China’s economic system and its accession to the WTO

CHINA'S ECONOMIC SYSTEM AND ITS ACCESSION TO THE WTO

Albert Keidel III In moving towards becoming a market economy, China has made dramatic strides since embarking on reforms in 1978, but liberal- izations have been accompanied by inflationary booms followed by bouts of social instability. These last account for much of the caution in China's approach to joining the World Trade Organi- zation, which is seen as critical to securing further foreign direct investment, foreign technology and access to foreign markets--all necessary to economic growth and development. There is a reluc- tance to make firm commitments to abide by WTO rules on a schedule faster than that expected of developing countries. Per- haps the commitments required could be undertaken in confidence-building stages.

In the two decades since the Mao Zedong's death, rapid diplomatic shifts and a new economic strategy have brought the People's Republic of China out of global economic irrelevance and made it the world's tenth largest trading country, 1 as well as the largest recipient of foreign direct investment in the developing world. 2 With 1.2 billion people, however, the PRC's level of per-capita performance is still abysmal. Nearly a third of the population lives at consumption levels of a dollar a day or below and, in spite of real GDP growth averaging nearly 10 percent a year for over fifteen years, increasing inequalitie~ have helped stall efforts to clothe and feed the country's poorest 60 million people.

The implications of China's poverty and economic strategy are a cause for concern among its trading partners. The history of smaller East Asian countries shows that economies so poor can continue to grow rapidly for many decades. If its growth success raises output per capita to middle-income levels, China itself will be an economic colossus.

How is the world economy to absorb such an economic colossus? This is the question facing members of the World Trade Organization (WTO). The critical issue is not that the People's Republic is in transition from commu- nism. The WTO might make room for Chinese-type institutions in a much smaller country. More important issues are China's size, poverty and development program. In particular, the PRC's combination of poverty and growth promotion leads to interventionist government institutions which, on the face

Albert Keidel III is president, Rock Creek Research Inc., economic consultants, Bethesda, Maryland, and teaches on China's economy in the Department of Economics, Georgetown University, Washington D.C.

46 JOURNAL OF NORTHEAST ASIAN STUDIES / FAIL 1996

it, appear to be in conflict with many of the WTO's basic principles. Such interventionist and growth-oriented institutions, however, may be essential for China's economic success in the medium term. Furthermore, an underly- ing purpose of the WTO system, it might be argued, is to encourage the expansion of international trade as one of the surest guarantees in the longer term of global peace and prosperity.

China's economic emergence obliges WTO members to consider again whether WTO principles are more suited to fully industrialized market economies than to poor economies in circumstances like China's. The WTO's greatest challenge may be to adapt itself better to global circumstances so that economies like China's can mature and expand within the WTO's competitive fold.

IS ACCESSION DESIRABLE? IT DEPENDS

Various arguments of uneven quality maintain that China either should or should not be welcomed into the WTO system. Clearly, the desirability and significance of the PRC's accession depends on the terms and circumstances, not the least of which are circumstances within China. In considering these issues, it is important to focus on the fundamental long-term interests of all parties, avoiding short-term negotiating postures.

Greater prosperity throughout the world economy is the best motivation for successful Chinese accession to the WTO system. China's economic circumstances invite both strengthened international specialization and richer same-sector two-way trade expansion. How can China's accession best serve this goal? Can the WTO serve the world economy if it excludes the People's Republic? China is the world's largest country in population terms; and it has one of the world's most impressive records for commercial expansion. Is the WTO framework of principles, rules and procedures so rigid that it cannot find a way for China's membership to contribute to global prosperity?

Strong counter-arguments counsel caution. Most persuasive are concerns about market access being asymmetrical, leading to domestic economic dis- ruptions in China's trading partners, without adequate compensating benefits from growth in exports to the PRC. Even if the consequent trade expansion were relatively balanced in a multilateral sense, it might be too rapid, leading to unemployment and social instability in certain sectors or regions of WTO member economies. Moreover, if China's membership results in its exports disrupting other economies so much that they must renege on their own WTO obligations, the whole system could be weakened. These are important concerns.

Less persuasive arguments contend that China's WTO membership would only speed the growth of its military capabilities and hence its threat to world peace and prosperity. Chinese commentators refer to this as the "contain-

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ment" argument. Similarly, arguments referring to the PRC's human rights record and lack of democratic institutions (as indications that China cannot be relied on to honor its WTO commitments) are not convincing. It is hard to see how greater commercial isolation of China would lead to speedier satisfac- tion of outside demands of this sort.

The agnostic position, that it does not really matter whether China accedes or not, is too extreme. The argument implies that the country's institutions and trade patterns would evolve in ways equally beneficial to everybody, whether or not it were a member of the WTO system. This is hard to believe. Perhaps accession to the WTO does not matter as much for China as it does for smaller developing countries because of its much stronger bilateral negotiating position. But if China's terms of accession are well designed, they could provide continuous pressures for behavioral, institutional and structural adjustments in both China and other WTO members, adjustments that benefit trade and prosperity for all members.

Even such a short review makes it clear that the desirability of China's accession depends on how WTO members and Beijing configure the terms. A successful configuration would require significant adjustments by China, by the WTO and by WTO members, adjustments that would not be easy for any of them. For the WTO and its members, designing such a mutually accept- able configuration for China's accession depends on an adequate appreciation of the country's fundamental economic situation and interests, given its size, poverty and development strategy.

CHINA 'S FUNDAMENTAL INTERESTS

China's long-term goal is to pull itself out of its low level of per-capita income and consumption as rapidly as possible, all the while strengthening its domestic stability and international security. In economic terms, this means acquiring foreign technology and achieving rapid economic development, with patterns of income distribution that balance individual incentives and avoid excessive gaps between rich and poor.

In spite of impressive urban development in its coastal cities, and in spite of its readily apparent and active commercial expansion, both domestically and internationally, careful statistical analysis shows that China is a very poor country. Casual observation is misleading, for although visitors can see the achievements of production and construction activities, they cannot see the scale of the population denominator. Whether one uses commercial rates of exchange or purchasing-power-parity (PPP) conversion estimates, statistical measurements of China's GNP per capita in U.S. dollars reveal that its aver- age per-person output is just above India's, is well below levels in Southeast Asia and is far below levels in Latin America. 3

China is also one of the poorest countries in the world in terms of income

48 JOURNAL OF NORTHEAST ASIAN STUDIES / FALL 1996

distribution and the incidence of poverty. A well-known international poverty benchmark is per-person consumption of one U.S. dollar per day (in PPP terms). In the early 1990s, close to one third of the PRC's population lived at or below that level. 4 By this international definition, in terms of numbers of people, only India has more poor. In the "transition" economies of the former Soviet Union and Eastern Europe, virtually nobody lives below this standard and, indeed, the poverty standard for these countries turns out to be not one but four U.S. dollars per day (in PPP terms). 5

Raising standards of living and reducing poverty are thus fundamental Chinese national objectives. China's cabinet, the State Council, has set the year 2000 as a target for eliminating poverty according to its own poverty benchmark. Its poverty benchmark, however, is much lower than the world standard of one dollar per day, being roughly 60 cents per day. This level barely avoids starvation and yet China had roughly 80 million people living at or below that level in 1993. By 1995, a nationwide program of job assis- tance, education and relief had only brought the number down to 65 million. China's leaders acknowledged in early 1996 that their program for eliminating poverty altogether by 2000, in spite of increased resources in the program, was behind schedule and achieving the goal on schedule would be very difficult.

A second aspect of China's low level of development is its weak technology base for mass production of high-quality industrial products. Before reforms began in 1978, the country's industrial technology reflected Soviet standards of the 1950s, which in turn reflected European technologies of even earlier decades. Foreign direct investment since 1978 has provided China with a wide array of light manufacturing technologies, but projects to date are heavily skewed in the direction of assembly and processing, with much less transfer of more sophisticated technologies. Middle-level and advanced technologies, including technologies of economical mass production, are essential if China is to grow out of poverty. Acquiring them will continue to be given the highest priority in reforms, institutions and national policies.

As for reforms themselves, China's leaders consider market reforms necessary ingredients in a program of economic growth and obtaining foreign technology. But market reforms are not an end in themselves. They are one part, and only one part, of a development methodology. In the words of one high-level policy maker, as he gave China's most important annual economic address:

Following the basic principle of seizing current opportunities, deepening reform, opening China wider to the outside world, promoting development and maintaining stability, we shall balance reform, development and stability. 6

This statement's call for a balance between reform, development and stability implies trade-offs. The development-stability trade-off is familiar, for

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too-rapid growth leads, by definition, to inflation and related instability. Chi- nese experience with reform, however, reveals a second trade-off: too much reform too fast can threaten both development and stability. China has repeat- edly experienced both of these trade-offs since reforms began. Learning to cope with them has shaped its reform experimentation, the evolution of its institutions and its approach to WTO accession.

CHINA 'S ECONOMIC SYSTEM--REFORMS AND STABILITY

China's economic reforms have simultaneously dismantled old institutions and created new ones. But the process has been full of imperfections. Dis- mantling has seldom been complete; new institutions, seldom completely new. Most important for China's WTO accession, many of the new institutions reflect practical medium-term solutions to bruising bouts of liberalization, inflation, bank runs, budget deficits, sudden current-account imbalances and unpopular credit crackdowns.

Reforms in the 1980s--Liberalization and Inflation

China's earliest reform efforts after Mao's death reflected a naive faith in the ability of oil exports to finance imports of technology along with an ambitious investment expansion in 1978-79. 7 These excesses, together with dramatic agricultural price reforms in 1979-80 and unexpected fiscal hemor- rhaging during China's 1979 war with Vietnam, led to large budget deficits, inflation and a sharp credit crackdown in 1980-82, during which the Com- munist party under Deng Xiaoping reformed itself and reassessed its history since the 1950s.

The first serious surge of financial, fiscal and enterprise reforms began in 1983, with decisions to sever most enterprise links to the state budget, mak- ing enterprises reliant instead on retained earnings and "loans" from specialized banks, themselves only recently differentiated from China's traditional monobank system of the Maoist era. These steps, on top of new degrees of management independence, rural land reforms, foreign investments in coastal regions and relaxation of export and import subsidies and restrictions, led to sudden difficulties in 1985-86. Grain production dropped sharply, exports contracted in favor of domestic sales, imports flooded into the country, especially automobiles, and China experienced its worst inflation since the famine years of the Great Leap Forward (1958--61).

Concerned at the crises brought about by market reforms, the central government reacted strongly. It cut credit to construction projects, reduced operating "loans" to enterprises, strengthened import restrictions and export subsidies, reassessed foreign investment projects and reinstated a degree of "duty" in farmers' grain planting. Most of the institutions revived and re-


cruited for these adjustments continue to function in one form or another today. As these measures took hold, inflation came down, while deficits contracted or disappeared. Other problems appeared, however, especially wage arrears to China's volatile urban industrial labor force. In early 1986 the government began selectively authorizing bail-out "loans" to those enterprises in greatest difficulty.

The severest repercussions of the 1983-86 boom-and-bust cycle gradually dampened out through 1987, but new financial reforms and new pressures for price and management reforms emerged, pointing to even more serious economic crises--with deadly political consequences.

Tiananmen--Reforms Gone Awry

The PRC's June 1989 Tiananmen political crisis and violence were argu- ably the result of economic reforms and their detrimental impact on urban income security and standards of living. The most interesting aspect of the 1986-88 reforms involved new or expanded non-bank financial institutions, such as trust and investment companies and enterprise finance companies. Local governments also relaxed controls on a wide range of informal financial institutions operating on the fringes of legality. These were offering higher rates of return than state-owned specialized banks. By early 1988 the drain of funds out of state banks had created a serious bank liquidity problem. Banks did not have the funds to support the government's priority investment projects. The central bank accommodated authorized bank cash needs with an expansion of the base money supply in early 1988 which created monetary conditions for the inflation and panic buying of mid-summer 1988. The problem of "leakage" from the banking system had become repetitive and it would reappear in the 1990s.

Other reforms and related policies caused further urban discontent. Farm- ers had received little relief from the impact of inflation. By late 1987, farmers were slaughtering their sows, as high feed costs and restrictions on pork prices forced them to produce pork at a loss. The government responded in early 1988 with significant increases in administered meat prices which, in turn, undermined living standards for urban workers and students. Students especially felt slighted by reforms. Inadequate compensation for the impact of inflation had reduced real student incomes. Education reforms were unpopular because they made scholarships and job prospects contingent on student performance. These and other factors contributed directly to large- scale antigovernment student demonstrations in the winter of 1986-87.

Inflation and financial crisis struck China in the summer of 1988 because word of a government decision to continue price reforms triggered panic buying and runs on the banks. The inflation was worse than in 1985 and the government struck back with an even more severe contraction of credit.

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Credit cutoffs stopped most construction projects. New credit to rural industries was eliminated. Administrative requirements for planting grain were significantly stiffened. Urban wage incomes suffered, pension payments were delayed and farmers received IOUs as payment for their grain deliveries.

In spite of government efforts, however, inflation persisted into 1989. Many workers were furloughed or received reduced pay; and after Chinese New Year celebrations in early 1989, rural construction laborers returned to cities in vast numbers, looking for work. When students and workers began their massive demonstrations in May-June of 1989, high on their list of griev- ances were economic "crimes" such as inflation and job loss, which activists blamed on "corruption" rather than reforms.

This brief account of financial and price reforms in the 1980s indicates their links to excessive money growth, inflation and credit contractions, all having detrimental consequences for China's subsidized urban population.

After the Tiananmen violence and killings of June 1989, the government's credit crackdown became much more serious, so by 1990 inflation had de- clined sharply, with urban employment security and incomes adversely af- fected even more. China seems to be caught in cycles of liberalizing reforms, credit leakages, inflation and sharp financial contractions, s Is it possible for China to introduce liberalizing reforms and not suffer serious economic, social and political instability? Experience in the 1990s is still inconclusive.

Reforms in the 1990s--Liberalization, Inflation and a Soft Landing

At the end of 1990, China's leaders decided that they had beaten inflation, but grew concerned about the resulting low rates of industrial growth. Credit in the second half of 1991 expanded dramatically and, after Deng Xiaoping's early 1992 "Walk (and Talk) in the South," an investment boom began that extended into 1993. But another round of financial liberalization reforms (interbank lending) in 1991-92 brought a new kind of "leakage" from the state banking system and by 1993-94 inflation had far surpassed 1988 levels. 9 Once again, liberalization had brought inflationary threats to domestic stability. Income inequality increased, rural-urban migration accelerated and farmland conversion to commercial purposes compromised grain supplies. Imports surged and opened a current-account deficit as a result of booming domestic demand and relaxed import restrictions.

The government response to this new inflationary surge was a more muted credit contraction than in the past, resulting in a "soft landing" by the end of 1995. "Soft landing" meant gradually reduced inflation without dramatically lower growth in production. There was more to controlling inflation in this period than macroeconomic credit tightening.

To control inflation, the government strengthened, or reintroduced, a wide


range of administrative measures to contain prices and unwanted credit flows. Grain rationing coupons reappeared in many cities. Grain production requirements were strengthened and placed under the direct supervision of provin- cial governors (the "governors' responsibility system"). Urban areas revived administrative price "supervision." And the State Planning Commission strengthened control over the use of credit for investment purposes.

Financial institutions and practices faced stronger administrative regulation. The central bank re-centralized loan supervision in the national head- quarters of state banks. Working capital loans were parceled out where threats of large-scale industrial layoffs risked social instability. Foreign direct investment flows, which contributed to unwanted growth in liquidity, were subjected to stricter administrative requirements to discourage projects deemed inconsistent with national industrial priorities. Going to the perceived source of the problem, the supervision of interbank lending was made much stricter.

In sum, as in previous efforts to control inflation, administrative interven- tions and regulatory mechanisms were centrally important as policy instru- ments in the 1992-96 inflationary cycle. Overall, China's experiences since 1978 have helped convince Chinese leaders that rapid liberalization of domestic, foreign and financial markets is certain to bring unacceptable levels of inflation, painful stabilization and social unrest. The alternative is a system of ad hoc institutional arrangements for maintaining the growth of production, employment stability and gradual structural realignment to market requirements.

Institutions Relevant to WTO Accession

The evolution of economic institutions may enable China's eventual or- derly transition to a mature market economy, but, in the medium term, these same institutions present challenges for WTO accession. Most notable is China's commitment to its industrial policy. In addition, and generally related to industrial policy, China has a system of policy-bank lending, a proposed system of currency convertibility conditional on transaction authorizations, a system of quantitative trade restrictions, a strategy for the reform of state- owned enterprises to keep them state-owned and combined in "industrial groups," and a system to use preferential credit arrangements to promote "pillar industries," which are for-profit strategic industries, often with an export orientation, as with consumer electronics and motor vehicles.

Industrial policy is the backbone of this system to maintain stability during the transition to full reliance on markets. It is essentially a list of sectors and products divided into three groups: discouraged, neutral and encouraged. In addition, it places scale restrictions on enterprises in various sectors, aimed at avoiding wasteful investments by firms and local governments with poor

KEIDEL 53

market information. Examples of discouraged sectors are luxury real estate and low-quality textiles. Encouraged sectors are essentially "pillar industries" and include infrastructure and energy projects. The authorities for enforcing these various policies are the State Planning Commission and its subordinate bureaus at province and local planning levels throughout the country. In addition, the central bank regulates the financial system, especially the banks, so that they do not make unauthorized loans in discouraged sectors.

One of the most difficult problems facing the authorities, however, is how to encourage investments in pillar industries. China's tax revenues at both national and local levels are inadequate to support budgetary funding of all such "public" investments and operating subsidies. Given the long gestation and low return of most infrastructure projects, and given the poor financial condition of many state-owned enterprises, few financial institutions volun- teer loans for such uses.

China's traditional method of meeting public investment and subsidy needs has been through the credit plan. A holdover from pre-reform days when all investment and operating funds came out of the state budget, the credit plan directs "public" outlays to various uses in the form of policy loans by state-owned specialized banks. Loan interest rates are set within a narrow band by the central bank and many such loans are never repaid. In an effort to phase out the credit plan, China's 1994 banking reforms began the process of separating policy loans from commercial banks, which is being done by inaugurating three development banks to make all loans to infrastructure and pillar industry projects. The scale of public investment projects is so large, however, and since development banks do not lend in support of operating costs for ongoing businesses, publicly directed commercial bank lending is likely to continue for some time, even though Chinese leaders have said that they want to end the credit plan before 2000, possibly as early as 1997.

China's industrial policy is important for WTO accession because it repre- sents China's commitment to integrate public policy purposes with competitive financial, industrial and foreign trade sectors. This commitment extends to quantitative import restrictions which protect, among other sectors, ma- chine tools, but which also appear to limit imports of consumer goods to reserve foreign exchange for technology acquisition and essential industrial inputs such as chemical feedstocks. Strategies for pillar industries have a pronounced export-promotion dimension to help ensure adequate future foreign-exchange earnings. The industrial policy program includes administrative restrictions on foreign direct investments in "discouraged" sectors, as well as coordinated national policies regarding rates of return on foreign investment in encouraged sectors, such as toll bridges and electric power generation.

Overall, China's economic experiences since Mao's death have resulted in cautious market liberalization, together with a range of institutions to ensure

54 JOURNAL OF NORTHEAST ASIAN STUDIES I FALL 1996

social stability and long-run growth. These experiences and institutions form the background to China's approach to WTO accession. Beijing is willing to agree to accession terms only if they are consistent with its strategy for development and stability. Those terms might fall significantly short of many WTO members' expectations.

ONE VIEW OF WTO ISSUES AS CHINA SEES THEM

China is currently pursuing its application for WTO accession, and so its views on various issues are not fixed. But a senior official of China's trade ministry, Zhongzhou Li, recently published an overview of the issues that is frank about important ways in which the PRC's accession would not meet WTO members' expectations.l°

Mr Li is adamant that China "will not practice privatization." Even though the People's Republic has widespread private ownership of property and large numbers of private, wholly foreign-funded firms, "China will not privatize state-owned enterprises and privatization is not a goal of its economic policy."

In a more general vein, Mr Li wrote that China's goals are an inflation- free economy, dedicated to securing long-run development health, rather than short-run financial gains on the basis of unrealistic assumptions. He acknowledges that China's need to undergo structural adjustments is greater than in other countries, because the PRC is in transition towards becoming a market economy, but in order to sustain growth it needs to be cautious in joining the WTO system.

One formula for Chinese accession would be to go ahead in a formal sense, while postponing compliance with various standards, providing for delayed or phased implementation. The schedules for China's phased commitment to those WTO standards would thus become the central issues. China has reduced tariffs significantly and pledges to reduce them more, but there is no agreement yet on the reduction of nontariff barriers. Mr Li considers that reducing nontariff barriers is important in speeding China's domestic structural adjustment, but he does not offer specific proposals, commenting instead that "postponement of membership in the WTO will prolong China's domestic structural adjustment effort."

Mr Li acknowledges that other issues are even more problematic. Reform of the foreign trade management system would open it to foreign entry and to general freedom for direct contracts between local and foreign firms for the supply of goods. Mr Li maintains though that for China to adjust its current laws in the direction of compliance might "spark chaos in management order, affect the development of foreign trade, or even encourage dumping." He also considers the resulting potential for bankruptcy of domestic firms as an additional reason for gradual progress in this area. But he does not propose a

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timetable or set standards for determining how gradual the progress should be.

Chinese laws on domestic content in the output of foreign-funded firms are another difficult area. Mr Li maintains that cancellation of these requirements conflicts with China's overall goal of developing domestic industries. The same holds for WTO standards calling for national treatment, canceling preferences for foreign-funded ventures. Mr Li points out that other countries encourage foreign investment with preferences. Not to do so, he says, would contradict China's policy objective of attracting foreign investment and could lead to a reduction in foreign capital inflows.

In other areas, compliance with WTO members' expectations faces vary- ing degrees of difficulty. Protection of foreign intellectual property rights has generally adequate legislation in China, but enforcement is expensive and developing an adequate enforcement mechanism should be in place "as soon as possible," with no more specific timetable available. As for WTO members' access to China's domestic service sector and freer trade in farm products, Mr Li makes it clear that the process of compliance will be even more drawn out, partly because of the weak competitiveness of domestic firms.

In short, paraphrasing the comment of another Chinese official working in the area of China's WTO accession process, as the requirements for accession become clearer it is found that if China agrees to rapid compliance with many WTO obligations its economy and prospects for economic development could be seriously harmed.l i

Are these merely bargaining positions or do they reflect China's difficult experience with steps towards market liberalization? The above review of the inflationary booms and bouts of social instability associated with China's market reforms suggest that these positions reflect genuine Chinese concerns and priorities. Similarly, examination of the economic institutions that China is gradually adopting to deal with its market transition experiences argues that Beijing is convinced of the need for laws and policies, embodied in its industrial policy and related financial and trade strategies, that can promote competitive efficiencies while at the same time ensuring adequate investments in strategic industries and protecting economic and social stability. These goals, then, must somehow become those of WTO members seeking ways to achieve early Chinese accession.

ECONOMIC FUNDAMENTALS OF CHINA 'S WTO ACCESSION

The foregoing discussion implies that China's position on WTO accession is based on practical development requirements gradually emerging from China's twenty years of reform experience since the death of Mat. To what degree do these contradict fundamental market principles of free trade and open competition as the basis for optimal economic policies? Although prin-


ciples of free trade and untrammeled competition are frequently invoked as inviolate foundations of optimal market systems, the most basic teachings of market economics argue otherwise. One does not have to rely on Marxist, North-South or mercantilist arguments 12 to justify the kinds of steps China is taking to protect growth and stability during the transition to greater reliance on market mechanisms.

Two cornerstones of market economics, or what is known more formally as the neoclassical economic tradition, are welfare economics and the theory of the second best. The former is important for China's efforts to maintain social stability and prevent inflation from damaging patterns of income distribution. A basic tenet of welfare economics is that economic change which makes some people better off at the expense of others, no matter what the degrees involved, cannot be considered an improvement without introducing a value judgment on the part of the analyst. Such value judgments are beyond the expertise of economists p e r se and must come instead from national authorities and other interested parties. In China's case, this market principle means that if reforms leave some workers unemployed or underemployed, they cannot be considered successful unless, in the judgment of national leaders and other relevant persons, the gains justify the losses.

According to welfare economics, the only way to provide clear conclu- sions for such situations with potential winners and losers in the reform process is if the losers are fully compensated, so they are not worse off than before. In China's case, compensation appears in the form of investments that provide new jobs for displaced labor, plus adequate unemployment compensation during the period of job search. These goals are part of China's program of gradual reform so that labor shedding by state-owned enterprises can proceed in rough tandem with the appearance of new jobs as the economy grows rapidly. To the degree that WTO accession would disrupt this process, its requirements need to be reconsidered.

The theory of second best demonstrates conclusively that if all the conditions for free-market operations are not satisfied, any single policy based on free-market assumptions may not be desirable and, in fact, may do more harm than good. In other words, one cannot simply apply free-market policies wherever one wants. If conditions are not right, they can do real damage. In China's case, where conditions are rife with gross market imperfections, there is no economic justification for assuming that application of this or that free trade or competitive market policy is the best decision. Whether or not it is depends on the specific circumstances.

The theory of second best has many applications in China, but perhaps one of the most significant is in the case of failures of markets over time. That is to say, investment decisions suffer from myopia and inadequate information about potential technologies, competition and market conditions. The likeli- hood that markets will fail over time is one of the unsatisfactory aspects of

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the neoclassical economic intellectual tradition. Once again, a value judgment is needed. At some future point in time, what investment strategy decisions will the country want its leaders to have made now? In the case of a country like China, these considerations offer justification for government influence over the structure of national investment, influence which goes beyond a government ' s ability to spend out of budgeted funds and which extends into a formal industrial policy and related government regulation of the financial system.

In several dimensions, then, China 's accession to the WTO challenges the expectations of member states with regard to China 's ability to comply with standard WTO membership provisions. And yet, the potential benefits for China and for WTO members are great, arguing for creativity and compro- mise in arranging terms of membership in confidence-building stages that reflect both practical circumstances and the necessary flexibility acknowledged by theory.

N O T E S

1. Based on Direction of Trade Statistics, International Monetary Fund, Washington, D.C., for the year 1995, using own-country data and treating Hong Kong and Taiwan as separate trading entities.

2. A recent review of current economic conditions in China can be found in The Chinese Economy: Fighting Inflation, Deepening Reforms (Washington, D.C.: World Bank, 1996).

3. See international comparisons in per-capita income by both exchange-rate and PPP methods in Worm Development Report 1996: Economies in Transition (Washington D.C.: World Bank, 1996), pp. 188-89.

4. For a discussion of the dollar-per-day standard applied to economies worldwide, as well as to Asia and more particularly to China, see Poverty Reduction and the World Bank: Progress and Challenges in the 1990s (Washington D.C.: World Bank, 1996). For more detailed treatment of China's poverty and issues in its measurement, see "Poverty in China: What do the Numbers Say?" East Asia & Pacific Region: Information Brief (Washington D.C.: World Bank, External Affairs Dept. 1996).

5. Four dollars per day is taken to be equivalent to $120 per month. See World Development Report 1996: Economies in Transition, op. cit., p. 69.

6. Chert Jinhua, "Resolution of the Fourth Session of the Eighth National People's Congress on the Implementation of the 1995 Plan for National Economic and Social Development and the 1996 Plan for National Economic and Social Development," adopted March 17, 1996, and printed in Chen Jinhua, editor-in-chief, Report on China's National Economic and Social Development for 1996 (Beijing: China Planning Press, 1966), p. 13.

7. For an excellent description of this nalvett, see Barry Naughton, Growing Out of the Plan (Cambridge and New York: Cambridge University Press, 1996).

8. A more detailed statistical description of such credit and investment cycles and an analysis of how they may even contribute to the long-term success of reform are set out in Albert Keidel III, "Cyclical Future of China's Economic Reforms," in China's Economic Dilemma in the 1990s (Armonk, New York: ME. Sharpe, for the Joint Economic Committee, Con- gress of the United States, 1991).

9. For a description and analysis of the macroeconomic consequences of such "leakages" from China's banking system in this period, see Economic Reform and Macroeconomic Stability (Washington D.C.: World Bank, 1995).

10. This section draws heavily on Li Zhongzhou,, "Chinese Economy vs. the WTO", Beijing Review, Beijing, July 22-28, 1996. Mr Li is Director-General of the International Trade


Depatlment in China's Ministry of Foreign Trade and Economic Relations. The Beijing Review is considered an official publication of the government for the purpose of dissemi- nating the text of important speeches and policy positions. Unless otherwise noted, quotes in this section come from Mr Li's article.

11. From the author's private discussions in Beijing. 12. See, for example, Marc Williams, International Economic Organizations and the Third

World (London: Harvester Wheatsheaf, 1994), pp. 149ff.

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China’s economic system and its accession to the WTO

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