and equipment, money, distribution channels, brandnames, (sometimes) low-priced inputs through the plan, etc. Whereas in thepast many subcontracting and other arrangements were based at least in part onnoneconomic motivations and administrative decisions by local governments,they are now increasingly entered into voluntarily by all participants toserve their own interests.

2.13 There are two key points concerning this kind of cooperation: (a) inthe more advanced rural areas, it is no longer essential to the TVE sector--inWuxi County, the share of TVE industrial output consisting of such subcontrac-ting declined from 702 in 1978 to only 21. in 1985; and (b) like "outsourcing"arrangements between firms in the United States and newly industrializingcountries, it may lead to partial "de-industrialization" of the state sectorand transfer of manufacturing capabilities to TVEs.

2.14 Overall, a policy and regulatory environment conducive to greaterintegration between state industry and the TVE sector needs to be built upover time. But such integration cannot be "forced", and its form should notbe prejudged. Given the competitive environment many TVEs function in andtheir demonstrated adaptability, it might well turn out that some of them growto the point where they are more-or-less on an equal footing with SEs in thesame industry.l5/ TVEs can also play a positive role in stimulatingefficiency improvements in SEs through competition.

Relationship with Agriculture

2.15 The TVE sector is closely linked to Chinese agriculture in a numberof ways. Though some of the linkages have been weakened by reforms since thelate 1980s, in other respects ties are now closer than ever. The TVE sector

15/ In order to achieve this, these firms would have to transcend thelimits of their rural community origins. See Chapter VIII.

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relies on much the same resource base as agriculture--the same land, the samehuman communities, the same banking institutions and other sources of invest-ment funds. Hence TVEs naturally compete with agriculture for theseresources. Agriculture and TVEs are the two most important means of employ-ment and personal income generation in rural areas. Finally, there are impor-tant financial flows between the two sectors. Past TVE development relied toa considerable extent on investment funds from agriculture. But financialflows now also go in the opposite direction: TVEs provide subsidies toagricultural production and for agricultural investment projects.

2.16 It has been suggested that competition between TVEs and agriculturefor resources is harming the long-run development potential of the latter.Funds of the rural banking system are increasingly being used in ruralindustry rather than in agriculture. Able-bodied and skilled personnel inrural areas with dynamic TVE sectors are reportedly shunning agriculture infavor of TVE jobs. The rapid growth of the PE sector also may have drainedpeople from agriculture. TVEs are occupying large amounts of good agricul-tural land in the more developed areas, since the profitability of land in TVEactivities is much higher than in agriculture.

2.17 It is difficult to assess the magnitude of this problem and theseverity of its adverse impact on agriculture.16/ But regardless, administra-tive restrictions against the TVE sector or diversion of additional funds fromTVEs to agriculture are not the answer. The problems of Chinese agriculturerelate to continued underpricing of some farm products; underpricing andinefficient allocation of key agricultural inputs like chemical fertilizer;the need for new methods of financing investments in agricultural infrastruc-ture; a land tenure system which does not facilitate consolidation of farmplots large enough to support highly profitable farming; and other factors.The fundamental solutions to these problems must be found in agriculturalpolicies and institutional reforms; the TVE sector should not be made a scape-goat for the problems of Chinese agriculture. Of course, solutions to China'spresent agricultural problems may not come immediately, and during the interimsome administrative measures to prevent excessive and irreversible encroach-ment of agricultural resources (particularly land) by the TVE sector may beappropriate. These should not distract attention from or serve as a substi-tute for needed institutional and policy reforms in agriculture, however.

2.18 Funds flow from TVEs to the agricultural sector through a number ofchannels. A portion of TVCE profit remittances to township and village autho-rities is used by them to purchase agricultural equipment, finance agri-cultural investment projects, and aid poorer communities. These transfers toagriculture have been declining both in absolute amounts and as a share oftotal TVCE profits (Table 2.2). In 1978 they totalled Y 2.6 billion, 30Z ofnet profits of TVCEs, whereas in 1986 they were only Y 700 million, 42 of TVCEprofits. During this period the ratio of TVCE net profits used for reinvest-ment in TVCE development (including both retained and remitted profits) toprofits used for agricultural support increased from 1.17 to 11.6. Thus this

16/ After all, one of the main goals of rural nonagricultural developmentis to absorb 'surplus" labor from agriculture.

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flow of funds from TVEs to agriculture would not eppear too burdensome atpresent. There are other flows, however, whose magnitude is uncertain butwhich may well be increasing. Most important is spending by township andvillage authorities on various kinds of subsidies for agricultural production,also financed largely from TVCE profit remittances.

Table 2.2: uSE OF TVCE PROFITS TO SUPPORT AORICULTURE, 1976-87(Y billIon and %)

1978 1980 1981 1982 1988 1984 1985 1986 1987

Total Net Profits of TVCEs 8.81 11.84 11.28 11.66 11.78 12.87 17.18 16.10 16.78

Shares in TotalUsed for *id to agricul-tur/ 30.0 19.2 15.1 12.4 11. 6 7.8 6.1 4.8 4.6Of whTeh:Purchase of equipment 18.1 7.7 6.2 4.6 3.6 n.a. na. n.s na.Field construction 13.4 7.9 7.1 6.2 6.1 n.s. n.. n.o n a.Aid to poor brigades 8.6 8.6 1.8 1.6 1.9 na. n a. na. n. .

Used for investment inTVCE sector 86 1 39.7 8. 1 41.2 48.0 47.4 46.4 49.8 58.2

Ratio of TVCE investment toagricultural support (X) 117.0 207.0 262.9 881.9 878.4 919.0 902.8 1,159.4 1,161.7

/a Apparently Includes profits turned over to township and village authoritioo by TVCE* andthen used by the latter for expenditures to support agriculture.

Sources: Statistical Yearbook of China, 1987, 1988; China Rural Statistical Yearbook, 1986,1986, 1987; China Agricultur- Yoerbook, 1988, 1984, 1986, and 1986.

2.19 Administratively directed flows of funds from the TVE sector to agri-culture are not the most appropriate response to the development needs of thelatter. There is some evidence that "aid-to-agriculture" funds are used in aninefficient and wasteful manner. More fundamentally, since they compensatefor underpricing of agricultural products, these flows effectively constitutea "tax" on the TVE sector (and hence on rural communities), which helps makeagricultural goods available to the urban population at low, subsidizedprices. Similarly, restrictions against TVE activities can be viewed as ameasure to force rural areas to maintain agricultural production for thebenefit of the cities. A much better approach would be to improve the incen-tives for agricultural production and the allocation of agricultural factorsof production (e.g. land) and key inputs like chemical fertilizer.

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Urbanization and Migration

2.20 Rural industrialization in China has been accompanied by urbanizationin small towns, mostly traditional market towns and township or county seats.In many areas agglomerations of people and nonagricultural activities havesprung up almost overnight. But many TVE factories are scattered throug ioutthe countryside, away from towns. A major reason behind urbanization in smalltowns and previously rural areas is the restrictions against migration intolarger cities, which have been relaxed to some extent but still greatly hinderpermanent moves and moves by families. But even within administrativelydemarcated rural areas, emerging patterns of industrial location and urbaniza-tion may be excessively dispersed. This is due to the strong community orien-tation of TVEs and entrepreneurs. Even at the village level, the bulk of TVEs(including PEs) are located in the communities to which they belong. Since atypical county has several hundred villages, the potential for overlydispersed patterns of industrial location is serious.

2.21 Dispersed factories and small-town urbanization carry high economiccosts. Infrastructure is scattered and inadequate; transport costs arehigher; excessive amounts of high-quality agricultural land may be diverted toindustrial uses; and industrial pollution is spread widely in the countryside,with consequent difficulties and high costs for pollution control. Over thelonger term, as rural industrialization proceeds, the costs of not moving to amore concentrated pattern of urbanization and industrial locationi will likelybecome progressively higher. Thus even if restrictions against permanent,family-based migration into large cities remain in place, there is consider-able scope and need for greater concentration of population and factory loca-tions within counties and, in the more industrialized areas, townships. Thiswill require incentives and possibly a zoning framework which encouragessizable TVEs to locate in towns, even if these are outside the home community.Such policies and reforms might best be carried out by counties or higherlevels of government setting aside land for 'industrial parks", not under thejurisdiction of any particular rural community, and providing economic incen-tives for TVEs and entrepreneurs to locate there (see Ghapter V).

2.22 At the broader level and from a long-term perspective, the policy ofrestricting migration into large cities and controlling city sizes can bequestioned. In the first place, it is increasingly ineffective, and largenumbers of "temporary" migrants are already living in large cities, taking onvarious menial and construction jobs. In any case, larger cities per se arenot necessarily inefficient, as long as the population and firms located inthem are paying the higher costs associated with large city size.17/ Thereare many economic activities with high returns which need the benefits of big-city location. Thus the crucial priority is more appropriate pricing andcosting of infrastructure and public services in large cities, so that theeconomic activities for which large-city location is economically appropriatewill indeed be located in them and other activities will be established in ormove to other areas. Such reforms are a prerequisite for any substantialrelaxation of migration controls. Even if there is considerable growth of

17/ See World Bank, Zheiiang: Challenges of Rapid Urbanization (World BankSector Report 6612-CHA) for a detailed analysis of urbanization inChina's cities.

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population in China's large cities, a large part of future urbanization willnecessarily have to occur in smaller towns.

Foreign Economic Relations

2.23 There is great variation in the degree of access of different partsof the TVE sector to foreign partners, markets, funds, technology, and equip-ment. In Nanhai County, TVEs are free to engage in all kinds of processingand compensation trade agreements with foreign partners. Because of thearea's large exports to Hong Kong and high remittance incomes, TVEs also havereasonably good access to foreign exchange. Most imported equipment and tech-nology comes to Nanhai TVEs through compensation trade. In Wuxi, by contrast,TVEs are not permitted to deal directly with foreign p'irtners, despite theirlarge direct and indirect exports. Access to foreign exchange and foreigncapital is highly restricted. In Jieshou, contacts with foreign businessesand even direct foreign investment are permitted, but activity has beenlimited so far due to lack of traditional connections. Inexperience in deal-ing with foreign businessmen has led to problems. in Shangrao County, thereis not one piece of imported equipment installed in any enterprise (includingstate and urban collective firms as well as TVEs). The county's exports(primarily handicrafts) go through Shanghai. or Jiangxi provincial foreigntrade authorities; producers have no direct contact with international marketsand no access to the foreign exchange proceeds from their exports. Overall,the TVE sector is already a major actor on the export scene, generating annualexports of over US$5 billion, more than one-eighth of total export value.

2.24 The TVE sector's access to foreign economic contacts should be openedup. This undoubtedly would benefit areas like Wuxi greatly. Small firmsoften make excellent exporters because of their quick response and flexibi-lity. Many TVEs potentially could be competitive in export markets, butexcept in southern Guangdong and a few other places, this potential has notbeen realized. As part of reforms in China's foreign exchange system, TVEsshould be permitted to participate in foreign exchange markets and buy foreignexchange at market prices to import equipment and technology, and to haveaccess to the foreign exchange proceeds of their exports. TVEs should bepermitted to have direct contacts with foreign businessmen and enter intovarious kinds of cooperative arrangements w'.th them, as is now possible insouthern Guangdong. For small firms to be successful exporters, a strongnetwork of trade-related services is necessary. TVEs should be given accessto the existing network of state trading agencies (on a fee-for-servicebasis). But liberalization of and greater competition in the state foreigntrade system also is needed. Trading companies and other kinds of enterprisesproviding trade-related services should spring up over time withiin the TVEsector itself.

2.25 There are a host of other mundane yet important changes which wouldhelp facilitate TVE exports. Greater standardization of product specifica-tions for many export goods and better quality control (including testingsystems) are two examples. TVE access to export financing on an equal basiswith other types of firms also would be very helpful. There may be great

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potential for subcontracting of export production tasks to TVEs by stateforeign trade corporations as well as state-owned industrial firms, which isalready occurring to some extent, and this should be further encouraged. Atthe broader level, the Government's exchange rate and related policies will,to a large extent, determine the competitiveness of many TVE exports andpotential exports.

2.26 A final question concerns what actions could be taken to give back-ward areas more access to beneficial foreign contacts. At the very least,they should not be given lesser access to internationai markets than the moreadvanced coastal areas (which appears to be the common pattern at present),because this would only further increase the handicaps they already face. Butit is only to be expected that given their lack of traditional ties and weakerindustrial base, the more backward areas will not be able to take advantage ofopportunities presented by opening up to foreign economic relations as quicklyor as easily as the developed coastal regions. Development of markets fortrade-related services could be very helpful for the backward areas, as wouldan inflow of export-oriented entrepreneurs from more developed localities (seeChapter VII).

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III. LEGAL AND REGULATORY FRAMEWORK

Legal Framework for TVE Business Activities

3.1 As in the Chinese economy as a whole, the legal framework governingTVE business activities is weak and rudimentary. Contracts to a considerableextent cannot be enforced through the legal system, which leads to a number ofproblems. The ineffectiveness of contracts reduces economic efficiency andforces reliance on other, more personalized and customary means of doing busi-ness, which may have higher transactions costs. The.ce is considerable diver-sity in local practices and hence uncertainty for enterprises.

3.2 Given the close ties between TVEs and the rural cammunities they arebased in, "outsider" firms or individuals are at a major disadvantage.l/ Thisinhibits factor mobility and mobility of human resources, because people arereluctant to set up businesses and production facilities outside their homecommunities. The community rootedness and commuiiity orientation of the TVEsector may be based primarily on the inadequate legal framework, rather thanon strong "community consciousness" on the part of China's peasantry.

3.3 The ir.adequate legal framework, combined with the strong communityorientation of the TVE sector, may also partly explain the relatively lowshare of services in output. Delivery of goods outside the home community isgenerally fairly straightforward--the value created by the producer is embo-died in the goods and moves with them to the place of purchase. Delivery ofservices outside the home community, on the other hand, often requires actionsby employees and other factors of production in the locality where the serviceis "consumed". Thus the inhibitions against inter-community mobility ofenterprises and factors also serve to restrict the growth of those serviceswhich are most economically provided on a multi-community basis.

3.4 Contract law also may not adequately support the rights of TVEs indealings with SEs. TVEs have found it hard to enforce contracts with SEs whenchanging business conditions caused the latter to renege on them, and conse-quently sometimes have suffered heavy economic losses without remedy.2/ Theunenforceability of many business contracts w'th SEs has forced TVEs intopractices that guard against losses from breaking contracts, even though thismay be more costly and less efficient for all concerned.

1/ In dealings with outsiders. there is identification between local TVEsand county governments and legal institutions. In this situation,criteria for determining where a case is to be adjudicated areobviously important, but these appear to be somewhat vague. Suits inprinciple are to be brought where the violation occurred or contractwas signed, but if it is "inconvenient" for a defendant to travel tothat location, they must be adjudicated in the defendant's homejurisdiction.

2/ SEs voice similar complaints about TVEs, which only further supportsthe assertion that the legal framework is highly inadequate.

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3.5 Strengthening contract law and particularly the enforceability ofcontracts is an urgent task. One option would be to follow the general prin-ciple that economic regulation of business entities under "local" ownershipshould be handled at higher levels of government so as to avoid conflictsbetween ownership and regulatory roles of government. This could be achievedthrough a system of courts and some kind of enforcement mechanism for dealingwith business disputes that cut across communities and localities, probably atthe provincial level.31 Such a system would provide recourse to "outsiders",while allowing disputes within communities and counties to continue to behandled by local economic courts or traditional methods. It would alsoprovide recourse for TVEs in contract and other business disputes with SEsunder local government ownership, and indeed for SEs in disputes with TVEs.

3.6 An alternative which does not involve establishment of entirely newinstitutions would be to strengthen existing mechanisms like the contractarbitration committees of the Industrial and Commercial AdministrationBureaus.41 To become effective and credible means for enforcement ofcontracts, these committees or other existing institutional mechanisms wouldneed to be "de-localized'. This might be a very difficult task, given themultitude of administrative, political, financial, and personal ties that bindlocal branches of the Industrial and Commercial Administration Bureaus as wellas other government agencies to community and county authorities. Neverthe-less, if these difficulties can be overcome, use of existing institutionsmight well be less costly and more effective than creating entirely new ones.

3.7 Another important part of the legal framework is the rules for estab-lishing and operating enterprises of different types (known as 'company law"in other countries). China is in the process of drafting and promulgatingenterprise laws (including one for TVEs), but there are already numerousregistration and other regulations in place. Generally the proceduralrequirements for establishing TVEs appear not too onerous, but for PEs theyvary considerably at the local level--in some places like Wuxi, local regula-tions are used to prevent the emergence of sizable PEs, whereas in other areasthey are encouraged, or at least tolerated. Very small firms, as in othercountries, are often set up without going through registration proceduresanyway. There is also a great deal of variation in the degree to which

3/ Since much TVE business transcends provinces, a central governmentjudicial body and enforcement mechanism for such disputes might also benecessary. This would be a key part of efforts by the centralgovernment to ensure "free trade" within China and prevent damaging'internal protectionism".

4/ The Industrial and Commercial Administration Bureaus (nominally underthe supervision of the General Bureau of Industrial and CommercialAdministration in Beijing) are generdlly responsible for registrationof firms, monitoring compliance with business laws, registration ofcertain contracts, etc. Like many other Chinese government agencies,they are to a considerable extent localized in terms of orientation,personnel and personnel decisions, and even actions.

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iocalities permit, support, or welcome the establishment of firms by outsid-ers. Some private entrepreneurs from Fujian Province have been allowed to setup plants in Nanhai County, for example. This is exceptional, however, and inmany localities allowing outsiders (particularly from outside the county) toestablish firms would he unthinkable.

3.8 The legal framework for establishing and operating enterprises to theextent possible should be neutral with respect to different types of firms.Substantially different regulations for CEs and PEs would not be appropriate,because this would facilitate discriminatory treatment and would adverselyaffect the objective of achieving a "level playing field" for competitionbetween them. In principle, "company law' should be similar for TVEs, SEs,and urban collective firms, though this may be hard to achieve immediately,and in any case smaller TVEs have a much more rudimentary organizationalstructure than SEs or larger CEs.5/ Nevertheless, a broadly similar legalframework as between CEs and PEs should be possible.

3.9 Another crucial part of the legal framework is the termination of theexistence of financially unviable firms and the adjudication of claims onthem. A bankruptcy law might facilitate exit or rehabilitation of loss-makingfirms, but the specifics and even the concept of bankruptcy in the TVE sectorraise complicated issues. For example, what happens if a community's CE sec-tor as a whole cannot meet payment obligations, since bankruptcy for a fixed-membership rural community is not realistic or meaningful? Another danger iLthat CGs might have an incentive to squeeze their CEs for funds, forcing thelatter to borrow excessively from local banks, and then allow them to gobankrupt, writing off what in effect are CG obligations (see Chapter IV).

3.10 Though new legislation is required in company law and bankruptcy lawand some strengthening of contract law and other business laws may be desira-ble, the crucial difficulties will increasingly lie in enforcement and judi-cial treatment rather than in law-making. These are especially essential inlegal matters that involve parties from different localities. Within communi-ties, laws may differentially affect TVEs with different forms of ownership.Given the likely continuing internal cohesion in China's rural communities andthe powers of CGs, especially at the township level, ensuring evenhanded legaltreatment within communities probably has to be a gradual process. Hence thehighest priority in the short run should be given to improved handling ofcases which cross community and county boundaries.

Regulatory Environment

3.11 TVE regulatory issues are closely related to the legal framework.Indeed, the distinction between the two is blurred as a result of the weaknessof the latter. The problems already mentioned of uncertainty, lack of even-handedness, bias against outsiders and consequent inhibitions against factormobility, etc. all arise in much the same way. In addition, certain other

5/ One possible approach would be to have a single "basic" company lawwhich applies to all kinds of enterprises, along with differentsupplementary laws for SEs, urban collective firms, CEs, and PEs.

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aspects also are very important, like administrative approval processes forproduction of specific goods, environmental protection regulations, treatmentof mineral resources, etc. "Management" of rural marketplaces by local gov-ernment agencies often leaves much to be desired, and in many rural areasthere are problems with excessive collections of road tolls by CGs and otherorganizations. More generally, predatory behavior on the part of governmentregulatory agencies and individual officials constitutes a severe hindranceagainst the smooth and efficient functioning of markets TVEs operate in.

3.12 The regulatory environment faced by TVEs is generally much weakerthan that in place for SEs, due to the small size of TVEs and also their non-state ownership, as well as the weakness of economic regulation by the centraland provincial governments in rural areas. Attempts have been made from timeto time to restrict entry by TVEs and locally-owned small SEs into lucrativelines of business like cigarettes and textiles, or into heavy industries withpresumed economies of scale, like iron and steel. But these have generallynot been very successful due to lack of enforcement.

3.13 The solution to all these problems is not to build up an extensivegovernment hierarchy to provide administrative support and a better regulatoryenvironment for TVEs. On the contrary, the lack of "mothers-in-law" for TVEsoutside the local community may be a major factor in their success. What isneeded instead is a more evenhanded and "neutral" regulatory system, whichgets away from the biases inherent in the present modes of intervention by thegovernment administrative hierarchy. Greater separation of the regulatory andownership functions of government agencies would be desirable in this regard.As in the case of the legal framework, a key principle to follow is that thedesign and implementation of economic regulations should be divorced from theexercise of ownership functions with respect to SEs or CEs. It would makesense for regulatory functions to be carried out at a level of governmenthigher than the level of enterprise ownership (e.g. the provincial level forregulatory policies and enforcement with respect to the TVE sector). Detailedregulation of numerous, mostly small firms is costly and ineffective anyway,and use of "macro" levers can be more efficient.

3.14 In addition to greater evenhandedness, more simplicity and transpa-rency are urgently needed in government regulation of TVEs and their activi-ties. This would help check predatory behavior and corruption by governmentregulatory agencies and improve the functioning of markets in rural areas.Some localities are experimenting with reforms designed to "clean up" marketmanagement, fees levied on traders, collection of road tolls, and approval andregistration procedures for TVEs. Consolidation of fees, specified in aprecise manner and with only one agency empowered to collect them, appears tobe an effective measure. Similarly, "one-stop procedures", with all theagencies brought together to a single place to process registration applica-tions by TVEs and other administrative matters, have been successful incutting down red tape and the potential for corruption. These kinds of verybasic reforms can be implemented rapidly at the national level, once effectiveand viable "models" have emerged from local experiments.

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3.15 Improved regulation and a strengthened Government regulatory appara-tus are urgently needed in the area of )ollution control. Rural industrialpollution has increased sharply with the rapid growth of the TVE sector. Lesseffective pollution controls in rural areas appear to have encouraged sometransfers of polluting activities from urban SEs to rural TVEs. The proximityof many industrial TVEs to rich agricultural land and rural water suppliesheightens the impact of their pollution. Policy measures and institutionalmechanisms to curb pollution in China's rural areas, whatever their precisenature, should be imposed in a transparent and nondiscriminatory manner ondifferent types of firms. In Wuxi County, local authorities used pollutioncontrols as a means of obstructing the emergence of industrial PEs, in orderto maintain and even strengthen the dominant position of TVCEs.

Treatment of Private Enterprises

3.16 The fundamental issue in this area is the need to strengthen,clarify, and systematize legal ownership rights with respect to PEs. Ambi-guity concerning the ideological desirability and legality of large PEs hasgenerated numerous distortions and has opened the door for a variety ofunhealthy personal relationships between PEs and local CG and countyofficials. Private entrepreneurs, unsure of their position, may divertresources to consumption or housing or otherwise run their enterprises in away that doesn't maximize their efficiency and growth. In the absence ofappropriate actions, these problems and distortions could get worse as the TVEsector continues to grow and the number of substantial PEs increases.

3.17 The central government's political and ideological blessing to PEswith more than seven employees, given in 1987, was a major step forward. PEsin principle are no longer limited in terms of the size they can attain andthe number of employees they can hire. But central government pronouncementsalone may not resolve all the ambiguities and problems. The political accep-tance of sizeable PEs should be backed up with concrete laws and regulatorymeasures to ensure that they receive fair treatment. Issues of how to treatnet worth of PEs, transferability, inheritance, roles and rights of workers,etc. still need to sorted out, and clear guidelines issued.

3.18 Discrimination against PEs is still practised in some areas. WuxiCounty, for example, directly restricts the formation of industrial PEs andtheir entry into different industries, through a host of regulations (energyconservation, land use, environmental protection, etc.). Competition forpersonnel between the PE and CE sectors is generally the most severe source ofconflicts in Wuxi and elsewhere. As part of the legalization of PEs and thestrengthening and clarification of private property rights, outright discrimi-nation against PEs by local governments should be prohibited. There is a large"grey area", however: county governments and CGs have many instruments andpositive rewards as well as negative sanctions which they can use to promoteor restrain different parts of the TVE sector. It is probably inevitable thatdifferential treatment will continue in some localities, which makes a clearand enforced policy on basic property rights of PEs all the more important.

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! Discriminatory Treatment vis-a-vis the State Sector

3.19 A major concern is whether TVEs suffer from discriminatory treatmentas compared with the state sector. This would only be natural because manygovernment industrial regulatory agencies also have hierarchical ("quasi-ownership") ties with SEs. Such discrimination would be damaging to the TVEsector and to China's efforts to instItute a "level playing field" on whichall kinds of enterprises can compete on an equal basis.

3.20 By and large, there is little if any discrimination against local CEsby county governments. These usually have a strong interest in promotinglocal TVE development, and moreover the number of county-run SEs and theiroutput are often small in relation to the local TVE sector. At higher levelsof the government regulatory apparatus, policies harmful to TVEs sometimes areinstituted. Restrictions against entry by TVEs into certain fields have some-times been imposed, but not very effectively. The whole system of mandatoryplanning treats the TVE sector differently from the state sector, by givingthe latter access to low-cost inputs through the plan. National creditrestrictions imposed in 1986 may have had a disproportionate effect on the TVEsector. TVEs may suffer from disadvantages in their commercial relationshipswith SEs, in particular biases against them in the legal and financialenforcement mechanism. On the other hand, TVEs in the past received conces-sional tax treatment, paying profit tax at much lower effective rates thanmost SEs. This is gradually being ended, as TVE tax rates are raised to con-form to the 8-level progressive income tax system for collective enterprises,and the "adjustment tax" levied on SEs is reduced. However, more lax account-ing systems for TVEs may permit them to continue to avoid high taxes.

3.21 Obviously, different forms of discrimination against or in favor ofthe TVE sector should be eliminated, so that competition among different typesof industrial enterprises can occur on an equal footing. There is an uneasybalance between different biases now in the system, however; to remove oneform of discrimination while maintaining others might not be very helpful.For example, sharply raising tax rates for TVEs to bring them into line withthose for SEs might be counterproductive, in the absence of comparable mea-sures to reduce and eventually eliminate the competitive advantages SEs gainfrom access to low-priced inputs, energy, and bank credit. As a generalprinciple, movement toward a more neutral and balanced environment for compe-tition among different types of industrial enterprises should come aboutthrough loosening of restrictions affecting more highly controlled firms (SEs)rather than through greater restrictions imposed on firms now subject tolooser government controls (TVEs).

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IV. FINANCIAL ISSUES

Current Situation and Problems

4.1 Financial capital is a critical resource for TVEs. The community-based institutional structure in China's rural areas and the community-orientedness of both TVEs and local financial institutions are in some waysbeneficial in this respect. The CG can serve as "guarantor" of bank loans toits subordinate CEs, enhancing their ability to obtain credit, providinginformational advantages to banks and borrowers, and reducing risk to theformer. Sin,ce bank credit funds for TVEs in the more developed rural areasare based entirely on deposit mobilization within the township, CGs andcommunity banking institutions--local Agricultural Bank of China (ABC) officesand Rural Credit Cooperatives (RCCs)--recognize that bank loans represent"community capital" and hence may be more careful in using it. Though thebanking system has gained a measure of independence from CGs in recent years,local l)anks are still subject to considerable influence from local governmentsin lending decisions.6/ But the relationship between the two is largelysymbiotic in many of the more developed rural areas, where CG involvement inlending decisions is in line with CG assumption of most of the risk of nonre-payment.

4.2 The same basic institutional structure and incentive pattern oftenworks very poorly itl the backward areas. CGs do not have adequate financialresources to absorb the risk from credit-financed investment projects. As aresult, risk is borne (involuntarily) by the banking system, in the form ofdelayed repayments.7/ CGs sometimes even use CEs as a means of obtaining"deficit financing" for local public expenditures (and CG payrolls) indirectlyfrom the banking system. CEs are required to turn fixed amounts of "profits"over to CGs, regardless of their actual performance, and to meet these targetsCEs borrow from the bank, consume their capital (drawing on depreciationallowances), or both. Under these circumstances, banks become very conserva-tive and fearful of lending to CEs, and as they gain more independence theymay reduce such lending.

4.3 Spatial flows of capital across communities and localities in China'srural economy are still limited. Outside the banking and fiscal systems suchflows are very small. Redistribution through these systems, considerable inthe past, may now be increasingly limited. Immobility of capital can lead toinefficient resource allocation. Combined with considerations of risk (see

6/ ABC is nominally structured as a nationwide vertical hierarchy underABC headquarters in Beijing. RCCs, though nominally independentcooperatives, were in fact part of the ABC system and subject tosupervision by ABC. However, local bank branches and RCCs tend to bevery responsive to local government and CG demands.

7/ Outright default is very rare in the case of CEs, since banks do nothave procedures for writing off bad debts (let alone for creatingreserves against anticipated losses). Thus the common practice issimply to continue carrying unrepaid (and unrepayable) loans on thebooks.

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below), it may also limit the maximum size TVEs are able to achieve, prevent-ing them from taking advantage of economies of scale and slowing down thegrowth of the most efficient, well-managed firms.

4.4 Investment resources for TVEs to a large extent must come from thefinancial resources of the local community. This need for financial "self-reliance' can provide beneficial incentives for efficient allocation and useof funds within the community, but it may result in wasteful and inefficientpatterns of investment across communities. The issue is not so much large-scale movement of financial capital across provinces and regions, which raisecomplicated issues if other factors like labor are immobile, but rather con-centration of funds for efficient TVE investment within localities.

4.5 TVEs on the whole are rather highly leveraged in comparison to SEs(see Table 1.8). This is due partly to their recent emergence and rapidgrowth, and also to their inability to draw on government cEpital to any sig-nificant extent. In a situation of extremely rapid growth mnd great opportu-nities, a high degree of leverage may be beneficial. But 's TVE outputmarkets become more saturated and competition intensifies, heavy reliance onbank debt may become more of a burden for the TVE sector. Many TVEs alreadyare or may become financially unviable, unable to repay their large bankdebts. More generally, risk management issues are coming to the fore, at thecommunity level as well as at the enterprise level.

4.6 In terms of capital structure, many larger PEs have no equity baseother than internal accumulation, since it is typical practice for PEs to"repay' their founders' initial investments as soon as they are on a soundfinancial footing. Thus how to augment (indeed, create) an equity base forthese firms is an important question. For CEs as well, risk-absorbing finan-cial instruments need to be devised.

4.7 The future institutional structure, ownership, and relationship toCGs of the rural banking system is another key issue. In some areas thepresent system has worked reasonably well, despite low interest rates, lack ofcompetition, and administrative intervention in lending decisions. In others,the banking system is not stimulating local development and carries a portfo-lio laden with bad loans. Among the key issues for national policy are:(1) decentralization of the "ownership' of the banking system; and (2) how tointroduce competition into the rural banking system.

Enhancing Capital Mobility

4.8 Greater capital mobility, at least within localities like counties,could help improve efficiency of resource allocation in China's TVE sector.More efficient, successful enterprises and communities would attract morecapital, allowing them to grow more rapidly and thereby improving aggregateefficiency. Enhanced capital mobility could also serve as a means of imposingtighter financial discipline on CGs, preventing them from using the TVE sectorand banking system to "soften" their hard budget coz;straints. Greater capitalmobility should start at the "local" level--between townships in a county,counties in a prefecture or province--to avoid large flows from poor to more

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developed regions, which in the absence of labor and population outflows couldadversely affect development prospects in the former.

4.9 The banking system has been and is likely o remain the most impor-tant channel for capital flows in rural aras. Reforms in the rural bankingsystem could increase the mobility of bank credit funds. Higher interestrates on discretionary interbank lending and borrowing across localities mightwell elicit larger capital flows. Restructuring of the banking system so thatbranches are not exactly contiguous with community and county boundaries alsomight enhance capital mobility (see the section below on the banking system).But banking reforms may be hard to implement and make effective in the absenceof meaningful competition for the existing state banking system.

4.10 Reform of the existing banking system would be facilitated bypressure from competition. Establlshment of new commercially-oriented finan-cial institutions will also directly improve provision of financial servicesto TVEs. A considerable amount of institutional diversification is alreadyoccurring in China's rural financial sector, but most new entities appear tobe community-oriented and community-based. To strengthen competition andenhance capital mobility, many of the new financial intermediaries created inthe future should cut across community and locality boundaries and should notbe owned or controlled by any particular CG. Cross-community financial insti-tutions could be structured as joint ventures, for example including severalCGs and possibly national- or provincial-level financial entities.

4.11 Another way to enhance local capital mobility in the TVE sector is toestablish a regulatory and administrative environment conducive to cross-community joint ventures. The community orientation of the TVE sector and theinadequate legal/regulatory framework create substantial barriers against suchjoint ventures. For instance, each partner would want the joint venture to belocated within its own jurisdiction. libor hiring might also be a difficu-issue. One way of encouraging cross-community joint ventures is for locaigovernments to establish "industrial parks" at which joint ventures could setup operations (see Chapter V). These areas would not be under the jurisdic-tion of any particular rural community: hence they would provide a "neutral"location for joint ventures involving several communities.

4.12 Still another approach would be to bAild on the existing practice ofissuing short-term (1-2 year maturity) ands with profit-related variableinterest rates by some CEs and township industrial corporations (TICs) in themore advanced areas like Wuxi. These bond issues (called jizi) have uncertainlegitimacy and an uneasy relationship with the banking system, which fearslosing some of its deposit base. Moreover, up to now they have been issued toworkers and to local community residents--few if any bond issues have crossedtownship boundaries. Finally, the linkage of returns to profits oftencontains a large discretionary element.

4.13 TICs or county industrial authorities in the more developedlocalities could issue variable-interest bonds (hereafter referred to as"income bonds"), which would be purchased primarily by entities and indivi-duals outside the community. Such bonds would carry a fixed minimum nominal

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interest rate, but they would also entitle their purchaser to a share of TE orTVCE net after-tax profits in a township (if issued by a township) or inseveral townships (if issued by a county). Thus they would spread some of thevariability in profits to investors, while at the same time assuring them of acertain minimum nominal return. Initially, bonds would be of fairly shortmaturity (say, three years), but maturities could be lengthened as peoplebecome accustomed to the new instruments. TICs or county entities rather thanindividual firms would be the appropriate bond issuers. TVEs are far toosmall; moreover, CEs in some ways are more like subsidiary parts of aconglomerate than like independent firms. With perhaps only few exceptions,lower-level communities also would not be appropriate bond issuers. Only TICshave a sufficient industrial base and adequate standing to be credible tooutside investors. Purchasers of income bonds could include other CGs,individuals, firms, and financial institutions. They would be marketed on aprovincial or local basis (but outside the community) and sold through banks,which would also serve as guarantor and collect a service fee. Banks wouldmarket income bonds of a number of TICs jointly, with a joint prospectusallowing would-be investors to compare past economic performance and terms ofissue. There would be provisions for advance redemption, but at a penaltywhich would discourage doing this and which would give banks that redeem bondsan attractive return for holding them to maturity.

4.14 Pricing of these bonds would be based on the fixed minimum interestrate and a set share of profits. The fixed interest rate could be mandated bythe government and set at the same level for all issuers. It should be signi-ficantly below the interest rate for time deposits of similar maturity atbanks, so there is indeed some risk to investors, though the maximum loss (interms of alternative opportunities) is limited. A relatively low minimumfixed interest rate would mean that only profitable issuers could sell theirbonds (since investors would not be attracted if there would likely be noprofits to share in as well). Thus poorly performing communities would beautomatically excluded from the bond "market". Given interest rates of over8Z p.a. on three-year time deposits at banks, a fixed nominal interest rate of4-5 p.a. might be the most appropriate level to meet the twin needs ofassuring investors some minimum return and providing sufficient variabilityand a large profit-related component. The share of profits carried by eachbond would then be set to provide an expected total rate of return attractiveto investors. This would have to be considerably above the "safe" interestyield on bank saving deposits. If the bank interest rate is 8Z and the fixedinterest rate on the income bonds is 4Z, an expected total yield of 122 oreven as much as 15Z might be necessary to attract investors.8/

8/ As an example, assume that the fixed interest rate is 4Z p.a. and thedesired total rate of return is 12Z. The issuing entity expects thatits net after-tax profits will be (for simplicity) Y1 million in eachof the three years the bond is outstanding. A holder of a YlOO bondshould receive Y8 in profit share each year in order to get a 12Z p.a.total return, so the bond's profit share should be 8/1,000,000 or0.000008Z. The calculations become more complicated if profits areexpected to change over time, but the basic principle is the same.

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4.15 Presuming the bonds are issued in series, an issuer that doesunexpectedly well, with sound financial performance, could lower the profitshares for subsequent bond issues. On the other hand, entities who could notsell their bonds in the first round or whose performance is worse thanexpected would have to raise profit shares subsequently in order to stay inthe market. Profit shares perhaps could be lowered gradually over time asincone bonds gain acceptability and the required "premium" over the depositinterest rate declines. The total value of bonds that could be issued by aTIC would be subject to a ceiling, perhaps specified in relation to itsprofits or assets. This would provide a measure of protection to investors,but more important is the "natural" protection offered by the fact thatunprofitable entities would be unable to market bonds.

4.16 Income bonds would lend themselves toward gradual transformation intomore "equity-like" instruments. This could be accomplished by reductions inthe fixed interest payment (eventually to a zero nominal rate), which mightrequire increases in profit shares, or at least smaller reductions thanotherwise.9/ Once suitable trading arrangements are formulated, resale ofbonds on secondary markets could occur. Another ingredient in this transfor-mation would be lengthening maturities, perhaps first to five years and laterto 10 years or longer. In the end, income bonds would become something akinto equity shares, but without voting rights or claims to the assets of theissuer.

4.17 Income bonds could be expected to have some important benefits in themore developed TVE areas. First, they would strengthen the capital structureof TICs issuing them and promote the evolution of TICs into true holdingcompanies, with less direct linkage to CGs. Second, they would stimulategreater capital mobility on the basis if profitability, generating competitionamong firms and CGs for capital and providing a counterweight against intru-sion of efficiency-reducing nonbusiness objectives. Third, they would serveas an indicator of performance for banks in their lending decisions. A TICunable to generate profits and hence unable to sell bonds, for example, couldexpect less sympathetic treatment from banks in decisions on loan applicationsof subordinate CEs. Fourth, they offer the rural banking system an opportu-nity to assume a more diversified role, and to focus on profits rather thanonly total lending (the primary indicator of bank performance in the past).Fifth, they would require and hence promote more accurate and open financialaccounting and reporting in the TVE sector. Sixth, they would serve as anevolutionary bridge to development of equity instruments and capital markets,without the instability that characterizes the small capital markets of manydeveloping countries, or that would likely be the result of an overly rapidmove to capital markets by the Chinese. Since there is no internationalexperience and little past Chinese experience to provide guidance on how wellthe income bond concept would actually work out in practice, experimentationshould start on a small scale, in a few of the more advanced areas.

9/ A lower minimum interest rate would require a higher profit share justto reach the previous expected total return, and moreover the greatervariability in returns might well cause investors to demand a higherexpected total return as compensation for the greater risk.

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Enterprise and Community Risk Management

4.18 Risk management undoubtedly has played a role in the success of thetraditional CE sector in the more developed areas. TICs pool and absorb thebusiness risk of subordinate TEs, which gives firms facing a downturn a tem-porary respite to recover, change product lines, etc. The main instrument forTIC risk management has been ad-hoc variation in the financial flows betweenTEs and TICs. This also serves as a means of pooling investment funds withintownships for major projects and new enterprise creation. CGs manage theirbusiness risk through their decisions on the number of firms to operate andthe degree of diversification of product lines. Even so. business downturnshave an inordinately large impact on CG finances and operations. Inadequaterisk management exacerbates the problems of backward areas. CGs there do nothave the discretionary funds to absorb enterprise risk, so much of it is borneinvoluntarily by the banking system, with harmful consequences.

4.19 There are three main issues concerning risk management: (1) how topool and absorb risk in the backward areas; (2) how to manage risk at thecommunity level, in developed and backward areas; and (3) how to deal withfailing CEs. In the more backward areas, wholesale assumption of CEs' risksby CGs is not appropriate, unlike in the developed areas where CEs generatesubstantial amounts of discretionary funds for CGs. De facto risk absorptionby the banking system is not desirable either, as noted above. The financialstrength of TICs is insufficient for them to issue risk-spreading financialinstruments. This is an issue that needs further thinking--attractive optionsare not immediately apparent.

4.20 At the comm.aity level, CGs need to diversify their risks, beyondwhat is feasible through enterprise creation and diversification of productlines. Beyond a certain point, both carry considerable economic costs; more-over, the degree to which CGs in different localities and regions can diver-sify risks in this way varies greatly. The need for new means of riskspreading applies both to backward areas, where economic returns of firms maybe low, and to developed areas, where enterprises are often relatively largeand products highly specialized. One way to allow CGs to further diversifyrisk is through purchase of income bonds issued by other TICs (mentionedabove) or other high-return financial instruments. CGs would then have thechoice between investing in these financial instruments and undertaking physi-cal investments in enterprise development, and could reduce their risk bycarrying a diversified "portfolio' of physical and financial assets.

4.21 The question of how to deal with failing firms primarily concerns CEsand large PEs. Small PEs enter and exit the scene frequently and apparentlyquite easily. In more developed areas, the CG commonly takes responsibilityfor repayment of debts of defunct firms under its ownership, usually byassigning them to other local CEs. This inhibits CGs from closing down money-losing firms, as long as their cash flow can service at least some of theirbank debt. But it also gives CGs strong incentives to supervise their enter-prises in such a way that they are able to service their debts. In backwardareas, CGs generally do not view themselves as responsible for bad debts ofsubordinate CEs. Banks in these localities are often reluctant to call inloans of money-losing CEs, in the absence of any reserves against bad loans oraccounting procedures for dealing with them.

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4.22 Carefully designed bankruptcy regulations would be useful in adjudi-cating claims on the assets of defunct PEs and clarifying priority amongclaimants, and they could play a similar role in facilitating exit by nonvia-ble CEs. But careful thought needs to be given to their precise terms, and inparticular the claims of banks should not be weakened vis-a-vis implicit orexplicit CG claims. Though keeping failing firms in business is often waste-ful, in the more successful TVE regions this usually does not go on for a verylong period of time, as the enterprises are forced to make drastic adjustmentslike developing a completely new line of products if necessary. On the otherhand, the danger of CG misuse of overly generous CE bankruptcy regulations isgreat in many of the backward areas.

Capital Structure of Large PEs

4.23 As has already been mentioned, large PEs have a problematic capitalstructure. Many of them depend heavily on bank credit, and in addition themore successful among them have built up considerable assets generated byinternal accumulation. But founders are usually "repaid" their seed capitalfrom enterprise profits as soon as the firm is financially viable, and theproperty rights of the owner(s) with respect to internally generated funds,like the ownership of the firm itself, are still vague and incomplete. Bothrisk spreading and clarification of ownership/property rights would be facili-tated by broadening the equity base of large and successful PEs. At the sametime, clarifying and strengthening the property rights of private owners ofPEs may be problematic if such firms depend largely on bank loans, since theserepresent "the community's capital" in a certain sense. This is particularlytrue because interest rates are low.

4.24 Ways need to be found to give large PEs sufficient access to capitaland other local community resources, in a manner which does not affect CGincentives. One possible solution is for banks to provide some capital tosuch firms in the form of nonvoting equity (or "ownership") shares rather thanbank loans. This would broaden the equity base of large PEs and allow clari-fication of their ownership. Banks could capture a significant part of theprofits of these firms in a transparent, legitimate manner; the access oflarge PEs to bank funds would probably be enhanced; and the ownership of thesefirms would be partly 'socialized', in a manner that should not be threateningto private entrepreneurs and would not interfere with their autonomy inmanaging their firms. This option obviously would require a major change inorientation and practices on the part of the rural banking system, and itwould also require careful monitoring and regulation of "investment banking"practices. The banking system would be making (probably nontradable) equityinvestments and hence would increase its risk, but since the firms concernedare by definition large, successful, and profitable, this should be manage-able. Banks could continue providing funds to these PEs in the form of loansas well.

4.25 Direct investments in larger PEs by CGs and other local communityentities could be handled in the same way. For example, TICs, as part oftheir evolution into investment companies, could provide some equity financing

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to larger PEs in the community. Given present Chinese conditions, to ensurethat the private owner/entrepreneurs maintain control and are not threatenedby the changed ownership structure, such equity participation should be on anonvoting basis.

4.26 There are numerous other options for structuring flows of communitycapital resources to PEs, expanding their equity base, and strengthening andclarifying ownership rights. The key requirement is to ensure that a consid-erable part of the return to capital provided by the community does accrue tothe community (which may be best accomplished through equity participation),while incentives of private entrepreneurs are not dampened and their autonomyis not threatened (which suggests nonvoting arrangements).

The Future Role and Structure of the Banking System

4.27 An issue of great importance is how to structure the rural bankingsystem. The:..e are many pitfalls to be avoided, and few if any transparentlyobvious and feasible options. Putting the local banking system under CGs(e.g. townships) would probably be harmful, making it easier for the latter todirectly or indirectly (through CEs) obtain "deficit financing" from banks andthereb- soften their budget constraints. This danger is especially serious inthe niore backward areas where these problems are already present.

4.28 One possibility would be to decentralize the ownership of the bankingsystem, but only to one or two levels of government above the level to whichclients belong. For example, county-level ABC branches could be the mainlenders to TVCEs, while township-level financial institutions like the RCCscould lend to PEs. To some extent this resembles the current division oflabor between ABC and RCCs.10/ More generally, any restructuring of theownership of the banking system in rural areas should if possible avoidcreating separate, independent banks that are exactly contiguous with CG orcounty jurisdictions. Simply making the township ABC offices, perhaps combinedwith the RCCs, into independent township banks would not be a good idea,because they easily could be coopted by township governments.

4.29 At present, there is virtually no competition between ABC townshipoffices and RCCs.ll/ Some competition has been introduced by the attempts ofthe urban Industrial and Commercial Bank of China to penetrate moreindustrialized rural areas, which seems to have been beneficial in improvingdeposit services. On the lending side, competition gives borrowers moreoptions, and by the same token it may weaken CG influence over allocation of

10/ However, ABC township offices in many respects are highly responsive totownship authorities rather than to the county government or ABCbranch.

11/ Though RCCs are nominally independent cooperative institutions, inpractice they are under ABC. Even in counties where they have beennominally separated from ABC, there is a clear division of labor (ABClends to TEs, RCCs to lower-level CEs and PEs), which severely limitscompetition in lending.

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the community's capital resources. Competition should result in improvedprovision of banking services to TVEs, but it will be difficult to generate agreat deal of local competition among existing rural financial institutions.

4.30 Institutional diversification should be an important part of reformsin the rural banking system, and indeed it is already occurring to someextent, through a proliferation of community "trust funds", creation of some"investment companies" and similar entities, and emergence of private finan-cial institutions in some areas like Wenzhou. This trend should be encou-raged. though any sizable financial institutions (especially those which takedeposits) should be subject to appropriate regulatiGn. Up to now, most insti-tutional diversification has occurred at the community level, which suggeststhat there may be systemic obstacles against financial institutions whosebusiness areas cut across community and locality lines, and which are notclosely tied to any particular township or county. Nevertheless, futureinstitutional diversification in the rural financial system should proceed inthis direction to the extent possible.

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V. INDUSTRIAL STRUCTURE, LOCATION PATTERNS, AND SUPPORT SERVICES

5.1 China's industrial TVE sector is characterized by for the most partrelatively small, community-oriented firms; a surprisingly broad range ofindustrial subsectors and products; a mix of simple, labor-intensive produc-tion techniques and more modern technologies; a dispersed spatial patteri ofindustrial location; and widespread lack of industrial support services (aninadequate independent commercial system, limited financial services, lack oftechnical services, etc.). Some of these features could become major sourcesof inefficiency and severe constraints on future TVE growth and development.

Enterprise Size and Economies of Scale

5.2 Despite rapid development of the TVE sector and extremely fast growthof GVIO in recent years, the average size of firms has not increased verymuch. As can be seen from Table 5.1, the average number of employees ofindustrial TVCEs increased at an average annual rate of only 5Z between 1980and 1986. GVIO and assets per firm increased at a faster pace, but thesefigures are specified in nominal terms and there has been significant infla-tion in the past several years, especially in construction costs and buildingmaterials prices. TVCEs on average tend to be no smaller than small-scalemanufacturing firms in other developing countries, and indeed many of themfall into the category of medium-sized firms.l/ However, the problem is notso much absolute firm sizes but rather the obstacles that may be preventingmore efficient and successful TVEs from growing and eventually entering theranks or large enterprises.

5.3 In many of the industries where TVEs account for a significant shareof output, economies of scale are not important enough to be a determiningfactor. But in other industries they may be substantial, and TVEs areprobably below the minimum optimal scale. One example is cement, anothersteel-rolling. In industries like these, small firm size may be a significantbarrier against efficiency gains. But more important than any static ineffi-ciencies are the dynamic costs of limitations on firm size in the TVE sector.The more efficient, successful, and rapidly growing enterprises at some pointare subjected to a slowdown in growth (or may be split up into smaller firmsas they develop new products), which could adversely affect the dynamism andefficiency of the TVE sector overall, as well as its competitiveness vis-a-visthe state sector.

1/ Generally firms are considered "very small" if they have fewer than tenemployees, "small" if they have 10-50 employees, and "medium-sized" ifthey have 50-100 employees. See Little, Ian M.D. etal, SmallManufacturing Enterprises: A Comparative Analysis of India and OtherCountries (New Yorks Oxford University Press, 1987), p. 8. By thesestandards, many TVEs would be considered medium-sized or even "large".

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Table 5.1: AVERAGE SIZE OF TVCEs, 1980-87(number of persons and Y '000)

All TVCEs Industrial TVCesEmploy- Gross Fixed Total Employ- Gross industrialment revenues /a assets /b assets /c ment ou.put valur! /a

1980 21 42 23 31 26 71

1983 24 69 35 47 29 102

1984 23 77 35 51 28 116

1985 26 116 48 75 33 170

1986 29 147 62 100 35 214

1987 30 186 78 133 n.a. n.a.

/a In current prices./b Undepreciated value of fixed asses at original purchase prices./c Net value of fixed assets (after accumulated depreciation is subtracted)

plus "quota" circulating assets (inventories of inputs and outputs andgoods in process).

Sources: Statistical Yearbook of China, 1981, 1985, 1987, 1988; China RuralStatistical Yearbook, 1985, 1986, 1987.

5.4 To some extent slow growth of firm size may reflect spread of TVEdevelopment to more backward areas where firms are much smaller on average.But average firm size even in Wuxi County has not increased very much. Theaverage industrial TVCE in Wuxi had 57 employees in 1980, 64 in 1985, and 76in 1986. Another possible reason for continuing small firm size may be aneffort to diversify industrial structure at the community level, accomplishedby establishing new firms in different lines of business. A large number offirms and a "conglomerate" industrial structure may help reduce communityfinancial risk. Frequent changes in products to take advantage of shiftingmarket conditions may also have been a factor preventing rapid increases infirm size. Another reason may be that the period of unfettered TVE develop-ment has been relatively short. Communittes may also desire to keep theirfirms small to facilitate management. PEs have been discouraged from reachinglarge size by the vagueness and weakness of private property rights. Butperhaps the most important reason for the absence of large enterprises in theTVE sector is their community orientation, combined with risk considerationsand lack of mobility of key factors of production across communities and loca-lities. This limits the pool of resources available to any TVE.

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5.5 If the main barrier against larger size is indeed the communityorientation of firms, limited community resource bases, and immobility of keyfactors of production across communities, the short- and medium-term remedy isto find ways in which successful and rapidly growing TVEs can draw inresources, in the first instance financial resources, from outside the commu-nity. Income bond issues, cross-community joint ventures, and greater mobi-lity of capital in the financial system, options suggected in Chapter IV,might facilitate growth of relatively large TVEs. Creation of 'industrialparks" where TVEs could locate their activities and which are not under thejurisdiction of any particular rural community (see below) could encourageemergence of TVEs which draw on resources from more than one community. Overthe longer term, transcendence of their rural community origins by some TVEsmay occur (see Chapter VIII).

5.6 Administrative restrictions against entry into certain lines ofactivity by TVEs or against 'inefficient" small firms are not the answer topossible problems with suboptimal firm size. TVEs function in a market envi-ronment, so those that are truly inefficient will be weeded out as the func-tioning of China's industrial product markets improves. The pressure of ruralsurplus labor will stimulate a great deal of TVE development, but the sector'sability to absorb this labor efficiently will be weakened if there arerestrictions against entry into particular industrial activities. Finally andperhaps most important, administrative restrictions invariably turn out to becostly and inefficient, and more often than not they fail to achieve theirobjectives. Thus fundamental solutions lie in removing or weakening thebarriers against larger firm size in the TVE sector, not administrativemeasures to exclude it from particular industries.

Community Industrial Structure and Subsectoral Composition

5.7 Some of the methods to enhance capital mobility and allow greaterdiversification of community risk through use of financial instruments shouldalso permit greater specialization in community industrial structure (and. rger firm sizes) where this is economically appropriate. In this context,ti.e question of whether particular communities and localities or indeed theTVE sector as a whole have overly diversified industrial structures wouldbecome moot--not an issue for specific policy measures but rather one thatwill be settled gradually over time as communities adjust their strategies inresponse to the reduced need for industrial diversity from a community riskmanagement perspective.

5.8 An even broader issue is the degree of concentration of TVE activityin industry. The most advanced TVE industrial centers like Wuxi are probablyoverindustrialized, as well as being under-urbanized (Wuxi has over 4,000substantial industrial TVEs). One of the reasons for increasingly fiercecompetition in the TVE sector is that each locality and community is trying toengage in manufacturing operations, regardless of whether this is economicallyappropriate given the local resource base, market situation, etc. In partthis is the result of population immobility--to absorb surplus labor, locali-ties have to do something, given that outmigration is so limited. Pricedistortions also may play a role, making industry overly attractive compared

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to nonagricultural services or specialized agriculture. Many services areclosely related to the level of local industrial development, however, andthere would be little or no demand for them in the absence of the latter.Hence a large part of the problem may be underdevelopment of services in thehighly industrialized rural areas, not in nonindustrialized localities.Rather than continuing the proliferation of industrial plants which dot thecountryside, places like Wuxi should be expanding industry-related services.

Technology

5.9 Technology in the broad sense is considered a crucial bottleneck inTVE industrialization efforts, and the shortage of technical personnel isperceived to be one of the most severe constraints on TVE development. Theflow of technological information is still somewhat restricted, and there isno real "market" for the host of technology-related services needed in amodern industrial economy. Technology problems vary with the level of TVEdevelopment in different regions and localities. In some of the more backwardareas, there is no nucleus of technicians and only a weak base of entrepre-neurs. Combined with lack of market contacts and ignorance of technologicaland market conditions, this often results in costly failures and use ofinappropriate technologies. The problem is not so much one of obtaining tech-nology per se, but rather inability to appropriately choose and adapt techno-logy suited to local conditions, and even to manage production and keep equip-ment running. In the more advanced areas, the existing technological base ismuci stronger. There is a core of technologically proficient people, andusually established contacts with urbani SEs and research institutes or otherproviders of technological information and services. In some areas likesouthern Guangdong, there is access to foreign equipment and technology.Adaptation of new technology and management of production hence tends to beless difficult. What hinders the more advanced TVE regions is systemicrestrictiens, for example against acquisition of technology from abroad, aswell as financial resource and foreign exchange constraints.

5.10 This suggests that solutions to technology problems may be somewhatdifferent as between backward and more developed areas. In the former, humanresource development and augmentation of humar capital is the mcst urgentrequirement (see Chapters VI and VII). Easing resource constraints orsystemic restrictions (e.g. against foreign business contacts) may not be veryhelpful in the absence of the human resources needed to choose, adapt, andmanage technology. In the developed areas, such policies are likely to bemore effective. In places like southern Jiangsu Province, just giving TVEsgreater access to the foreign exchange they are already generating throughexports may be highly beneficial. One of the main reasons southern Guangdonghas been able to largely "catch up" with southern Jiangsu in terms of TVEindustrial and technological development, despite a weaker prereform base, isits ability to rely on foreign technology, along with needed management andtechnical personnel from Hong Kong.

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Industrial Location and Spatial Patterns

5.11 Related to the community orientation and small average size of TVEsis the highly dispersed location pattern of TVE plants. Though rural indus-trial development has been highly uneven as between different parts of thecountry, within many of the most industrialized rural localities factories dotthe countryside. Virtually all CEs are located in their home community, asare most PEs. The costs of this dispersed location pattern are substantial,though further research would be necessary to quantify them with precision:(1) infrastructure either is very costly or simply is not invested in, andthere is under-provision of 'urban-type" public services for TVEs; (2) theadvantages of 'economies of agglomeration" may be largely lost; (3) transportcosts are higher; (4) it is much harder for a dense network of industrialsupport services for TVEs to emerge, since potential customers are scattered;and (5) wasteful patterns of land utilization becanme pervasive, in particularcccupation and pollution of high-yield agricultural land by industrial plants.Though pollution problems in the industrial TVE sector are significant intheir own right, they are exacerbated by the dispersed location pattern.

5.12 Since the basic cause of dispersed location patterns is the communityorientation of the TVE sector and the near-immobility of firms and factors ofproduction across communities, any solutions to the problem must be aimed atthe firm-community nexus. Though over the long term the community orientationparticularly of larger TVEs may weaken (see Chapter VIII), this will be agradual process which may not even affect the bulk of smaller firms. Thus waysmust be found in the short run to achieve more concentrated location patternsfor TVEs without a severance of firm-community ties, through economic incen-tives rather than administrative decrees.

5.13 One option is for local government authorities at county or perhapsprovincial level to establish "industrial parks" at which CEs, PEs, and cross-community joint ventures could set up operations. These areas would not beunder the jurisdiction of any particular rural community; hence they wouldprovide a "neutral" location for all types of TVEs.2/ Infrastructure invest-ments would be undertaken by the sponsoring government of the industrial park,and public services would be provided to enterprises which locate there,priced on a full cost-recovery basis. Sites and buildings could be rented byenterprises, or firms could be permitted to acquire land and construct theirown plants. If necessary, enterprises locating in the new industrial parkscould be given certain tax advantages at the beginning (reflecting theexternal economies and social benefits of more centralized location), but ingeneral, an advantageous site and availability of services (including, perhapsmost importantly, electric power) should be sufficient to attract firms.Another important inducement might be credit availability.

5.14 The industrial park concept would have to be carefully designed towork well; most such schemes in other countries have not been very successful.

2/ Obviously, for this to work the agency administering the industrialpark would have to be perceived as neutral, without strong interests ofits own that would affect its management of the territory.

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International experience suggests that industrial parks wi11 not be successfulif they are located far from cities and try to attract small-scale entrepre-neurs away from the urban environment they tend to prefer. In this context,it should be recognized that the goals of industrial parks for the TVE sectorwould be quite different from those of industrial parks in most other develop-ing countries. In China, a primary objective would be to promote more concen-trated location patterns for the TVE sector, not to move small-scale industryout of large cities. Hence if systemic obstacles can be overcome, industrialparks may have a greater chance of success in China's TVE sector than hastypically been the case in other countries.

5.15 A number of issues specifically related to China would need to beresolved. For example, tax policy toward enterprises that locate in theindustrial parks would have to be carefully balanced between covering thecosts of provision of government services to these firms (which calls forcertain taxes to be levied and collected on the spot) and maintaining CEs'fiscal ties with their home communities (which would call for tax collectionat the home community). Another issue relates to employment--since providingjobs for local community residents is one of the main motivations for estab-lishing CEs in labor-surplus areas, they would be unwilling to relocate ifthis means severing employment linkagee. This is one reason why limiting thescope (at least initially) to counties makes sense. Flows of labor and popu-lation into the industrial parks should be facilitated for those who havegainful employment there (as well as for private entrepreneurs who want to setup their own firms). Ways also need to be found to discourage setting up newfirms in a dispersed manner, based on the real economic costs involved in thiskind of location pattern. Appropriate land-use and land-conversion fees andpublic utility charges, as well as pollution fees and pollution control stan-dards, might help encourage communities to locate their firms in industrialparks. Still another issue relates to the primary reliance on gross indus-trial and agricultural output value as a performance indicator for communitiesand CGs. This would have to be modified for CGs to be willing to let "their"CEs locate in industrial parks (perhaps by allowing them to count the outputvalue of these firms in their communities' GVIO).

5.16 Certain Chinese counties are moving toward something akin to theindustrial park concept. Jieshou County encourages private entrepreneurs torelocate their activities (and residences) to the county town, through avariety of inducements including the possibility of changing household regis-tration from rural to 'long-term urban". Other counties are putting largeamounts of resources into building county seats of their own, and encouragingTVEs to locate there. But these latter efforts are to some extent vitiated bytheir primary objective of establishing an administrative center for thecounty. Finally, several counties in Fuyang Prefecture (where Jieshou Countyis located) have created "industrial development zones", which in somerespects come close to the industrial park concept elaborated above.

Industrial Support Services

5.17 The network of services supporting TVE industrialization is for themost part inadequate. The underdeveloped commercial system serving TVEs

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forces them to do their own marketing, spending large sums to sell theirproducts as well as to procure inputs. Financial services also appear not tohave kept up with the rapid growth of the TVE sector. Transport services forTVEs may also be insufficient, though the proliferation of individually ownedrural trucking companies must have eased bottlenecks somewhat. The inadequacyof technical assistance, market information networks, consulting, and"extension-like' services to TVEs may be the most severe zonstraint emanatingfrom the service sector. The underdevelopment of services in the TVE sectormirrors the same problem in Chinese industry as a whole and in the entireeconomic system. But the problems for TVEs are exacerbated by (1) TVEs'relative lack of access to services provided by state institutions and (2) thegreater need of small firms like TVEs for specialized services, since it isharder for them to engage in self-provision.

5.18 Some of the main causes of the weakness of the TVE service sectorhave already been noted. These include the dispersion of customers (indus-trial TVEs), possible price distortions, remnants of the prereform ideologicaldisdain for "nonmaterial" services in general, a narrow focus on the part ofCG leaders and county authorities on development of manufacturing industry,etc. Another major factor most probably has been TVEs' relative lack ofaccess to urban/state service networks. The community-oriented institutionalstructure in China's rural areas may well inhibit the flow of services acrosscommunities much more than the flow of goods, generating a bias in favor ofgoods production and against services. As reforms and the rapid growth of theTVE sector continue, the need for industrial support services may become evenmore acute, and continuing inadequacy in the service network could become anincreasing liability for TVEs.

5.19 Part of the solution is to improve the ability of TVEs to tapexisting urban state-oriented service institutions. This is already beginningto happen, as the latter become more profit-oriented and freed from restric-tions against taking fees for services provided. But this trend needs to beencouraged, and competition needs to be promoted, so that monopolistic state-owned service institutions will not overcharge TVEs. "Bridge' serviceorganizations also need to be formed, which TVEs can turn to, rather thanbeing forced into costly direct searches in (often distant) urban areas. Tosome extent this is already occurring in Wuxi County, which has made majorefforts to improve human capital, technology, and related services for TVCEs.More important than access to the state service network is development ofindustrial support services within the TVE sector. This is not only essentialfor the healthy development of the sector in the future, but it also hasimportant positive benefits. The employment generation potential of servicesis very great, and since many of the services concerned are most efficientlyprovided by small firms, they represent a great opportunity for the TVEsector.

5.20 A number of measures .o encourage rapid development of TVE servicescan be envisaged. Freedom for CE professionals and skilled workers to leave

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their firms and go into business for themselves is crucial.3/ Greater concen-tration in location patterns will increase the effective demand for varioussupport services to TVEs, which in turn should elicit a supply response.There may also be scope for industrial support services to be mobilizedthrough the voluntary TVE industrial associations that are now forming in manyrural areas. Since the relative importance of the PE sector is greater inservices than in manufacturing, improvements in the legal and regulatoryenvironment for PEs could also help stimulate more rapid growth of services.CG cadres could be evaluated as much for their progress developing services asfor achievements in local industrial and agricultural development, which wouldh3lp get rid of any remaining ideological bias against service activities.The key role of government is to create an administrative and regulatoryenvironment conducive to the development of TVE support services on a profit-oriented basis, to a large extent provided by specialized TVEs themselves.Except in the case of services which carry substantial externalities, likeeducation and training, governments should not get involved in direct provi-sion or financial subsidization of TVE services. Finally, there is a need forfurther research on the obstacles which hinder development of TVE serviceactivities.

3/ This would likely encourage a proliferation of new "spin-off" firms andservice activities. It could also have some negative effects, likedisruptions in activities, reduced identification with their firms bythese personnel, disincentives for TVEs to provide training for theiremployees, and sharply rising wage levels as a result of competitionamong enterprises for highly-qualified personnel. Nevertheless, thebenefits most probably outweigh these costs.

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VI. LABOR AND HUMAN RESOURCES

Current Wage Practices and Labor Relations

6.1 There is abundant evidence that TVE workers are not treated purely asa variable input in a "capitalist' production process. The bulk of TVEs (bothCEs and PEs) use wage systems based on individual and enterprise performance.Job security is not as airtight as in SEs, but it is substantial, and turnoveris low. TVE workers appear to have implicit claims on the returns generatedby their firms. There is virtually no formal worker ownership or participa-tion in enterprise decisionmaking, but most CE workers are also members of therural community that "owns" their employer.

6.2 One of the main sources of TVEs' competitive advantage vis-a-vis SEsis their lower labor costs. Differences in nominal wage rates are often notvery great. But the mandated benefits package for SE workers (subsidizedhousing, pension, medical care, etc.) is very expensive, and there are fewbenefits which TVEs are legally required to pay their workers. Nor are thereanything like government-set minimum wage laws for TVEs. Overstaffing in SEsalso contributes to their higher labor costs. Wages of TVE employees are muchmore closely tied to individual and enterprise performance (growth of outputand/or profits) than are those of most SE workers. Piece rates are extremelycommon, and many CEs pay some profit- or output-related year-end bonus. Thereare powerful incentives to put more effort into work and to work long hours.Labor relations in TVEs seem relatively good, particularly considering thehard work, long hours, difficult working conditions, and often relatively lowwages. Superior labor motivation and effort are probably even more importantthan lower wage costs in explaining the performance of the TVE sector.

6.3 The community orientation of TVEs makes labor relations verydifferent from the typical pattern in capitalist firms or in Chinese SEs, andin particular workers may be much more willing to accept piece rate wages.4/Managers and owners (i.e. the CGs) are probably less willing or able to usepiece rates to "exploit" workers (e.g. by increasing work norms) than incapitalist firms. The ubiquity of piece rates also is facilitated by thesimple, easily quantified nature of many tasks in TVEs. The rapid growth ofthe TVE sector and increasing capital intensity may have allowed many enter-prises to be generous in setting piece rates and bonuses. Most TVE workershave spent only a few years outside of agriculture, and the overwhelmingmajority are first-generation. The drastic improvement in their living stan-dards accompanying the shift from agricultural to nonagricultural activitiesmust make these workers more receptive to performance-based wages and willingto put in long hours (to which they are accustomed from farming). The possi-bility of being forced to return to agriculture may inhibit excessive concernabout wages, wage systems, or working conditions.

4/ Piece rates are now rare in industrialized market economies, due toconflicts over work norms and competition among workers which threatensworker solidarity. Experiments with piece rates in Chinese SEs in theearly 1980s were for the most part unsuccessful, for similar reasons.

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6.4 Some of these factors may change over time, leading to more difficultlabor relations in the TVE sector and consequent deterioration in worker moti-vation and efficiency. To avoid this, it is necessary to carefully considerdifferent options for wage systems, ownership, worker participation (in finan-cial and decisionmaking spheres), firm-CG relationships, etc., which will helpmaintain a relatively efficient incentive environment for TVE workers. Theissues are complex, and the danger of costly wrong choices is great, as can beseen from the experience of nonstate, noncapitalist firms in most parts of theworld.

Workers' Role and Protection

6.5 As the community orientation of CEs as well as PEs weakens, as in atleast some areas they hire more workers from outside the community and/or on ashort-term basis (which is already occurring in places like southernGuangdong), and as TVE workers become more conscious of their own interests,pressures may arise for greater and more formalized worker participation.Moreover, the lack of effective legislation protecting workers from abuses, orof unions to represent workers, which may not have been too harmful in asystem of community-oriented enterprises where the bulk of employees werecommunity members, may become less and less acceptable in the future.

6.6 Over the long run, the main alternative to unionization on anational, provincial, or industrial basis may well be some form of workerparticipation, at the enterprise or possibly community level.5/ This couldhelp preserve the advantages of the present, community-oriented system even asfirms become more autonomous, but well-known pitfalls cooperative and labor-managed firms have run into in other countries should be avoided. A systemwithout any significant worker participation but with trade unions, on theother hand, could encourage a trend toward "Taylorist" management practicesand confrontational labor relations, which might have considerable costs interms of worker motivation, effort, and efficiency.

5/ It is only to be expected that organizations will emerge to promoteworkers' interests and represent them in bargaining with employers.The real question concerns hcw these entities will be structured andwhether they will be enterprise-based (involving some form of workerparticipation) or more broadly organized.

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6.7 Regardless of whether China attempts to introduce some form of workerparticipation or goes the trade union route, some basic legislationdelineating acceptable labor practices is needed.6/ This should not be overlyrestrictive, but it would be helpful, both in protecting workers and inprotecting employers from arbitrary charges of "exploitation". Legislation isespecially necessary if there is a relatively free labor market, with neitherworker participation nor effective unions. These regulations would have to bewidely perceived as appropriate and fair, and they would need to be backed upby meaningful sanctions and an enforcement mechanism.

Wage/Incentive Systems and Pay Differentiation

6.8 Choices on ownership/participation have obvious implications for TVEwage systems. Even in the absence of worker participation, performance-related wages, s0 successful in the TVE sector in recent years, obviouslyshould be continued. The precise form of such wage systems depends greatly onthe characteristics of the industry, product, and production process con-cerned. Over time, as complexity increases in many firms, there may need tobe a shift from piece rate payments based largely on individual physicaloutput to year-end, profit-related bonuses, variable pay based on subjectiveevaluations, etc. Rewards could become linked to future as well as currentprofits, to further strengthen worker incentives.

6.9 A number of issues concerning wage levels and differentials areevident. One of the most serious is the difficulty of attracting managers,technical personnel, salesmen, and other highly skilled persons to backwardareas, given limited pay and income differentials within communities. Forexample, if the allowable difference between "high" pay and average pay withina community is 3 to 1, and the differential between averages in advanced andbackward areas is 6 to 1, it would be necessary to pay highly qualified people(generally from the more developed areas) at least 18 times the local averagepay level in order to attract them to the poorer, backward areas. Such dif-ferentials would meet social resistance. Among the options for dealing withthis problem are bringing in entrepreneurs as owners of firms with largeresidual incomes (but whose fixed base pay may not be too out of line withlocal standards); providing major noncash benefits like housing to padincomes; or treating such personnel as "temporaries", whose pay is off thelocal scale but who cannot build up a permanent stake in the community.

6/ At present, some surprising labor practices are being used in China'srural areas. One is labor contracting (under which an individualcontracts to obtain labor for a given job and is paid an agreed totalsum, and he himself decides how much to pay the workers). Bringing inworkers from poorer regions to do hard work that local residents are nolonger willing to do, often with lower wages and benefits, also isincreasingly common. Wiien it occurs on a large scale, this canadversely affect both incomes and employment opportunities of localcommunity members. In Nanhai County in 1986, an inflow of workers frompoorer rural areas and hiring of these people by local TVEs apparentlyforced some local residents to return to agriculture.

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6.10 In the past, worker-manager differentials within enterprises werevery low. Community attitudes and pressures tend to limit such gaps, thoughthese limits have eroded in recent years, and differentials have widened. Therapid development of private firms in many parts of the country has given CEmanagers the option of moving to the private sector, which has sometimesforced CGs to allow them to earn higher rewards. There may be conflictsbetween managerial incentives, narrowly construed, and community and workerinterests and "solidarity". For example, in Wuxi County managerial salariesare linked to workers' average pay at the enterprise level. This results inmore harmony between workers' and managers' financial interests, but on theother hand it may encourage excessive wage increases. In Nanhai County thereis no such linkage, and directors of CEs, responding to profit incentives, areactively recruiting low-cost labor from outside the community.

Development of Rural Nonagricultural Labor Markets

6.11 The TVE sector is characterized by highly segmented labor markets.Though there is an increasing flow of "temporary' migrant labor from poorerrural areas to the more developed ones, so far this has not been sufficient tocause any significant equalization in TVE wage rates in different regions.'Two-tier" labor and wage systems are emerging in the developed areas whichpermit inflows of workers from outside. Wages of "outsiders" may or may notbe somewhat lower than those of community residents, but the former are noteligible for benefits or for profit-related "dividends". Moreover, outsiderstend to move into the most difficult, onerous, and dangerous tasks, likebrick-making and construction work. This emerging "guest worker-like" systemhas some important advantages. It provides considerable amounts of employmentand extra income to people from backward areas. By reducing surplus labor inthe backward areas, the outflow of temporary migrant labor may also help raiseincomes of the remaining residents. On the other hand, the influx of low-costlabor into the more advanced and rapidly growing areas helps check the rise inlocal labor costs, with possible benefits for capital accumulation and labor-intensive industrial growth. On-the-job training and experience gained by thetemporary laborers can augment the human capital of backward areas if theyreturn to their homes and set up small businesses. But large-scale temporarylabor movements could lead to social strains in the future, and the long-runbenefits for the backward areas which supply temporary migrant labor may belimited. In areas which inhibit the inflow of outsiders, like Wuxi County,labor shortages and tendencies toward capital intensification may result.

6.12 One of the most critical institutional and policy questions faced byChina's rural economy is whether and to what extent well-functioning rurallabor markets should be allowed to develop, along with consequent labor andpopulation flows. Mobility of labor, especially of highly skilled and talen-ted people, is one of the most important means by which new and improved tech-nologies and practices are diffused throughout the economy. Movements oflabor may also permit more flexible adjustment to changing economic conditionsby firms as well as by workers. But there are counterexamples like Japan,with its near-guaranteed lifetime employment system for a large segment of thelabor force. What seems more important than large-scale movements of ordinarylabor is mobility of "high-quality human resources" (entrepreneurs, managers,

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engineers and technicians, procurement and marketing agents, and other skilledpersons). This was gravely hindered in China's prereform system, and therehas been little improvement in this respect in the urban/state sector sincethe late 19709. TVEs in the more developed areas increasingly have been ableto attract high-quality himan resources from the urban/state sector in recentyears, by offering very high wages and benefits (often more than twice whatthese people were earning previously). Retirees from SEs and other stateinstitutions are another fertile source of human resources for the TVE sector.Nevertheless, there are still shortages, and within the TVE sector CE managersand professionals often are prevented from leaving their firms by varioussanctions available to CGs (e.g. threatening to refuse to let family membersand relatives work in the local CE sector if a person leaves his job).

6.13 This all suggests that measures to enhance the mobility of high-quality human resources are desirable and urgently needed (some options arediscussed in the following section of this chapter). Large-scale mobility ofordinary unskilled labor is a much more problematic issue. Though in princi-ple freer flows of labor across communities P.nd localities would be desirable,it is unrealistic to expect the emergence of anything approaching national oreven regional rural labor markets in the near future. The social costs oflarge-scale, "permanent" movement of peasants and their families across local-ities would be very great; unlike tempora:.y migrants (who invariably do notbring their families with them) permanent migration would meet with resistancefrom community residents in the richer, more developed areas, since this woulddilute the per-capita resource base in the latter.

6.14 Policies toward labor mobility and development of rural labor marketsmust be coordinated with those toward mobilit:y of other factors of production.For example, it may be more. efficient to improve overall efficiency throughmovement of capital (Chapter IV) and entrepreneurs (see below) from the moredeveloped, high-wage areas to backward, low-wage regions than through large-scale movement of ordinary labor in the opposite direction.7/ In the absenceof such labor migration, free flows of capital from backward to developedregions could be counterproductive. Greater labor mobility and development ofrural labor markets should also be linked to a more liberalized attitudetoward rural-urban migration. The bulk of the shift of China's vast rurallabor force from agricultural to nonagricultural activities will have to occurthrough "local" rural-urban migration and local urbanization rather than as aresult of large-scale movements of labor and population from one rural area toanother.

Mobility and Nurture of Human Resources

6.15 Restricted m( 'lity of high-quality human resources has an adverseeffect on TVE sector eiiiciency and performance at the micro level, as notedabove. It also may contribute in a major way to the problems of backwardareas and to uneven spatial patterns of rural nonagricultural development (seeChapter VII). Imbalances in endowments of high-quality human resources are

7/ This would require major improvements in the policy and regulatoryenvironment for "outside" investors in backward areas (see ChapterVII).

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almost certainly a main cause of the severe gap in economic development andindustrialization between successful and backward areas. The very immobilityof conventional factors of production means that backward areas have plenty oflabor and at least some capital, and often natural resources of various kindsas well. But the entrepreneurial, managerial, and marketing abilities neededto organize these factors of production into profitable businesses as well asthe necessary networks of contacts with potential customers and suppliers aremissing. Under these circumstances, increasing the mobility of conventionalfactors might well exacerbate gaps if entrepreneurs and other high-qualityhuman resources remain relatively immobile. The fact that in recent years anadvanced TVE area like Wuxi has developed its textile industry in a major way(from a zero base in 1978) while a poorer low-wage locality like Shangrao hasno textile plants suggests the depth of the problem.

6.16 If immobility of high-quality human resources is the major source ofuneven rural economic and industrial development, at least in one respect theproblem is somewhat manageable: the sheer volume of resources that need to bemade more mobile is relatively small, and large population movements may notbe necessary, at least in the short run. Moreover, selective investments in'human capital" may have high pay-offs for the backward areas. The problemcan be attacked in two ways: (1) measures to encourage greater flows of humanresources to areas where they can earn the highest returns. and (2) policiesand investments to nurture "indigenous" human resources its the backward areas.

6.17 The first of these options runs into obstacles because of the wholenexus of rural community connections that makes for immobility in the firstplace. Moreover, not just temporary mobility of high-quality human resourcesis desired. In the case of entrepreneurs at least, what is important is wherethey set up firms, and major institutional and policy changes will be requiredbefore the strong preferences of entrepreneurs for locating in their home com-munities will be swayed. Increasing mobility of entrepreneurs will not neces--arily cause them to flow toward backward areas, at least initially. The easeof doing business in the more developed areas and the financial rewards thatcan be earned may cause entrepreneurs to gravitate toward them for some timeto come. Implicit limits on the margin by which 'high" personal incomes canexceed the local average make it even more difficult to attract entrepreneursto backward areas.

6.18 Despite these and other obstacles, it may be possible for greaterentrepreneurial mobility to generate enterprise development and industrializa-tion in the more backward areas. The more developed areas are increasingly-^rowded' with entrepreneurs, so it is becoming more difficult to earn extra-ordinarily high returns. On the other hand, the lack of indigenous entrepre-neurial resources in some of the backward areas means that many market nichesremain unfilled and opportunities for entrepreneurial profits are greater. Toencourage movements in this direction, backward areas need to provide a rela-tively good administrative environment, with a minimum of red tape and govern-ment intervention; they should also ensure that entreprenrurs can earn returnswhich are competitive with those that can be earned in the more developed

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areas;8/ and they should facilitate movement of entrepreneurs' families andtheir establishment of longstanding residence.

6.19 The second option requires resources and is not a short-term measure.but it may be effective. A great deal can be gained by sending out managersand entrepreneurs from the backward areas to the developed regions, not to domenial, low-skill tasks but to gain useful experience through apprenticeshipsand various forms of on-the-job training. Formal education and training alsocan play a role, but to avoid exacerbating the "brain drain" problem that manypoorer localities already suffer from, people receiving such education ortraining should be required to return to their home communities to work forsome minimum length of time. Finally, the entrepreneurial and other high-quality human resources that the backward areas already have are often notwell-utilized. Thus a top priority is to create an administrative andregulatory environment thet is conducive to indigenous entrepreneurs.

8/ This is probably best done by letting outside enterpreneurs set upfirms which are essentially private in their ownership and autonomousin their management (though the local CG perhaps could participate intheir capitalization on a nonvoting basis).

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VII. PROBLEMS OF BACKWARD AREAS

7.1 The degree of spatial inequality in rural incomes, economic develop-ment, and industrialization is striking and, to some extent, worrisome. Themagnitude of the problem can be illustrated w4th some local data shown inTables 7.1 and 7.2. Table 7.1 provides basic information on a per-capitabasis for the four counties that were subjected to intensive fieldwork inves-tigation. They by no means span the full range of variation in China, buteven so, the gap is rather large. Average per-capita income in Nanhai Countyis 3.6 times that in Jieshou County; GVIO per capita in Wuxi is an astonishing95 times that in Shangrao, and agricultural output per capita is nearly 1302higher. Wages paid by TVCEs per capita in Wuxi are 28 times those in Jieshou,gross profits of TVCEs per capita in Wuxi 128 times those in Shangrao. Countystatistics mask even greater differentials between rural communities. Ahighly developed, industrialized township in Wuxi County is compared with abackward township in Shangrao County in Table 7.2. Not only is the gap inper-capita income larger (nearly 7 to 1), but differences in industrializationare astronomical. GVIO per capita in the developed township is close to 700times the figure in the backward township. These differences in income levelsand rural industrialization translate into huge gaps in local financialresource mobilization capacity (about 1%,000 times).

7.2 Such unbalanced rural and TVE development patterns are caused mainlyby the combination of highly uneven endowments of human and other resourcesand immobility of population and factors of production. The problems of back-ward areas are exacerbated by their lack of entrepreneurs, managers, andcontacts with markets; by predatory fiscal practices on the part of many CGstoward CEs; and by greater difficulties their TVEs now face in getting a foot-hold in increasingly crowded and competitive markets. Fiscal redistributionis substantial but does not address the fundamental causes of uneven develop-ment. Moreover, "aid" from higher levels of government is often inefficientlyutilized, and the widespread use of interest subsidies in backward areasencourages waste of capital. Massive state investments in urban industrialdevelopment in the cities of interior provinces had virtually no beneficialimpact on the backward rural areas.

7.3 The extremely rapid growth of the TVE sector in many parts of thecountry in recent years has highlighted the problems of the backward areaswhich have not fully participated in such growth. Emergence of a certaindegree of relative inequality is only to be expected under such circumstances.The TVE sector itself is not the source of rural inequality in China, and itwould be unrealistic to try to reduce rural inequality solely through reformsand policy changes affecting the TVE sector alone. Nevertheless, to theextent that it is possible, more rapid growth and better performance of TVEsin backward areas can play a significant role in redressing the most severemanifestations of rural spatial inequality.

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Table 7.1: ECONOMIC INDICATORS IN FOUR COUNTIES, 1985(Y per capita of agricultural population) La

Wuxi Nanhai Jieshou Shangrao China

Average per-capita income ofrural population 754 1,029 285 322 398

Rural GVIO 4,656 2,313 244 49 207

GVAO 604 610 210 266 429

TVCE gross profits 512 208 9 4 24

TVCE wage bill 364 276 13 23 36

/a For China as a whole, the figures are per member of the rural population.The agricultural population is an administratively defined category usedat local levels, which includes people engaged in nonagriculturalactivities but not receiving grain rations or other subsidies.

Sources: Information from fieldwork; Statistical Yearbook of China, 1986.

Table 7.2: ECONOHIC INDICATORS FOR TWO TOWNSHIPS(Y per capita)

Township A, Township B, RatioWuxi County, 1985 Shangrao County, 1986 A/B (X)

Average per-capitaincome of ruralpopulation 907 131 692

GVAO 399 197 203

GVIO 11,268 17 663

Sales revenues of TEs 5,846/a 14 418

Local revenue mobili-zation /b 1,268 9 14,089

Expenditure 522 18 2,900

la Industrial TEs only./b Includes both budgetary and nonbudgetary revenues, but not additional

budgetary funds provided by the county for 'quota' budget expenditures.

Sourres Tnformattnn from fieldwork.

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7.4 The main issues concerning backward rural areas include: (1) the needto eliminate "fiscal predation" by CGs; (2) the need to improve the adminis-trative and regulatory climate in these areas, especially to get rid of exces-sive CG intervention in the operations and personnel decisions of TVEs; and(3) the need to take positive actions to augment and improve human resources.Given the seriousness and complexity of their problems, major efforts will berequired to stimulate more rapid TVE growth and development in the backwardareas. Mere liberalization of controls and elimination of restrictionsagainst TVEs will be helpful but may not be sufficient.

Ameliorating Fiscal Predation

7.5 "Fiscal predation" occurs when CGs' regular revenues are insufficientto cover their largely fixed exp%--.itures on public and social services and onthe CG payroll. In this situatiku which generally arises only in the morebrckward areas) CGs are forced to levy funds from their subordinate CEs,regardless of whether or not the latter earn profits. CEs in turn obtain themoney they need to meet these remittance requirements by "eating" their capi-tal stock (i.e. using depreciation funds), borrowing from local banks, orboth. This severely strains bank-CG relationships and harms the financialviability and development prospects of the CE sector (see Chapter IV).

7.6 Specific measures to deal with the problem of fiscal predation havebeen implemented at the local level (in parts of Shangrao County) with somedegree of success. These involve a combination of election of factorydirectors by workers, "contracts" between elected factory directors and theCG, and a credible pledge by the latter not to levy more than a certain pro-portion of enterprise profits. Another part of this strategy is mandatoryretirement (sometimes with a 'golden handshake") for incompetent CG officialsand enterprise managers. But these solutions may not work everywhere, andthey have been most successful where community resource constraints were atleast temporarily eased by inflows of funds of one kind or another.

7.7 There are some nationwide policy changes which could help reduce theneed for fiscal predation, but they represent a sharp departure from pastpractices and may have substantial resource requirements. The fiscal problemsof backward townships can be viewed from two different perspectives: (1) Inthese areas, government and its activities are too big (in particular, thenumber of people on the CG payroll is too large) in relation to the resourcesof the community. (2) One way China has been successful in meeting basicneeds of the rural population is by placing much of the financing burden ongrassroots rural community institutions, regardless of their ability to pay.

7.8 Thus the problem of fiscal predation needs to be attacked from twoangles. In the first place, backward areas cannot afford and do not need thefull government administrative structure and the numbers of CG employees thatmay be necessary in the more advanced areas where economic activity is so muchgreater. The organizational structure of CGs in the backward areas should besimplified and the number of CG personnel reduced to the point where it is

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more in accord with local community resources. While the process of retrench-ment may be a difficult and gradual one, the objective should be clear. Thelarge numbers of CG cadres nearing retirement age in many localities presentan opportunity for reductions through attrition which should not be wasted.To encourage CGs to reduce their staffs and cut overhead expenditures, suchactions could be made a condition for expanded budgetary allocations forsocial expenditures (see below).

7.9 There are various public and social services now being financed fromnonbudgetary rural community resources which are important in meeting thebasic needs of the Chinese people and in developing the "human capitaln thatis so necessary for local economic development. These should not be adverselyaffected by CG retrenchment in backward areas. A good example is the finan-cing of rural primary education (a large part of which occurs outside thebudget). If these kinds of expenditures get neglected in the more backwardareas, inequality in resource endowments, levels of living, and developmentprospects could become even worse.

7.10 A reassessment of the public expenditure responsibilities of CGswould be desirable. After a careful evaluation, those which are found to betruly important in furthering national social objectives could be incorporatedpartially or wholely into the state budget. This would require additionalbudgetary resources, but the pay-off could well be much higher than that fromthe large amounts of government resources which now go into financing orsubsidizing interest charges for poorly-chosen investment projects in backwardareas. The budgetary costs could be held down, if necessary, by permittingbudgetary financing of the expenditures concerned only in localities that meetspecified criteria concerning poverty and backwardness, which would also givethe measure a more decidedly "redistributional" tinge.

7.11 Eliminating fiscal predation will greatly help in the task ofreducing CG intervention in the operations of CEs. Educating CG officials onthe benefits of releasing controls also could be efficacious, particularly ifthere are examples at hand where such reforms he-'e stimulated TVE developmentand general prosperity.

Human Resource Development in Backward Areas

7.12 Chinese rural communities have been largely dependent on the localhuman and material resource base to stimulate TVE development. Those thathave failed to industrialize successfully tend to lack needed human resources,due to a variety of historical, geographical, economic, and systemic reasons.As was noted in Chapter VI, high-quality human resources in backward areas canbe augmented and improved both by encouraging the inflow of these resourcesfrom the developed localities and by investments in "human capital" in thebackward areas themselves. Though international experience provides ampleground for pessimism on the prospects for success of such measures, there arereally no attractive alternatives short of a substantial outflow of populationfrom backward areas (discussed in the following section).

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7.13 Any program for high-level human resource development in the backwardareas would have to be carefully designed and to the extent possible market-oriented. Sending local people out for on-the-job training and appren-ticeships in managerial work in the more developed areas may be an effectiveoption. Training programs within the backward areas should be geared towardactual needs rather than narrow technical specialties. Finally, measureswould need to be taken to ensure that human talent remains in the backwardareas and contributes to TVE development there. The fact that Shangrao Countyhas a high-quality basic education system whose graduates each year include aconsiderable number who pass their examinations, go on to universities, andthen never return to the county should give pause for thought.

7.14 To encourage inflows of high-quality human resources from otherareas, the most important tasks are to create an administrative and regulatoryenvironment conducive to development of profitable enterprises and to offerpotential returns that are competitive with those in the more developed areas.The best way to achieve the latter may be to allow outside entrepreneurs toset up PEs in the locality, possibly with nonvoting equity participation bythe local CG. These entrepreneurs will then have a strong incentive toidentify and bring in the other human resources needed to run a profitablefirm (managers, technicians, marketing personnel, etc.).

Greater Population Mobility and Rural Industrialization

7.15 The options and measures discussed above, as well as other possiblereforms, could have some impact on poverty and backwardness in China's under-developed rural areas. But experience in other countries w'th government-mandated 'regional development programs" has been decidedly mixed. Over thelonger term, outward flows of population from some of the more backward areasmay be the most effective means of alleviating poverty and raising incomes.This would mark a sharp departure from the present system of fixed-membershipcommunities in rural areas. The weakening of this system might be only agradual process, to minimize the possibly large social costs involved. Thoughresistance agelnst moving out by the populations of poorer localities may notbe very great, it could still be a factor, and moreover local CGs and countyauthorities would probably be opposed because it would weaken their powerbase. Perhaps more important, there would be strong resistance from thelocalities absorbing such migration. Though immigration of temporary, low-paid workers for the most part doing menial tasks may be accepted by the localpopulation, this would not be true of permanent immigration, since it wouldmean sharing community resources (land and local nonagricultural job opportu-nities) among a larger pool of "members". Local governments might resistpermanent settlement of immigrants because of the added responsibilities andfinancial burdens involved. Despite these obstacles, outward movement ofpopulatlon from backward areas deserves consideration as an option and as partof a long-term national urbanization strategy. It is probably much morefeasible if it occurs as part of widespread urbanization, in which largenumbers of people from richer and poorer areas alike are leaving their homecommunities.

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7.16 Even with substantial human resource development and elimination offiscal predation, it is unrealistic to expect every nonindustrialized countyin China to be able to follow the high-industrialization path of Wuxi orNanhai. Though there may be some room for development of other nonagricul-tural activities, many of these do not have great potential in the absence ofindustrialization. Many of the localities concerned may well be suited pri-marily for various types of agriculture only. Development of nonagriculturalactivites to absorb surplus labor from agriculture would still be the bestmeans of raising incomes in these areas, but the nonagricultural activitiesconcerned would emerge primarily elsewhere, requiring substantial outmigration(which would leave the remaining local population, still primaril.y engaged inagriculture, better off).

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VIII. PROSPECTS FOR THE FUTURE: INSTITUTIONAL AND POLICY ISSUES

8.1 The future role and share of the TVE sector in the Chinese economydepends on many hard-to.-predict factors. But from all indications, its impor-tance will continue to grow over the short and medium-term. The TVE sectorwill likely maintain double-digit growth for the next several years, at a paceconsiderably faster than that of state industry. TVEs represent the only hopefor achieving the Government's ambitious goals for shifting a large part ofthe rural population from agriculture to nonagricultural activities over thenext several decades. TVE development is also to provide the foundation for'urbanization in small towns". Great hope is invested in the TVE sector as agenerator of exports and export earnings. The potential role of competitionfrom TVEs in stimulating the state-owned industrial sector to reform itselfand improve efficiency should not be underrated.

8.2 But the TVE sector will need to further evolve and develop if it istn continue to be a highly dynamic "leading sector" in the economy, particu-larly if urban reforms are successful in improving the efficiency and competi-tiveness of SEs. The barriers against reasonably large firm size will have tobe overcome, so that more efficient and successful TVEs will be able to growbeyond community-based limits. At the same time, closer and mot. organicforms of integration with the state sector may become increasingly necessaryfor many of the smaller firms. The costs of the present highly dispersedlocation pattern of TVEs will likely become a progressively severe competitivedisadvantage; hence there needs to be evolution toward greater concentration.TVEs will also have to improve technology and product quality, cut wastage ofmaterial inputs and energy, and engage in a host of related efficiencyimprovements in the increasingly competitive business environment which isemerging. Competition within the TVE sector is already severe in manyindustries and will only become more heated over time. A reformed, moredynamic, and efficient state sector may also put increasing competitivepressure on TVEs in the future.

8.3 One set of issues of crucial importance for the future development ofChina's TVE sector concerns Government policies. Policy liberalization hasplayed a major role in allowing the TVE sector to grow so rapidly during thepast decade. Government policies may be even more important in encouraging orhindering needed transitions by the TVE sector in the future. The legal andregulatory framework for TVE activities has already been discussed (ChapterIII). The future evolution of industrial markets will be crucial and willdepend to a considerable extent on Government policies. Government industrialstrategies and policies may also have an important bearing on future TVEdevelopment. These policy issues will be examined in the second half of thischapter.

8.4 Institutional aspects lie at the heart of both many of the problemsand much of the needed future evolution of the TVE sector. They have alsoplayed a major role in its successful performance to date. The most strikingcharacteristic of the TVE sector is its strong community orientation, yet itis possible to foresee a weakening of this in the future, with major

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consequences. In this context, the freure role of CGs at different levels isa crucial question. A more immediate issue concerns the strong fiscal incen-tives for TVE development and possible distortions these may induce. Owner-ship is a key part of the institutional structure, particularly since owner-ship patterns vary so greatly across different regions and localities (seeChapter I). One question concerns the future evolution of the ownership formof CEs. Another issue is the scope and potential for further development ofPEs. There are also more specific issues and ptions, related to the identityand roles of entities exercising ownership righits (CGs, TICs, banks, outsideentities, workers, community members, etc.). Institutional issues will betaken up in the first part of this chapter.

Fiscal Incentives Related to TVE Development

8.5 The need to generate revenues to meet local public expenditurerequirements has been a potent incentive for CGs to actively promote TVEdevelopment. It is much easier for CG officials to levy funds from TVEs,especially CEs, than from agricultural activities or directly from peasanthouseholds. Rural communities with successful, profitable TVEs also tend tohave a better CG financial situation and adequate funds for public services,social services, and investment in needed infrastructure, public facilities,and further TVE development. On the other hand, localities that have not beenable to develop TVEs seem to be caught in a vicious cycle of fiscal predation(see Chapter VII).

8.6 Though fiscal incentives have played an important role in the recentrapid growth of China's TVE sector, problematic aspects of these fiscallinkages also are readily apparent, particularly in the backward areas. Theycarry the danger of increasing spatial inequality in provision of variousrural social services, which in turn could result in further entrenchment ofuneven rural development and industrialization patterns. The fiscal incen-tives of CGs related to TVE development may be in a certain sense "excessive".In the backward areas, excessive reliance of CGs on CE remittances is obvi-ously harmful and adversely affects TVE development. But even in the moredeveloped areas, the fiscal impact of the TVE sector on the local community isso great that it may lead to undesirable buffeting of government expenditures,uneven provision of some government services over time, and possibly inappro-priate uses of TVE profits.

8.7 Some separation of the fiscal/governmental and business developmentroles of CGs may be desirable. Though this might weaken fiscal incentives forTVE development, other incentives like employment generation would still bequite strong, and enterprise profit incentives might well be strengthened.The beginnings of such a separation can be seen in the TICs of Wuxi. Whilestill under overall supervision by the TG, the TIC there does serve as theintermediary between TEs ar.d the TG, and it effectively pools resources ofsubordinate enterprises. The business development role of TICs might befurther strengthened by allowing them to issue income bonds (see Chapter IV)and through other measures. TICs could move further in the direction ofbecoming profit-oriented holding companies, owning and supervising local TEs

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and mobilizing funds for them through bond issues, investment in joint ven-tures, etc. The link between the TIC and the TG could gradually evolve into amore arms-length relationship.

8.8 Overall reforms in China's public finance system may profoundlyaffect the fiscal incentives and linkages related to local TVE development.For example, the trend toward giving tax collection responsibilities andincentives to lower and lower levels of government (culminating with theestablishment of townships as a new level of public finance in many areas) maybe reversed in the future. If the tax collection functions of townshipgovernments are taken away and put in the hands of higher levels of govern-ment, this may greatly weaken the former's fiscal incentives to promote TVEdevelopment. It thereby might facilitate the separation of CG corporate andfiscal roles.

Future ROLe of Community Governments

8.9 CGs have played a crucial role in the development of the TVE sectorso far, which undoubtedly will continue for some time into the future. Butthere are already signs of friction and change. CGs have not been effectivein stimulating TVE development everywhere. The traditional CE model of ruralindustrialization is now only one of several; other models have differentimplications for the role and importance of CGs. Though PEs are in many waysstill part of the communal economic and social structure and often have closeinformal ties with CG leaders, these are uneasy, unstable relationships whichmay gradually erode over time if the property rights of PEs are strengthenedand clarified. Greater population and labor mobility will affect CGs in waysthat are hard to predict but will tend to weaken their authority. Theincreasing independence of the local banking system and possible futurereforms in its structure may affect the ability of CGs to allocate communitysavings. The market situation faced by TVEs is becoming increasingly competi-tive, which makes the task of CGs in the areas where TVEs have not yet devel-oped even more difficult. More generally, economic development will likelyerode the communal nature of Chinese rural society over time.

8.10 It is hard to forecast how rapidly the community structure in China'srural areas will evolve and change. In 1980, nobody would have predicted theuniversal implementation of the PRS, the demise of the commune system, and, inmany areas, the virtual elimination of production teams as significant commu-nity entities, all of which actually occurred during the next few years. Thusthere is at least the possibility of further rapid institutional change inChina's rural areas. On the other hand, there are elements of stability,particularly in the more developed localities where CGs have built up dynamicand relatively efficient CE sectors.

8.11 As part of the separation between the corporate and fiscal roles ofCGs, mentioned above, TICs may begin to transcend the limits of their commu-nity orientation. This could occur first in their obtaining resources fromoutside the community, mainly capital (e.g. through bond issues), but latersuch transcendence may become broader and may lead to changes in orientation.T!Cs may eventually become relatively autonomous, linked to CGs by ownershiprelations but without the many noneconomic ties which exist at present.

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8.12 CGs would then focus on their more narrowly defined "governmental"functions, relying on shared local revenues and/or grants from higher levelsof government, as well as possibly some continued remittances from TICs. Thisevolution should help improve the provision of public and social services inrural areas. More generally, CGs in many parts of the country will have toshift their orientation away from a narrow focus on rural industrialization asthe primary means to promote economic development, generate employment, andsolve fiscal problems. It is simply impossible for every township in China toattain the level of industrialization achieved by Wuxi and Nanhai. Some ofthem may develop specialized agriculture, while others may be able to carveout a niche in nonindustrial activities outside of agriculture. Many of themmay lose population eventually, as urbanization elsewhere attracts labor frompoorer regions and restrictions against migration erode (see Chapter VII), butit will require a major change in the mind-set of CG leaders to accept this.

Community Orientation of CEs

8.13 Like TICs, some CEs will need eventually to transcend the limits oftheir rural community roots if they are to attain large firm sizes and fullyexploit economic opportunities. This will require some difficult transitions,but if it does not occur the CE sector will be constrained in its ability tocompete with SEs and may run into severe problems if the latter become morecompetitive. Under these circumstances, CEs would also be in danger of beingleft behind by PEs, which might find it easier (in an appropriate policy andregulatory environment) to transcend their community ties. Transcendence forCEs could occur as part of the change of orientation of TICs; another transi-tional possibility is for some large CEs to be structured as joint venturesamong several neighboring communities. But eventually, the successful CEsthat are able to become large firms will probably be structured much as largecorporations elsewhere--as joint stock companies in which the "founding" CGmay still be the largest shareholdei but no longer dominates. Such firmswould no longer be narrowly construed as TVEs, though they might derive muchof their efficiency and competitiveness from their TVE antecedents.

Role and Importance of Private Enterprises

8.14 This issue will become increasingly important as the PE sectorcontinues to grow rapidly, more and more relatively large PEs emerge, and theybecome more autonomous vis-a-vis CGs. Though PEs are still largely community-oriented despite their lack of formal community ownership ties, this couldeasily change over time, in which case PEs might become a vehicle for weaken-ing the community orientation of the TVE sector in general.

8.15 A key issue is the different kinds of interactions and competitionbetween PEs and CEs. As was mentioned earlier, competition for labor, and inparticular for "professionals", has been one of the key sources of frictionwhere PEs have been permitted to develop rapidly, and served as the mainjustification for a harsh clampdown against PEs in Wuxi County. Over time,continuing growth of the PE sector may sap the vitality of CEs by attracting

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away many of their best people, or alternatively will force CEs to pay highwages to these personnel (as is already occurring in Nanhai), leading tolarger pay differentials within firms.

8.16 Another important linkage between the two parts of the TVE sector isvarious forms of 'privatization' of CEs. These usually involve some type ofcontract-based autonomous management of CEs by individuals or small groups,with a large element of residual claimant status with respect to profits.Such methods often seem to work well in the short run, permitting greaterautonomy of management while still maintaining links to the community andaccess to community resources. But there needs to be a clearer specificationof property rights in these firms to avoid future problems. Outright sale ofCEs to individuals is becoming more widespread; if this trend continues, itcould lead to substantial further reductions in the share of the CE sector.

8.17 Still another kind of linkage is joint ventures or other forms of"attachment" by PEs to local CGs. These are often motivated by the need forprivate entrepreneurs who have gained a certain degree of wealth and visibil-ity to obtain "administrative protection' from the local community, as well asaccess to community resources. The potential for abuse and personal corrup-tion in these arrangements is great. Many of them might turn out to be unnec-essary if the legal framework and regulatory environment for PEs is improved.

8.18 In the absence of heavy-handed restrictions, the PE sector is likelyto continue to grow rapidly and further increase its share in the rural non-agricultural economy. This will have important implications for CEs and CGs.But there will probably continue to be a great deal of regional and localdiversity.

Diversified .wnership in the TVE Sector

8.19 As part of the weakening of CG-CE ties, and as part of the integra-tion of sizeable PEs into the rural economy, diversification of ownership oflarger TVEs would appear desirable. This should not be considered as a goalin itself, but rather it should be permitted to occur as enterprises pursuedifferent channels for obtaining capital needed for expansion; as firms andCGs strive to spread and reduce the financial risks they face; and as inves-tors seek high returns. Among the different rural institutions and personswho could be appropriate 'owners' of TVEs are the following: (1) individualproprietors and partners; (2) CGs at all levels, both inside and outside thecommunity in which a firm is located; (3) ABC branches and RCCs (with limitedexposure and only in the case of large and relatively profitable TVEs);(4) enterprise workers (also to a limited extent); (5) community members notemployed by the firm; and (6) individual investors from outside the community.

8.20 Though the TVE sector would benefit greatly from a clearer specifica-tion of ownership and property rights, free trading of ownership claims mightnot be possible for a long period to come (though trading of the income bondsdescribed in Chapter IV could become feasible). Most enterprises are toosmall for this, and it might not be appropriate for trading of shares in TICsto occur, since these really represent their communities, and the lattercannot be liquidated.

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8.21 In terms of the precise exercise of ownership functions and how theseare to be structured, something akin to the board of directors concept mightbe appropriate for larger TVEs, though there are many other workable options.Most if not all owners would be on the board, given their small numbers, so itwould really function more like an owners' council. In the case of PEs,partial ownership by banks and other entities could be on a nor.voting basis,as suggested earlier, to help maintain autonomy of the private proprietors.

Legal and tegulatory Environment

8.22 Desirable improvements in the legal and regulatory framework for TVEsparallel those needed in the rest of the economy (Chapter III). In the futurethe focus will gradually shift from codification to meaningful adjudicationand enforcement, where the system still has a long way to go until it becomessupportive of autonomous, business-oriented enterprises in a well-functioningcompetitive market environment.

8.23 The importance of a nondiscriminatory legal and regulatory environ-ment for the TVE sector and a "level playing field' for competition within theTVE sector as well as between TVEs and other types of firms has been stressed.Progress in achieving this goal will probably be only gradual. Nevertheless,it is important to keep the ultimate objective in mind, and to ensure thatspecific policy measures in the short run go in the right direction even ifthey leave something to be desired from a long-term perspective.

8.24 In this context, the separation of regulatory and ownership functionsin the state-owned industrial sector should prove helpful. At present somegovernment agencies with regulatory responsibilities for industry as a wholeor for entire industrial subsectors simultaneously have close hierarchicalties with SEs, which may bias their regulatory actions. Similarly, a gravita-tion of government regulatory functions toward higher levels, particularlyprovincial and central governments, would facilitate the separation of owner-ship and regulatory roles at lower levels.

8.25 A problem that pervades the legal and regulatory apparatus, withprofound adverse consequences, is the bias against outsiders (see ChapterIII). This has to be addressed in some way, even though fundamental improve-ments in the situation may come only gradually. In business disputes,outsiders need to have some recourse to reasonably impartial legal institu-

I tions, so that they can be conf.dent about engaging in commerce and otheractivities outside of their home localities. Whether existing governmentagencies can be improved to the point whiere they can provide such recourse, orwhether new institutions with much weaker local ties need to be created, is aquestion which requires further study.

Competition and Market Structures

8.26 Government policies toward markets and competition can have a majorimpact on the future evolution of the TVE sector, since it is the most market-oriented part of Chinese industry. Measures which improve the functioning of

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markets and promote the emergence of more unified regional and nationalmarkets will have a beneficial effect on the TVE sector overall. Tt.is is trueeven though in the short run and in some industries and localities, broaderand better-functioning markets may cause considerable suffeting for particularTVEs, their employees, and their communities. It is only through flexibleadjustment to increasingly competitive markets that the TVE sector as a wholecan prosper over the medium- and long-term future.

8.27 The TVE sector at present benefits very little if at all from thevarious kinds of "internal protectionism" that provincial and local govern-ments in China sometimes engage in. Thus effective enforcement of the centralgovernment's repeatedly enunciated stand against such protectionism will causelittle if any harm to TVEs even ±n the more backward areas. Some TVE activi-ties in these areas are protected "naturally" by high transport costs or bytransport bottlenecks; these firms might be subjected to severe competitivepressures if transport constraints in the economy are eased, requiring painfulthough necessary adjustments. Improved transport conditions will also meangreat opportunities for many TVEs to expand business; for the sector as awhole these should outweigh the possible disadvantages for transport-protectedTVEs.

8.28 As part of this tempering through market competition, greater open-ness to interntational markets and international competition could play auseful role. Government policies should facilitate export activities by TVEs,most importantly by allowing direct contacts and business arrangements betweenproducers and foreign customers and permitting TVEs to retain a substantialportion of the foreign exchange they earn through exports. The development ofa dynamic, supportive network of trade-related services for small export firmsshould also be encouraged. TVEs should be permitted to acquire capital, tech-nology, and management and other expertise from abroad. Host of thesepolicies are already being followed in southern Guangdon Province, so a largepart of what is needed is simply to broaden the application of these "open"policies to other parts of China.

8.29 Just as important as any positive actions which may be called for isthe need to avoid explicit or inadvertent policies which dampen market compe-tition or result in segmented markets. In this context, the impact of currentpolicies promoting "horizontal coordination" and "industrial groups" should becarefully examined. In certain industries, these may have the unintended sideeffect of restricting competition and encouraging monopolistic tendencies.Local government "licensing" of TVEs making specific goods to prevent overpro-duction or excessive new entry easily can become an anti-competitive weaponfor existing members of the industries concerned and their sponsors. Finally,it is important to remember that industrial structure, market structure, andthe extent and form of rompetition will vary across industries and products.To try to fit the entire industrial TVE sector into a single mould would becounterproductive.

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Government Industrial Policies

8.30 In the past, Government policies to "guide" the development ofcertain industrial subsectors more often than not had a restrictive effect on

TVEs. A good example is the textile industry--the number of spindles in eachprovince and locality is subject to ceilings, which increasingly encompass thesector as well as state-owned textile mills. On the other hand, in someindustries there has been excessive proliferation of new entrants, overproduc-tion, and financial problems. This can be very costly to the TVE sector incapital-intensive industries characterized by a high degree of "asset specifi-city" (i.e. the assets concerned cannot easily be transferred to other uses).Numerous localities invested in TVE aluminum extrusion plants producing windowframes, for example, but most of them now make losses and some have gone outof business.

8.31 Elaborate Government plans and programs for development of particularindustries in the TVE sector are likely to prove costly and ineffective. But

judiciously applied tax and other incentives to promote more rapid growth ofsome industries may be useful.9/ Such incentives may also play a role inencouraging TVE growth in more backward areas. But they should be limited andselective to avoid introducing large new distortions into the system. It isalso important that these incentives should apply to all types of firms thatmeet the stipulated conditions, e.g. by investing in the activity or regionconcerned, not restricted to TVEs or, for that matter, SEs.

8.32 International experience especially in India has shown that encourag-ing small-scale enterprise development by "reserving" certain industries andsubsectors for small firms is counterproductive. Competition is dampened bythe exclusion of large enterprises; inefficient, high-cost small producers are

allowed tc survive; and successful small firms are discouraged from expandingbeyor.d a certain size. China fortunately has not employed policies ofhreaervation" to promote TVE development. But r-serving certain industriesand products for SEs only, excluding TVEs, has occurred in China in the past.

These policies also are either redundant (if the economics are such that smallfirms will choose not to enter the industries concerned anyway) or counter-productive. In the future, attention should be concentrated on generating an

appropriate incentive environment for industrial firms of all types, ratherthan forcing an artificial "division of labor" through administrative direc-

p tives and guidelines.

The Facilitating Role of Government

8.33 The above discussion of Government policies clearly shows that forthe most part, the future development of the TVE sector does not call for

massive Government support, financial or otherwise, or for large newGovernment agencies, major, costly new programs, or administrative coutrols.Given the heterogeneity of the TVE sector, its strong market orientation, and

91 However, subsidization of interest charges on TVE loans to encouragecertain types of investments, a common practice at present, distortssignals on the cost of capital and should be avoided.

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the inherent difficulties of government involvement in the small-scale manu-facturing sector in any country, these kinds of measures would at best beineffective, at worst very costly and with adverse consequences for TVEdevelopment.

8.34 Nevertheless, the role of Government in the future evolution anddevelopment of the TVE sector will be crucial in *iome respects. A facilitat-ing rather than a restrictive or control-oriented role is called for. Moreimportant than a.iy positive measures to support the TVE sector is the need toavoid Government policies and practices which inadvertently do major harm toTVEs. This is true of regulation, policies toward markets and competition,and industrial policies, which have already been discussed in this chapter.The need for a facilitatipg role of Government is also evident from thediscussion of macroeconomic considerations and intersectoral issues in ChapterII. The TVE sector will most likely continue to prosper under a permissive,facilitating policy regime, as it has in the past. The long-term prospectsfor the TVE sector are bright, as long as it is allowed to develop, evolve,and adapt to the changing economic and institutional structure of the Chineseeconomy.