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«Incomplete financial reform in China is puzzling because Premier Zhu Rongji, a seemingly promarket technocrat, was largely insulated from explicitly ...»

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Comparative Political Studies

Volume XX Number X

Month 2006 1-25

© 2006 Sage Publications

Partial Reform 10.1177/0010414006290107


Equilibrium, Chinese Style hosted at


Political Incentives and Reform

Stagnation in Chinese Financial Policies

Victor Shih

Northwestern University, Evanston, Illinois

Incomplete financial reform in China is puzzling because Premier Zhu Rongji, a seemingly promarket technocrat, was largely insulated from explicitly rent-seeking pressure and leftist ideology when he carried out a massive restructuring of Chinese banks in 1997. Yet at the end of his tenure as premier, the financial sector continued to channel the bulk of savings toward the state. Given the complexity of Zhu’s policies, we cannot begin analyzing them if we conceive reform as a neat, coherent policy shift. In this article, competing hypotheses of policy change are tested on Zhu’s financial “reform,” which is conceptualized as a bundle of discrete policies, each having different and at times contradictory impact on the economy. With this conceptualization, banking centralization, the Herculean efforts to digest nonperforming loans, and stagnation in interest rate and private banking reform can best be understood as a coherent political survival strategy.

Keywords: China; reform; economic policy; technocrats; finance; bank E ven when all the conditions are ripe, relatively insulated, technically competent, and well-informed technocrats may choose to forgo reform to increase their chance of political survival. Unlike the Eastern European version of partial reform, in which private rent seekers capture state policies and delay reform, partial reform in the Chinese context stemmed from central technocrats’ desire to maximize political capital and retain the ability to accomplish future policy and political objectives, two strategies that Author’s Note: I would like to thank my colleagues Ben Schneider, Andrew Roberts, and Laura Hein for insightful comments and suggestions. I would also like to thank Kun-chin Lin and Susan Blum of the political economy workshop at the Kellogg Institute at Notre Dame University for providing invaluable suggestions. Of course, all mistakes are my own.

2 Comparative Political Studies increase their ability to survive in the uncertain world of Chinese politics.

In this manner, fundamental financial reform is delayed, at least until a lowcost option can be devised to move reform forward.

In discussing this incomplete reform in China, this article touches on two central aspects of the reform literature. First, what constitutes a reform?

The case of Chinese financial policies shows that reform is not a single dichotomous variable but a multitude of continuous and discrete variables that can affect the efficiency of resource allocation in a number of different dimensions. This conceptualization of reform suggests that explanatory frameworks should account for the variation in the degrees of reform in discrete policy areas rather than simply explaining why reform has taken place. Furthermore, explanatory frameworks are tasked to account for the full efficiency impact of a bundle of policies and explain why plausible policy alternatives are abandoned in the course of reform. This article shows that even within financial policy alone, reform in different areas can take place at different pace, depending on the political incentives of the technocrats. Second, this article asks whether there is a single sufficient condition for reform. In addressing this issue, the heart of this article applies previous explanations of reform to the case of Chinese financial policies and finds them inadequate in predicting the policy outcomes. Instead, an explanation based on the political incentives of key actors—the senior technocrats—is developed to predict the pattern of financial policy implementation during the Zhu Rongji Administration between 1998 and 2003.

On the whole, the Chinese case reveals that the process of reform is necessarily a political one, not a simple policy exercise by insulated, beneficent social planners.

Explaining Reform

As with many concepts in political science, reform is a commonly used term with rather vague meaning. For the sake of convenience, I adopt Drazen’s (2000) general definition of reform as “policies that enhance the efficiency of resource allocation” (p. 620). At a more specific level, the Washington Consensus outlines a list of market enhancing measures, including fiscal discipline, trade liberalization, interest rate and exchange rate liberalization, stable prices, among others (Williamson, 1990, 1994).

Nonetheless, there are two issues that arise from this definition.

First, few developing countries have adopted all the policies outlined in the consensus to the full extent. If a country adopts four policies on the list, Shih / Reform Equilibrium 3 is it carrying out reform? What if a country implements six on the list?

Would we consider this country reformed but not the former one? These questions highlight the multidimensionality of reform. By labeling a set of policies as reform, we risk not explaining the variation in reform implementation among the various policies in a policy bundle. Second, nearly every policy has an impact on more than just one area in the economy, and the efficiency impact of a policy remains unclear, unless we examine how a policy affects outcomes in multiple dimensions. Although some policies, including tariff reduction and interest rate liberalization, are widely recognized to increase the efficiency of resource allocation, the efficiency impact of other policies is less distinct. Rapid state-owned enterprise privatization in post-Soviet republics, for example, led to the creation of sectoral monopolies and oligopolies, which ended up lobbying the government for rentseeking opportunities (Hellman, 1998). Although the voucher program was intended to increase the efficiency of resource allocation, it ended up introducing substantial market distortion because of the vast information asymmetry between the average voucher holder and knowledgeable insiders.

Given that reform measures impact efficiency outcomes in more than one area with time, the true effect of a reform policy may not be apparent in the short run (Stallings & Peres, 2000).

For political scientists explaining a bundle of reform policies, the above conceptualization of reform gives rise to a demanding explanatory framework. First, an explanatory framework needs to explain the implementation and the failed implementation of policies in a policy bundle, instead of treating a single policy as the determining marker of a set of policies. For example, if the privatization of a sector is accompanied by government policies supporting monopoly, it remains unclear if reform has taken place.

Second, an explanatory framework of reform policies should account for the net efficiency impact of a set of policies in multiple dimensions rather than just in one dimension. Returning to SOE privatization in Russia, although the new private owners of SOEs possessed stronger profit-maximizing incentive (Aslund, 1995), they also lobbied for preferential policies to maximize their profit, rendering the net efficiency impact of SOE privatization ambiguous.

Finally, an explanatory theory of policy change calls for an account of why a policy was adopted and why similarly plausible options were abandoned. In other words, the dependent variable when one analyzes policy change is not a dichotomous variable with status quo and new policy as the only two values. Besides these two outcomes, there is also a set of reasonable policy choices that are never adopted but could well have been. An 4 Comparative Political Studies explanatory account of policy change needs to explain why a policy shifts from the status quo to the new policy and why it does so instead of another reasonable option. Although the definition of a reasonable option remains vague, I show below that analysts can define reasonable options as policy alternatives that policy makers themselves consider seriously.

The 1998 financial restructuring in China serves as the perfect example of an inaccurately labeled reform, which in reality was a complex bundle of policies with multidimensional impact on the economy (e.g., Pei, 1998).

Although Premier Zhu enacted some changes that clearly brought the Chinese banking sector closer to international standard, other policies increased the state’s control over financial resources. Meanwhile, some of the most important reform measures, including the legalization of private banks and interest rate liberalization, were repeatedly vetoed by the premier. Without conceptualizing reform as a series of distinct variables, each with variegated impact and without examining abandoned policy proposals, it would be difficult to begin analyzing the Chinese case.

Alternative Explanations

Besides the political survival framework introduced later in this article, several alternative hypotheses provide plausible explanations of the financial policy outcomes in China. Yet a close scrutiny of these alternative hypotheses, most of which fall under the umbrella of the insulated technocracy framework, reveals that none of them can quite explain the complex pattern of Zhu’s financial policies.

The most obvious theoretical framework with which to analyze Zhu Rongji’s financial policies is the insulated technocracy framework. After all, Zhu Rongji successfully introduced significant changes to the financial system over the objection of powerful vested interests (discussed below). In the literature on technocrat-led reform, an insulated technocracy with specialized knowledge about the economy constitutes an ideal guardian of reform, because it shields the reform process from groups suffering initial losses from the reform, groups uncertain about the eventual payoffs of reform, and groups whose vested interests are harmed by reform (Przeworski, 1991;

Rodrik & Fernandez, 1991; Williamson, 1994).

Even without referring to the Chinese case specifically, however, two objections arise from insulated technocracy framework. First, it seems unrealistic to assume that the insulated technocrats, even those trained in elite U.S.

institutions, would have better ideas about efficiency-maximizing solutions Shih / Reform Equilibrium 5 in every policy area than other actors in society (Evans, 1995; Rodrik, 1996).

Moreover, it is even more unrealistic to assume that technocrats have only efficiency in mind. Without ready knowledge about the political and careerist incentives of technocrats, one can hardly a priori predict the reform outcomes of a bundle of policies.

The proponents of a technocratic solution counters that insulated technocrats, especially those trained as economists, are clearly motivated by a desire to realize more efficient allocation of resources (Harberger, 1993).

Nonetheless, studies of bureaucrats point out that their preferences arise from a complex mix of social backgrounds, career incentives, and ideology (Aberbach, Putnam, & Rockman, 1981; Schneider, 1993). Unless we assume their preference for reform in all policy areas, we would have to examine the political and private incentives facing technocrats to determine their likely policy preferences (Haggard, 2000). Indeed, several recent studies reveal that insulated technocrats are motivated by a mix of political and personal incentives when they implement policies (Grimes, 2001; Kessler, 1998; Murillo, 2002).

Indeed, if technocrats are the political incumbents, their preferences are likely to be more antireform than that of the average public. Even if we control for ideological outlooks and social background, incumbent technocrats are used to a steady stream of either economic rent or political benefits, rendering them proponents of the status quo (Krueger, 2000). In postcommunist countries, this problem is particularly acute. Technocrats often controlled the flow of vast resources under the planned economy. Thus, they are willing to change the economic system only to the extent that the new equilibrium produces just as much, if not more, benefits for them than the status quo. As the case of post-Soviet reform shows, winners in the partially reformed economic system tended to be insiders from the old regime who gained access to valuable resources at nonmarket prices (Hellman, 1998). Given the questionable assumptions about technocrats made by proponents of the insulated technocrat framework, we would do well to broaden our analytical framework beyond technocrats’ education background and the level of insulation to include a wide range of political and careerist incentives facing technocrats.

The pattern of financial policy in China is undeniably affected by ideas about how a financial system should be organized (Steinfeld, 2004). Indeed, the case studies presented below highlight the intense debates between policy makers who supported policies informed both by neoliberal and statist thinking. Although ideational explanations allow us to derive a set of feasible options considered by policy makers, they often cannot specify which 6 Comparative Political Studies policy option is ultimately adopted. This especially applies to policy options that were informed by similar ideas but had vastly different distributive consequences. For example, the policy options for digesting nonperforming loans (NPLs) all called for using the market to auction off NPLs, but they had vastly different implications for government budget deficits. In this work, I recognize the role of ideas in determining a set of feasible policy choices, whereas the political survival framework provides more specific predictions about which policies within this feasible set were ultimately adopted.

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