Issue: 2014: Vol. 13, No. 2

Market vs. Government in Managing the Chinese Economy

Article Author(s)

Xuepeng Liu

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Dr. Xuepeng Liu is a professor of Economics at Kennesaw State University and an associate of the China Research Center. 
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One issue that stands out in the Decision concerns the relationship between market forces and the power of government in the Chinese economy. In previous government statements or reports, the market was expected to play a fundamental role; while in this report, market will play a decisive role and have the final say in resource allocation. As stated in Chapter III of the Decision, “Establishing a unified, open, competitive, and orderly market system is the basis for the market to play a decisive role in the allocation of resources.” (emphasis added by author) The changing role of the market means China is seeking to inject vitality into the economy by allowing market forces freer reign. We would expect to see a more level playing field for businesses, a more important role played by private sectors, and an improved market mechanism such as a unified urban and rural construction land market and a more open financial market system. To some extent, this transition has met the expectation for market-oriented reforms from both within and outside China.

The articles on protecting property rights and developing a healthy non-public sector are in line with China’s commitment to continued free market reform. Despite the determination of the Chinese government in implementing and deepening the market reforms, government will still play a leading role in the economy. The Decision says in Chapter II:

The basic economic system with public ownership playing a dominant role and different economic sectors developing side by side is an important pillar of the socialist system with Chinese characteristics and is the foundation of the socialist market economy. We must unswervingly consolidate and develop the public economy, persist in the dominant position of public ownership, give full play to the leading role of the state-owned sector, and continuously increase its vitality, controlling force and influence. (Emphasis added by author)

Even after several decades of market reform, the government today still has control of the commanding heights of Chinese economy, usually the upstream sectors such as resource and energy sectors.[1] By analyzing the domestic value-added content of Chinese exports, Tang, Wang and Wang (2014) shows that state-owned enterprises (SOEs) are consistently more upstream than small and medium-sized enterprises. This finding suggests that SOEs indeed still play an important role in shaping China’s exports.[2]

The dominant role played by state ownership stated above seems to contradict somewhat with the decisive role of the market. Such an inconsistency just reflects the mixed feelings about the role of government in China’s economy. Over the last several decades, along with the economic boom, China has developed a mixed economy with cross holding by and mutual fusion between state-owned capital, collective capital, and non-public capital. The problems of socialist policies had been well understood, and the government has gradually loosened its grip on the economy. At the same time, we also observed many issues with privatization in Russia and Eastern European countries, such as insider trading and voucher privatization,[3] and their much less impressive economic progress. All of these, together with the 2008 world financial crisis, have spawned new critiques of privatization and free market economy, giving us an impression of the crucial role of government in the economy. They also gave rise to the so-called “China Model” or “Beijing Consensus,” with both market and government playing key roles in an intertwined way, as opposed to the neoliberal “Washington Consensus.”

On one hand, China has demonstrated the effectiveness of a gradual and determined reform that releases the vitality of the market in a controlled way to maintain fast economic growth and a stable society. China’s pragmatic use of innovation and experimentation has achieved an “equitable, peaceful high-quality growth” and “defense of national borders and interests” (Ramo, 2004).[4] This is exemplary for many developing and transitional economies. On the other hand, however, some may be suspicious of such a type of “China Model.” To a large extent, the dominance of state capital is simply a leftover of the socialist era. The true impetus to China’s economic growth over the past decades is not government control but the introduction of market mechanisms. In other words, China’s economic success should be attributed to less, not more, government controls. But the coexistence of the still relatively high share of state assets and China’s economic success tends to give people a false sense of the importance of public ownership and an underestimation of the inefficiencies of government controls.

Since the reform of the agricultural sector in 1978, Chinese government has been retreating from the commanding heights of the economy, and private sectors have been playing a larger and larger role. Because China adopted a gradual approach to reform, unlike the shock therapy in the USSR and Eastern Europe, the change in public ownership has been gradual. Promoting this kind of mixed economy may have been a good move for China; it is debatable whether it has been the optimal choice. This point is especially important when other countries consider copying China’s approach to transform their own economies.

Although the Chinese government considers the dominant role of public ownership a feature of its socialist market economy “with Chinese characteristics,” it can be better understood from classic economy theories of market failures. As we know, government controls may be able to improve market outcomes in the cases of market failures. But public ownership is rarely the best option. The appropriate role of government in economics is not as a player, but as a referee that guarantees a level playing field. There is much evidence in the literature of the inefficiency of SOEs. For example, Dollar and Wei (2007) find that even after a quarter century of reforms, state-owned firms still have significantly lower returns to capital than private firms. By their calculation, if China succeeds in allocating its capital more efficiently, it could reduce its capital stock by eight percent without sacrificing economic growth.[5]

Another serious problem associated with the state ownership in some key industries in China is “red” capitalism, a symbiosis between large businesses and high-level government officials, their delegates, or family members. This nurtures an environment for corruption and rent-seeking, discourages innovation and fair business practice, and hence is against the objective of enhancing the role of free market in the economy. Of course, this is also a political problem. Although the step-down of government from the commanding heights may not eliminate this problem, it can at least help to alleviate it. It can also help to transform the functions of the government.

I am not saying that China should privatize its state-owned sectors completely and immediately. The lesson from the shock therapy in Russia and Eastern Europe should be remembered. The importance of stability should never be underestimated, and the gradual approach adopted by China can be indeed conducive to long-term economic prosperity. My point is on the direction of change regarding the roles of market versus government in the economy. The Decision, emphasizing the decisive role of market on one hand but the dominant role of state-ownership on the other, is rather confusing. The Chinese government is obviously correct in promoting modern corporate governance for SOEs. At the same time, it is also important to point out that a stronger SOE sector does not necessarily imply a bigger SOE sector.

History can be a good guide for the future, so it is useful to review the rise and fall of the roles played by government versus market over the last 100 years. At the turn of the 20th century, the market dominated western economies. With the Great Depression and two world wars, however, the advent of state-dominated economies was seen. The state gradually extended its sphere of influence into areas originally controlled by the market. At the extreme, the Communist states planned their economies so that government would be an omniscient entity. Many industrial countries in the West and in developing countries around the world were building “mixed economies” in which the government dominated but still allowed a functioning market system. The goal of such reforms was to provide justice, opportunity, and a good life for all. Until 1970s, this “mixed economy” remained practically uncontested and government was unceasingly enlarging. However, starting from the 1970s, government started to lose ground. Led by Margaret Thatcher in the U.K. and Ronald Reagan in the U.S., western governments were casting off power and tasks as the spotlight was shifting to “government failure” rather than “market failure.” Privatization or deregulation became the goals of governments as they rushed to sell state-owned assets to the public and took hands off the operation of businesses. After the failure of Communism in 1990s, the system disappeared in Eastern Europe and what had been the Soviet Union and had been replaced by a more market-oriented economy in China. Today all over the world, government planning has decreased, regulation has decreased, and markets have grown. Markets began the 21st century again in a dominating position.[6] During the 2008 world financial crisis, however, the role of governments expanded again in many countries through ambitious rescue plans, and fiscal and monetary policies.

In sum, economic development and reform remain the major focus of this report. To achieve continued economic growth and prosperity, radical reforms are still needed. The Decision recognizes the importance of finding a good balance between government and market in the economy. A revolutionary breakthrough on this issue in the Decision is the recognition of the key role played by the market in resource allocation, but the dominant role of state-owned sectors as stated in the report may cause some confusion. The planned deeper market reform is encouraging, while its true effect remains to be seen and will rely on its successful implementation. Several current economic difficulties can well prevent the government from following the rules of market. For instance, under the backdrop of a potential significant slowdown of Chinese economy after the 2008 world financial crisis, the government had already carried out stimulus plans and may step in again to avoid the collapse of its housing market. In addition, many new concerns such as environment protection and building the social security system also require the government to play a key role. Therefore, we may continue to see ups and downs of government in China in the years to come.

Liberalizing International and Domestic Trade

The Decision shows the continued commitment of China to open economic policies by further relaxing control over investment access; by providing equal treatment to both domestic and foreign investment; by providing stable, transparent, and predictable policies; by promoting the orderly opening up of finance, education, culture, healthcare, and other service sectors; and by further liberalizing general manufacturing. Although many people claim China has given up the “crossing the river by stepping on the stones” strategy and started to embrace whole heartedly the free market and open economic policy, I would still expect to see gradual changes. The reforms in the above areas may be carried out in a faster pace than before, but will not happen immediately.

A good example is the establishment of the China (Shanghai) Pilot Free Trade Zone. It is a major step that China has taken to deepen reform and open up in the face of new circumstances. Different from the special economic zones and export processing zones established in earlier years aimed mainly at promoting manufacturing, this new type of free trade zone focuses instead on financial and business services, which China has been very reluctant to open. A competitive services sector, as a typical feature of a modern economy, is crucial to sustained growth of China. If the experiment carried out in this free trade zone is successful, we would expect to see its expansion soon to the whole country.

Trade liberalization is usually achieved through various trade agreements. Besides the multilateral liberalization approach under the GATT/WTO, free trade agreements (FTA) have been on the rise, especially after the 1990s, partially because of slow progress made under the WTO in the last two decades. China also intends to speed up the construction of FTAs with neighboring countries, covering many traditional and non-traditional trade and investment related issues. FTAs may serve as an experiment for China to carry out some deeper liberalization initiatives in the areas such as investment, property rights, and services trade. In these areas, China and many other developing countries have been reluctant to open their domestic markets for fear of the fierce competition from advanced economies. Different from the multilateral approach adopted by the WTO, however, FTAs are by their very nature discriminatory because the preferential treatments apply only to member countries within the bloc, not to countries outside the bloc. This is a major exemption to the most favored nation clause of the GATT.

One pitfall of FTAs is the potential trade diversion effect when a country switches from a highly efficient non-FTA member country to a less productive FTA partner that enjoys preferential tariffs. In addition, the complex rules of origin and overlapping FTA networks, called “spaghetti bowls” by Jagdish Bhagwati, is another undesirable feature of regionalism. As a result, China should be cautious when moving away from the multilateral approach under the WTO to the bilateral approach. China has to balance well the potential benefits and costs of forming FTAs with neighboring countries.


Opening the Hinterland


The Decision also discusses how to further open up inland and border areas. China intends to promote the development of inland industry clusters by using preferential policies and promoting cooperation among regions. China will also accelerate the construction of infrastructure connections to neighboring countries and regions to build a Silk Road Economic Belt and a Maritime Silk Road, so as to form a new pattern of all-round opening. All of these policies are conducive to the economic development of the inland region.


When it comes to trade barriers, people tend to focus on international barriers and ignore domestic ones, even though domestic trade barriers can be significant. It is encouraging to see that the Decision also emphasizes developing transportation and logistics infrastructure to form a “corridor” of foreign trade that links different regions within China. Together with the market reform policy to “combat regional protection” in Article 9 of the Decision, this policy initiative intends to address the high cost of doing businesses among different regions within China. Although this issue is touched in the Decision, the economic cost of barriers within China and the potential impact of lowering such barriers may not be fully understood. Despite China’s impressive export performance in recent years, internal trade barriers remain surprisingly high but are less well understood. For example, it was reported that,


… a kilogram of cargo shipped from Shanghai to New York costs 1.50 yuan while the same weight shipped from Shanghai to Guizhou (the capital city of an inner province that is 2,000 km away) costs between 6-8 yuan. This makes the total cost of shipping from Shanghai to Guizhou four to five times as expensive as shipping to New York, which is 11,862 km away.  Transportation costs added to storage, and distribution management costs, lead to logistics costs 18 percent of GDP, that’s more than twice as much as the U.S. … Any western fashion brand from Gap to Versace, even clothing made in China, are priced 30 percent to several times more than the same product in the U.S. [7]


Much work has been done to examine national borders as impediments to international trade, but less attention has been paid to inter-state/provincial border effects. The internal trade barriers in China are significant and the domestic market segmentation is substantial, but these have been largely concealed by the country’s impressive export performance. These barriers not only explain why many Chinese-made products are sold in China at higher prices than in the U.S., but also help to demonstrate why China’s growth relies heavily on exports rather than domestic demand (arguably a contributing factor to global trade imbalance). A reduction in intra-China trade barriers and a less segmented national market is critical to a successful transition of an export- and investment-driven economy to a domestic consumption-driven economy.




To conclude, the Decision reconfirms China’s dedication to further liberalization of international and domestic trade in not only manufacturing sectors but also services sectors. Because policy making in a globalized economy becomes more complicated, the coordination of various policies remains to be a challenging task for China. It is inevitable to see some policy inconsistencies, loopholes and even setbacks during this process. For both policy makers and researchers, it is important to evaluate these policies appropriately and provide policy remedies in a timely manner.






Further Readings:


Ramo, Joshua Cooper, 2004. “The Beijing Consensus,” The Foreign Policy Centre.


Williamson, John: What Washington Means by Policy Reform, in: Williamson, John (ed.): Latin American Readjustment: How Much has Happened, Washington: Institute for International Economics 1989.


Yergin, Daniel and Joseph Stanislaw, The Commanding Heights: The Battle for the World Economy, Published by Simon & Schuster, New York, 2002.

[1] Upstream industries refer to sectors that process raw material into an intermediary product for the final production of finished product by the downstream industries. For instance, petroleum refineries refine crude oil into intermediary chemicals which can be used to produce plastics by other firms.

[2] Tang, Heiwai, Fei Wang and Zhi Wang, “The Domestic Segment of Global Supply Chains in China under State Capitalism”, CESifo Working Paper No. 4797, May 2014.

[3] Voucher privatization is a privatization method in which citizens are given or can inexpensively buy a book of vouchers that represent potential shares in any state-owned company. See

[4] Ramo, Joshua Cooper, 2004. “The Beijing Consensus,” The Foreign Policy Centre.

[5] Dollar, David, and Shang-Jin Wei, 2007. “Das (Wasted) Kapital: Firm Ownership and Investment Efficiency in China,” NBER Working Paper No. 13103.

[6] For more detailed discussion, please refer to The Commanding Heights: The Battle for the World Economy, by Daniel Yergin and Joseph Stanislaw, Published by Simon & Schuster, New York, 2002.

[7] Li, Waiching, 2011. “Why ‘Made in China’ Costs More in China.”