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Federalism, Chinese Style: The Political Basis for Economic Success in China

  • Gabriella Montinola (a1), Yingyi Qian (a2) and Barry R. Weingast (a2)

China's remarkable economic success rests on a foundation of political reform providing a considerable degree of credible commitment to markets. This reform reflects a special type of institutionalized decentralization that the authors call “federalism, Chinese style.” This form of decentralization has three consequences. First, it fosters competition, not only in product markets, but also among local governments for labor and foreign capital. This competition, in turn, encourages local government experimentation and learning with new forms of enterprises, regulation, and economic relationships. Second, it provides incentives for local governments to promote local economic prosperity. Finally, it provides a significant amount of protection to local governments and their enterprises from political intrusion by the central government.

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1 See McKinnon, Ronald I., “Financial Control in the Transition from Classical Socialism to a Market Economy,” Journal of Economic Perspectives 5, (1991); North, Douglass C., Structure and Change Economic History (New York: Cambridge University Press, 1981); idem, Institutions, Institutional Change, and Economic Performance (New York: Cambridge University Press, 1990); Hilton Root, Environment for Investment: Institutional Reform for a Market Economy,” Country Report, no. 11 (Iris Center, University of Maryland, 1993); Weingast, Barry R., “The Economic Role of Political In-ttitutions: Market-Preserving Federalism and Economic Growth,” Journal of Law, Economics, and Organization 11 (Spring 1995).

2 Hartford, Katherine, “Socialist Agriculture Is Dead; Long Live Socialist Agriculture! Organizational Transformation in China,” in Perry, E. and Wong, C., eds., The Political Economy of Reform in Post-Mao China (Cambridge: Council on East Asian Studies/Harvard University, 1985); Saich, T., “Much Ado about Nothing: Party Reform in the 1980s,” in White, Gordon, ed., The Chinese State in the Era of Economic Reform (London: Macmillan Professional and Academic, 1991).

3 Shirk, Susan L., The Political Logic of Economic Reform in China (Berkeley and Los Angeles: University of California Press, 1993).

4 Federalism in the West is nearly always associated with political freedom and the protection ofin-dividual rights. See Weingast (fn. 1) for details of these federalisms, including a discussion of how federalism provided the important political foundations for the impressive growth of England in the eighteenth century and the United States in the nineteenth century.

5 Weingast (fn. 1); see also McKinnon, Ronald I., “Market-Preserving Fiscal Federalism” (Working paper, Department of Economics, Stanford University, 1994),

6 North (fn. 1); Weingast (fn. 1).

7 Kornai, Janos, Economics of Shortage (Amsterdam: North-Holland, 1980).

8 Although the most pervasive forms of the soft budget constraint are observed in the centrally o planned economy where the government controls nearly everything, the problem occurs in all modern economies. Indeed, the exploding savings-and-loan problem in the United States resulted from aversion of this problem. So, too, is the rampant inflation typical of many Latin American regimes.

9 McKinnon (fn. 5).

10 Weingast (fn. 1).

11 McKinnon (fn. 5); Weingast (fn. 1).

12 See Williamson, Oliver, “The Institutions and Governance of Economic Development and Re-form” (Working paper, University of California, Berkeley, 1994).

13 In contrast, eighteenth-century England was characterized by market-preserving federalism, al-though the English did not call their system federal. See Weingast (fn. 1).

14 This section summarizes an extensive literature in economics, including the classic work of Tiebout and Oates. For a review of this literature see Rubinfeld, Daniel, “Economics of the Local Public Sector,” in Auerbach, A. J. and Feldstein, M., eds., Handbook of Public Economics, vol. 2, (New York: Elsevier, 1987).

15 McKinnon (fn. 5).

16 Weingast(fn. 1).

17 See, for example, Krugman, Paul, Geography and Trade (Cambridge: MIT Press, 1991).

18 For example, the common market in the United States in the early nineteenth century could not have been sustained without vigilant policing by the Supreme Court. Policing the market against encroachments by state governments proved a major use of the Court's constitutional powers. These cases reveal the remarkable diversity and cleverness of the states in their efforts to erect such barriers. See Barry R. Weingast, “The Political Foundations of the Antebellum American Economy (Working paper, Hoover Institution, Stanford University, 1993). Similarly, such barriers are a major reason underlying the movement for economic and political union in Europe. See Garrett, G., “The International Cooperation and Institutional Choice: The European Community's Internal Market,” International Organization 46 (Spring 1992).

19 See Qian, Yingyi and Xu, Chenggang, “Why China's Economic Reforms Differ: The M-form Hierarchy and Entry/Expansion of the Non-State Sector,” Economics of Transition (June 1993). Qian and Xu provide a detailed analysis of how and why this happened in China, offering an institutional explanation of differences between economic reforms in China and in Eastern Europe and the Soviet Union.

20 Wong, Christine, “Between Plan and Market: The Role of the Local Sector in Post-Mao China,” Journal of Comparative Economics (September 1987).

21 Qian and Xu (fn. 19).

22 See China Statistical Yearbook (various years).

23 Hainan was added as the largest special economic zone when it was organized as a separate i province in 1988.

24 See, for example, Oi, Jean, “Fiscal Reform and the Economic Foundations of Local State Corporatism in China,” World Politics 45 (October 1992); Oksenberg, Michael and Tong, James, “The Evolu rtion of Central-Provincial Fiscal Relations in China, 1971-1984: The Formal System,” China Quarterly (March 1991); and, Wong, Christine, “Fiscal Reform and Local Industrialization,” Modern china 18 (April 1992).

25 The five cities are below the provincial level but have independent budget agreements with the tenter. The list is based on: Roy Bahl and Christine Wallich, “Intergovernmental Fiscal Relations in China” (Working papers, Country Economics Department, World Bank, WPS 863 1992); Christine Wong, “Central-Local Relations in an Era of Fiscal Decline: The Paradox of Fiscal Decentralization in Post-Mao China,” China Quarterly 128 (December 1991); idem (fn. 20).

26 For discussion of the Russian case, see Litwack, John, “Discretionary Behavior and Soviet Economic Reform,” Soviet Studies (March 1991); and idem, “Legality and Market Reform in Soviet-Type Economies,” Journal of Economic Perspectives 5, no. 4 (1991).

27 See Wong (fn. 24). In a recent comprehensive study of China's internal market, the World Bank concluded that “despite considerable progress in the substitution of allocation by the price mechanism, markets for both goods and factors of production (capital, labor and foreign exchange) are still region ally fragmented.... Links with the overseas exterior appear to have been easier to develop than links with other provinces, both in terms of the mobility of goods and some factors, particularly capital in-vestment. There has been some tendency for individual provinces to behave as separate countries, Other than as parts of a single large country. China: Internal Market Development and Regulation (Washington, D.C.: World Bank, Country Operation Division, China and Mongolia Department, 1993).

28 Peoples Daily, October 11,1993, overseas edition, p. 2.

29 For example, it is reported that one provincial government instructed its automobile registration department to refuse to issue license plates to unauthorized automobiles produced outside the province.

30 Wang, C., “Hog Production Problems in Jiangxi Province,” Economic Study (May 1988).

31 Though the details differ, this pattern was repeated in 1986 and 1987.

32 This conclusion is standard in the fiscal federalism literature. See, forexample, Oates, Wallace, Fiscal Federalism (New York: Harcourt Brace Jovanovich, 1972).

33 A burgeoning literature studies this topic. See, for example, Byrd, William and Lin, Qingsong, eds., China's Rural Industry: Structure, Development and Reform (Oxford: Oxford University Press, 1990); Nee, Victor and Sijin, Su, “Institutional Change and Economic Growth in China: The View from the Villages,” Journal of Asian Studies 49 (1990); Oi (fn. 24); Qian and Xu (fn. 19); Weitz-man, Martin and Xu, Chenggang, “Chinese Township-Village Enterprises as Vaguely Defined Cooperatives,” Journal of Comparative Economics (April 1994); Chang, Chun and Wang, Yijiang, “The Nature of the Township Enterprise,” Journal of Comparative Economics (December 1994); Andrew Walder, “The Varieties of Public Enterprises in China: A n Institutional Analysis” (Manuscript, Harvard University, 1994); Jiahua Che and Yingyi Qian, “Boundaries of the Firm and Governance: Understanding China's Township-Village Enterprise” (Manuscript, Stanford University, 1994).

34 People's Daily, March 23,1990, overseas edition.

35 Almanac of China's Finance and Banking. Beijing: China's Financial Publishing House, 1992.

36 This topic is further explored in Qian, Yingyi and Weingast, Barry R., “Institutions, State Activism, and the Role of Government in Economic Development” in Aoki, Masahiko, Okuno-Fujiwara, Masahiro, and Kim, Hyung-Ki, eds., The Role of Government in East Asian Economies: Comparative Institutional Analysis (New York: Oxford University Press, forthcoming).

37 Shirk (fn. 3).

38 Paralleling these problems is the substantially diminished reach of the central planning system. Put simply, the central government no longer has the administrative apparatus to monitor and plan the economy as necessary under the older system.

39 Shirk (fn. 3).

40 It should be noted that reforms in many southern regions went ahead despite actions from the central government during the period from 1989 to 1991.

41 Additional evidence is provided by Steve Lewis, “Marketization and Government Credibility in Shanghai: Federalist and Corporatist Perspectives” (Manuscript, Washington University, 1994).

42 “Heilongjiang Province Implements Project 383 to Control Prices,” Price Theory and Practice (July 1990).

43 Economic Daily, November 25,1991.

44 Stories of this type can be replicated manyfold. As an additional example, we note the comparison of Nanyang and Xiangfan, two cities in Henan and Hubei provinces, respectively. The latter made much faster progress, and when this was reported in the Economic Daily in 1984, the former designed a new set of developmental programs to learn from and imitate the advanced regions. Five years later, Nanyangwas ranked as one of the best among middle and small size cities within the nation (Economic Daily, December 6, 1991).

45 Economic Daily, May 15,1991, and July 4, 1992; Outlook, February 22, 1993.

46 See, for example, Dorothy Solinger, “The Floating Population as a Form of Civil Society” (Paper presented at the forty-third annual meeting of the Association for Asian Studies, New Orleans, La., April 11-14, 1991).

47 Undoubtedly there are other factors underlying these policies, for example, keeping the benefits of local services (such as education) for local residents. Moreover, under other circumstances, these mechanisms could be used to cartelize labor markets, or for other political purposes.

48 Solinger (fn. 46).

49 Financial Times (China), March 9, 1993; Peoples Daily, January 2, 1993.

50 Peoples Daily, January 30, 1993; South Weekend, March 5, 1993; Guangming DailyJune 29, 1993

51 Among the new development zones, only ninety-five are approved by the various departments of the central government. Most development zones were established by different local authorities, from provincial governments down to township governments.

52 Financial Times (China), April 1, 1992.

53 Economic Information Daily, May 3, 1992.

54 Shirk's more extensive discussions allow her to treat a much wider range of topics central to the success of reforms for example, the importance of gradualism, the initial role of agrarian reform, and the political mechanisms underpinning reform within the central government. See Shirk (fn. 3); and idem, How China Opened Its Door (Washington, D.C.: Brookings Institution, 1994). Our analysis also has much in common with Oi's recent work. See Oi (fn. 24); and idem, Rural China Takes Off: Incentives for Industrialization (Berkeley: University of California Press, forthcoming).

* The authors gratefully acknowledge the helpful conversations of Masahiko Aoki, Nina Halpern, Anne Krueger, John Litwack, Ronald McKinnon, Paul Milgrom, Ramon Myers, Douglass North.Jean Oi, Gerard Roland, Susan Shirk, and Dorothy Solinger; and the research assistance of Jiahua Che. This paper was prepared under a cooperative agreement between the Institute for Policy Reform (iPR) and the Agency for International Development (AID), Cooperative Agreement No. PDC-0095-A-00- 1126-00. Qian's research was also supported by the Research Incentive Fund from the Office of Technology Licensing (OTL) at Stanford University. Views expressed in this paper are those of the authors and not necessarily those of IPR, AID, or Stanford.

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