Finishing China’s Economic Reform: Challenges and Pitfalls

We argue that China’s journey towards a market economy is far from being finished. Instead, in many areas, reforms have been delayed and economic problems accumulated. There are six major reforms that have to be accomplished in the near future in order for the economy to stay on the trajectory of growth. Meanwhile, the current reformers face more and bigger challenges than their predecessors, including ever more vocal losers of reform and increasing difficulties to arrange credible ways to compensate them. Facing these challenges, the reformers are prone to falling in two major pitfalls of reform. That is, overwhelmed by short-run issues, they may lose sight of the importance of pushing for fundamental reforms. Also, yielding to the pressure of interest groups, they may choose to implement anti-market and inefficient institutions in the name of “convergence to international practice.” There is a fundamental disparity in the recent history of the Chinese economy. On the one hand, the performance of the economy, as measured by the growth rate of output and increases of living standard, has been impressive. In fact, it is miraculous in comparison with other formerly socialist economies undergoing reforms. Meanwhile, China’s progress towards building a market economic system has been rather limited when compared with those better-reformed Eastern European countries, such as Poland, the Czech Republic, and Hungary. For instance, twenty years after reform in China, the market for corporate control is still largely missing, as most large enterprises are still tightly controlled by the state. The credit market as normally defined is non-existent with the largest creditors being non-market-oriented state banks. The housing market is very limited, with most land and apartments being owned by the government and not being easily traded. Related to this, the labor market in the urban area is at best emerging. There is no properly functioning wholesale market for grain and fertilizers, as the state monopolizes the distribution of these goods. Land for agricultural production is still controlled by collectives and not freely tradable. In a word, the Chinese economy is still half-way between a socialist economy and a market economy. The fundamental disparity raises three important questions. First: Why and how did China achieve its enviable economic performance before complete market institutions are in place. Indeed, a large literature has emerged trying to address this question. This article is not intended to make a contribution to this line of inquiry. Second: Is China showcasing a new type of economic system that is different from both socialism and market economy but is superior to both in stimulating economic performance? Unseemly as the question is, there are people who have been arguing 1 For a survey, see Qian (forthcoming). Also, see Bai, Li, Qian, Wang (1998 and 1999) for an example of research motivated by the first question. for this case. We do not share this view. As will be illustrated below, we believe that major economic problems have been accumulating in the Chinese economy. Without finishing the reforms towards a market economic system, sustained growth is impossible for the Chinese economy. In this article, we are concerned with the third question. That is, what are the remaining reforms China must accomplish in order to complete its journey towards a market economic system? We shall identify those reforms that China needs to accomplish urgently. In addition, we will identity the challenges facing China’s reformer and the pitfalls that China’s reformers must pay particular attentions to lest the reform stalls or goes astray. 1. Unfinished Reforms in China There are six critical economic reforms China must accomplish in order to complete it journey towards a market economic system. In fact, it is imperative for China to accomplish these reforms quickly in order for the economy to stay on a growing path. The past two decades of reforms have avoided tackling the hard-core issues of the six reforms. This is due to the necessity of the sequencing of the reform, which is mainly driven by political economy considerations. As a result, fundamental problems have accumulated that threaten continued growth of the economy. 1.1. Transforming the State-Owned Enterprises (SOEs) 2 See, for example, Cui (1994) and Cui (1998). SOEs have been a major problem in the Chinese economy for the past decade. The symptoms are prominent and painful. With the gradual entry of nonstate enterprises, such as private or collective enterprises and foreign enterprises, most SOEs have been out-competed in the market place. Many consequences follow: Sales are slow; Inventories accumulate; Production capacities idle; Workers are underemployed, furloughed, or laid-off; Debt payments, tax payment, and payment of trade-credits are delayed or delinquent. In today’s Chinese economy, other than a few high-profile and highly publicized cases, most SOEs in industries that allow entry of non-state enterprises are having serious problems. In addition to these performance-related problems, asset stripping, which is an extreme consequence of unchecked insider control, is another major problem of Chinese SOEs. Not only does asset stripping aggravate the financial performance of SOEs, it also brews a potential financial crisis in the economy by rendering many SOEs worthless and default on their debts to banks. Moreover, asset stripping is widely regarded as a extreme form of corruption of government officials and has created enormous complaints against reforms in general. It is not surprising to see these problems of SOEs mushrooming by the late 1990’s, since until very recently, reforms on SOEs had been rather limited and superficial. The theme of the SOE reforms of the 1980’s was granting autonomy and incentives to SOE managers and employee. The center-piece of the SOE reform was the so-called Contract Responsibility System, i.e., letting SOE managers (and employees) sign performance contract with their supervising government 3 In an highly popular book in China complaining about problems of China’s reforms, The Pitfalls of Modernization, He (1998) launches her case against the on-going reforms almost entirely from the observations of asset stripping of SOEs. She claims that between 1982 to 1992, 25% of state assets were lost in various ways due to asset stripping. (He, 1988, page 106) agencies. Although these reforms had some positive initial impact on SOE efficiency, by the early 1990’s problems began to emerge. In retrospect, the cause was very clear. Unlike those performance contracts in a market economy, which are backed by a legal system evolving rights of property owners, the contracts between SOEs managers and their government supervisors were nothing but glorified bureaucratic agreements. Such agreements are subject to frequent renegotiations prompted by either side. As a matter of fact, by the early 1990’s, most SOE managers had lost interests in such contracts. The contract-based reform came to a stop. It is high time to deal with the problems of the SOEs. Their poor financial performance is crippling the banking sector and brewing a potential financial crisis. Their unemployment problem is destabilizing the society. Their poor corporate governance allowing for asset stripping is generating a massive social discontent and public opinions against reform in general. The top leadership in China are obviously well aware of the seriousness of the SOE problem. However, it is not clear that they have embarked on the right track and have mustered the commitment to fundamentally transforming the SOEs. Judging from their public speeches and proclaimed policies, the government’s objective seems to be very narrow-minded and short-termist. Their main goals, it seems, are to help SOEs turn profitable and to minimize the impact of unemployment from SOEs. To these ends, various policies amounting to 4 Groves, et al (1994) documents some of the improvement in SOE efficiency due to granting managers autonomy and incentives. Jefferson and Rawski (1994) seem to be more optimistic with China’s SOE reform based on their estimations of productivity growth in the 1980’s. 5 See Wu (1995) for a careful analysis for the failure of the Contract Responsibility System. Dong and Tang (1992, Chapter 12) document the reluctance of SOE managers to continue the Contract Responsibility System reform in the early 1990’s. subsidizing SOEs have been designed and implemented, such as privileged loans, reducing debt burden of SOEs, and even anti-competition policies (e.g., prohibiting “excessive” price competition). An extremely worrisome outcome is that in the short-run, these policies may become effective and many SOEs may turn profitable so that the senior leaders may proclaim their SOE reform successful. However, since the fundamental defects of SOE persist, performance of SOEs will deteriorate soon after. The so-called SOE problem is not really resolved. What is needed is a massive and fundamental transformation of the Chinese SOEs. Strictly speaking, the SOEs, so long as they are SOEs, are not reformable. An SOE, by definition, represents a control right structure where the government (i.e., bureaucratic agencies) functions as active and large control rights and cashflow rights holders. Once in such a position, no government or bureaucratic agencies can resist the temptation of direct intervention in their SOEs in order to advance their own non-economic objectives. For example, there are few cases in which the government can resist the temptation of bailing out financial distressed SOEs. According to this analysis, the task of the transformation of SOEs is twofold in its core. First, there should be a smooth retreat of the government from the SOEs. The government must be transformed from an active and large shareholder of the SOE to a passive and (necessarily) small shareholder of the newly transformed enterprise. Such a process must be smooth so that the government as well as the 6 In September 1999, an annual plenary meeting of the central committee of the Communist Party was in session. It was reported that a major debate erupted during the meeting. One side argued for drastic measures of selling most SOEs. The other side insisted on mild measures aiming at helping SOEs overcome the current difficulties. See South China Morning Post September 20, 1999. The final report of the meeting was a product of compromise between the two sides, calling for "retreat" (i.e., privatization) of SOEs in certain sectors and the "strengthening" SOEs in other sectors including Hi-Tech industries. state banks can avoid losing an enormous amount of financial assets in the SOEs and that those insiders of SOE are prevented from usurping enormous real control rights. Second, new institutions of corporate governance need to be established, so that those non-government outside investors are able to monitor and discipline the insiders effectively. The Russian experience of mass privatization offers negative lessons in this regard. 1.2. Reforming the Financial Sector The financial sector is perhaps the least reformed sector of the Chinese economy. It is overwhelmingly dominated by a few large state-owned commercial banks and the sector has been essentially closed to foreign investment and foreign competition. While the stock markets are very small and corporate bond market is negligible, by far, bank deposits are the most important means for households to accumulate financial assets. The key feature of Chinese financial sector can be properly summarized as a mild financial repression. That is, through state monopoly of the financial (mostly the banking) sector and control of international capital flow, the government maintains a below-market rate of return for holders of financial assets. This enables the government to collect implicit taxes on households holding of financial assets. It is a mild financial repression, because for most periods during the past two decades, real interest rates on bank deposits were positive. Thus, households are mostly interested in accumulating financial assets in the forms of bank deposits. This way, the trend of financial deepening, a key feature of economic development, has not be hampered in China. The implicit taxes that the government collects from the financial sector are often referred as quasi-fiscal revenue. It comes from three sources: the increase in the stock of cash issued, the wedge between market interest rate and deposit rate, and non-interest bearing reserves of the state banks with the central bank. So far, it has been a purposeful and arguably very wise decision for the Chinese government to maintain a mild financial repression by delaying drastic reforms of the financial sector. This is purposeful, since, from early on, the Chinese policy makers understand very well the importance of financial deepening as an instrument to fight inflation. The political cost of inflation is very clear to the policy makers. Thus, a mild, rather than severe financial repression avoids inflation. Specifically, the key instrument for them to fight inflation is to attract household savings and therefore to manage aggregate demand by offering positive real interest rates on bank deposits. At the same time, the huge amount of quasi-fiscal revenue, which is as high as explicit tax, helped the central government to make up its badly needed tax revenue. Understanding this mechanism very well, the Chinese policy makers have been very leery of any tendencies of diverting household savings into places other than the state banks. Thus, financial reforms have been very slow. Despite these defendable economic rationales, the Chinese financial sector has to be reformed in order for the economy to continue enjoying its high growth path. There are two major reasons for this. The first is efficiency. As a result of the state monopoly of the financial sector, the sector has been very inefficient in channeling savings into productive outlets. In fact, the central government has been diverting a significant amount of the accumulated household deposits into non7 It should be noted that the rapid increase of money supply in China, as reflected in the dramatic increase in M2 to GDP ratio from around 50% to over 110% from the early 1980's to the late 1990's, has mostly driven by rapid monetization of economic activities, mostly in rural areas. 8 Bai, Li, Qian, and Wang (1999) did calculations of the size of the quasi-fiscal revenue over the years of reform. They found that has been as high as that of explicit taxes. productive and profit-losing projects, mostly in state-owned enterprises. The large state-owned banks are accustomed to directing loans to established state-owned enterprises. They are inexperienced and often times, simply reluctant to lend to start-up enterprises led by entrepreneurs. This is very costly to the whole economy, since the start-ups have proved to be the driving force of economic growth in emerging market economies. To a great extent, the current difficulties with which the Chinese government tries to spur economic growth are due to the lack of effective channels to extend credit to small and private enterprises. The second reason for the urgency of reforming the state sector is that without reform, the current situation may not be sustainable. Due to the inefficiency of the financial sector, non-performing debt as a proportion of the banks’ total loan has been increasing. As of now, it is roughly 30 percent of total loans outstanding, equivalent to 27 percent of total GDP. The level of nonperforming debt is manageable today, since these are essentially national debt owed by the state to household depositors. In fact, a simple calculation reveals that the ratio of required interest payment on national debt to government revenue is similar to that of the U.S. in the mid 1990's. Moreover, since the Chinese government still holds the majority shares of listed state enterprises in the stock market, it should be able to mobilize enough financial resources to service national debt of the current level. However, without reform, the debt level may easily increase very rapidly. To finance it, high interest rates will have to prevail, costing future economic growth. The reform of the Chinese financial sector will prove to be very tricky. It has to be an act balancing two potentially conflicting objectives. On the one hand, it has to find ways to help the existing state banks to recoup from the bad-debt problem. Direct injection of capital may not be a feasible solution, since this involves increasing the central government budget deficit. A more plausible solution is to require the state banks to continue attracting household deposits so as to dilute the proportion of bad loans and to increase provisions for non-performing debts. 9 But this may conflict with the second reform objective. That is, to introduce new financial institutions and new financial products, which takes away household savings from existing banks. There are no obvious solutions and it seems that the reform of the financial sector will be a long and gradual process. 1.3. Liberalizing International Trade and Investment Although international trade and investment is an area in which China’s reform has been very successful by many standards, much reform is still needed in order for China to be a fully open market economy. There are two critical issues that the reform has to deal with properly. The first is non-tariff barrier to trade. There are many implicit restrictions to imports that are not reflected in tariff, which is scheduled to come down significantly from around 50% to around 25%. The most significant non-tariff barrier consists of many restrictions obstructing foreign manufacturers from setting up direct sales channels in China, therefore giving domestic manufactures an artificial advantage. This not only reduces consumer welfare but also will prove to be counter-productive to improve the long-term efficiency of domestic producers. 9 On jointly resolving the non-performing debt problem and pushing for SOE reform, see Li and Li (1996) for a proposal of debt-equity conversion that aims to restructure both the control rights and financial structure of the SOEs at the same time. 10 For a proposal of gradually introducing non-state banks without aggravating the financial woe of the existing state banks, see Li, Li, and Wang (1997). 11 See Song (1999). The second task of reform, which is more difficult and more critical than the first one is how to phase out those pervasive entry barrier to Foreign Direct Investment (FDI). FDI, defined as the cross-border investment for direct corporate control, is the most effective form of international capital flow that brings in technology transfer, generates knowledge spillover, trains professional employees, and promotes market oriented reforms. Despite being the second most popular destination of FDI in the worlds, China still has a lot of potential to attract much more FDI. Currently, many sectors are almost completely closed to FDI, including financial services, retail, telecommunications. Not surprisingly, these are exactly the sectors that domestic producers are extremely inefficient by the world standard. Introducing strong international competitors in these areas implies the greatest potential to improve consumer welfare, to enhance economic efficiency, and to spur economic growth. For example, allowing foreign entry to the telecommunication sector surely will dramatically improve the quality and lower the cost of services. Very likely, this will generate enormously positive externalities to the internet service industry, high-technology industries, and financial services. Needless to say, the immediate impact of opening these sectors to international competition is traumatic on existing domestic firms. Very quickly, all other benefits to the whole economy will overwhelm the costs, including higher employment, higher efficiency, stimulating growth, and higher wage rates. The recent agreement between the Chinese and U.S. government on China's accession to the WTO is an i mportant step towards China's trade liberalization. The comprehensive and bold agreement covers all areas discussed above. It is no doubt that is an important step forward in China's trade liberalization. However, equally sure is that the implementation of such a bold trade agreement, assuming that China accession to the WTO is successful, will be full of tricky and controversial issues. These issues reflect the difficulties of trade liberalization discussed above. We remain cautiously optimistic in this regard. 1.4. Labor Market Reforms China’s labor market reform has to deal with three problems at the same time. The first one is how to make peace with the current cohort of employees of the SOEs that were hired before and during the early days of reform, i.e., the early 1980’s. These are the employees that were hired with a promise of life-time tenure together with various employment benefits, such as free housing and zero-cost medical care and pension. In exchange, their monetary wage is lower than their marginal product. Obviously, these promises are inconsistent with the basic premise of a functioning labor market. With reform, this generation of SOE employees are potentially the biggest losers. But, because these employees are politically vocal and relatively well-organized --the organization of the workers’ union was still intact when they were hired, a successful labor market reform should find ways to compensate at least partially the welfare loss of these employees. Thus, the labor market reform is likely to be financially costly to the government. The second problem comes from establishing those supporting institutions and related markets that are essential to the proper functioning of the labor market. Top on the list is the housing market. Without a functioning housing market, labor cannot move from locations of lower labor productivity to higher labor productivity. The challenge of creating the housing market is how to release the huge housing stock that has not been tradable in the market place. More specifically, once the stock is tradable, who will get the windfall, which is the capitalized future housing benefits to those who have already obtained the cheap/free housing allocation? To avoid massive discontent, SOEs and government agencies must credibly commit to using the revenue from the housing sales to compensate those who were promised but have not been allocated apartments or houses. In addition to establishing full-fledged housing markets, the other goal of labor market reforms is to establish those market-oriented social security programs providing medical insurance and pension. To the credit of China’s reformers, certain reforms have been implemented towards this goal. However, currently, medical insurance and pension plans are managed by individual municipalities, rather than provinces or nation-wide agencies. In addition, only SOE employees are covered in these programs. Employees of collective and private enterprises are not covered. It is difficult for a mid-career employee to migrate to different cities or provinces for new job opportunities. It also creates a artificial stickiness of SOE employees to SOE jobs, those better pay non-SOE jobs do not have comparable non-wage-benefits. This is apparently hampering the emergence of a nation-wide labor market, especially for the skilled labor. The next step of reform has to resolve these obstacles. The third problem that China’s labor market reforms have to deal with is the huge amount of migrating labor from rural to urban areas. The magnitude and potential gain in economic efficiency associated with such a labor movement is unparalleled in modern human economic history. But, the flooding of an enormous amount of migrating labor into the urban area is potentially very disruptive. This threatens to lower the life quality of city residents and the productivity of those urban sectors relying on high-skilled labor. Because growth of these sectors is highly complementary to that of sectors employing low-skilled labor, unrestricted and unregulated labor migration into the urban sector is extremely damaging. Therefore, China’s labor market reforms have to strike a balance between regulating an orderly flow of migrating labor and helping the rural labor find employment opportunities in urban areas. 1.5. Agricultural Reforms China’s economic reform started in the agricultural sector, but twenty years later, major problems still remain in the sector and further reforms are needed. A fundamental problem is that Chinese policy makers have attached too much importance to grain production so that much control has remained in the grain market and other related markets. As a result, the wholesale markets for grain and major production inputs (such as fertilizers) are missing. The state still functions as monopolist and monopsony in these markets. The proclaimed rationales for government monopoly/monopsony are provision of insurance to the farmers and maintaining self-sufficiency of grain production. Both objectives, although questionable, could be achieved via indirect intervention in a fully functioning market. The current system not only generates a wasteful over-supply of grain products but also has created an enormous inefficiency that in the end is born by the farmers. For example, the local branches of the state grain procurement agency offer very poor services and often delay cash payment to farmers. Thus, a key step of further agricultural reform involves liberalization of the markets of agricultural products and inputs. 12 See Li (forthcoming) for discussions of major problems of China’s social security reform. Very interestingly, establishing private land ownership should not be an outright objective of further agricultural reform. Currently, land (except for private plots for households’ self-consumption) is still owned by the collectives. Farmers only own the use right of land up to a long duration. Surveys of farmers reveal that the status quo is preferred by a wide margin to private ownership of land. This is not surprising, as the system of private land ownership only functions well in a market environment. Studies of post-Soviet agriculture show the same tendency. Therefore, the objective of the reform should be aimed at liberalizing markets relevant to agricultural production. Meanwhile, the reform should create a freechoice environment for the farm household to voluntarily opt for private land ownership in the due course. 1.6. Reforming Governments Contrary to conventional belief, China implemented a swift and effective reform of its bureaucracy well before those economic reforms in the urban sector started (Li, 1998). The reform, initiated by Deng Xiaoping soon after the Cultural Revolution, induced retirement of old revolution veterans (by offering relatively lucrative compensations), imposed strict age and education requirements for each level of government positions, and effectively abolished life-time tenure of officials in any government position. It is these reforms that laid a solid foundation for the success of subsequent economic reforms. 13 Li (1998) argues that political reform should be broadly defined as including reforms of the bureaucracy. According to this view, it is a wrong perception that China’s political reform lagged behind its economic reforms. However, very serious problems remain with Chinese governments. It is hard to exaggerate the importance of drastic reforms to structure the government in order for the economy to continue performing well. First, government agencies are still overly expansive and intrusive. The scope of control of government agencies has to be reduced. Moreover, different agencies within a government (e.g., a provincial government) overlap with each other in their scope of control, causing enormous frictions and confusion. For example, typically any decree of significance from a government is co-sponsored and signed by three or more agencies. With so many agencies co-responsible for a policy, its implementation and enforcement is destined to be difficult. The second problem is that the size of employment of most government agencies is excessive to the extent that the marginal product of labor is most likely to be negative. Layoff of government employees is a must. Related to this, the third problem is that the average salary of government employees is low. It is very low in comparison with the average pay of similarly educated and experienced business professionals. Coupled with the fact that many government officials still enjoy excessive control over many economic activities, this creates an ideal environment for the epidemic of corruption. Greatly increasing the average salary of government officials after reducing the number of officials and imposing a moderate amount of monitoring should go a long way to reduce the prevalence of corruption. 2. Challenges Facing the New Reformers 14 To the credit of the incumbent reformist policy makers, an extensive reform was carried out in 1998 to streamline the central government agencies. The total number of ministries was reduced from 50 to 29. A significant percentage of central government employees were also furloughed and eventually will be laid off. The current problem is how to implement similar and more effective reforms with local governments. The remaining reforms in China are more challenging than the ones of two decades ago, since they have to be implemented in a changed political economy set up. Moreover, the economy is more efficient than it was when the reform just started so that efficiency gains through reform are more difficult to realize. Thus, the new reforms will have a harder time to compensate the potential losers than before. A case in point is the SOE reform. In the early 1980’s, profit incentives were very poor in SOEs and inefficiencies are easy to identify. Reforms of that time injected incentives to SOEs by giving profit shares to employees. Both the employees and the government benefited from the increase of work efforts. Very differently, current SOE reforms require that many of the SOEs be transformed into non-state enterprises or simply liquidated, generating a large number of laid off workers. Theoretically, the profit loss that is saved through such transactions could be used to compensate those unemployed workers. In reality, claimants of such savings have already existed, e.g., banks needing to capitalize for the loss of nonperforming debts. Therefore, it is difficult to arrange credible mechanisms through which the laid off workers be completely compensated. Making it even more challenging for the reformers is that the losers of the new reforms are more vocal than their predecessors. The main reason is the much liberalized press and mass media. Not only are the volume and traffic of the mass media in today’s China enormously bigger than before, the government simply cannot control the wide spectrum of opinions on most non-political issues. Against this background, virtually every social group in the economy has its representatives and voices in the market of ideology. The potential and perceived losers of a reform are particularly active and often win sympathies from the general population. At the same time, the central government is in a much-weakened position than ever in implementing reforms. Ironically, like the liberalization of the press and mass media, this is an outcome of desirable political reform. The administrative branch of the state, where many initiatives of reform origin, is increasingly monitored and interfered by the National People’s Congress (NPC). While the NPC is much more susceptible to the mass media and popular opinion, this makes the job of determined reformers in the government much more difficult than before. More over, there are a few recent cases in which ministries of the central government, representing interest of existing large SOEs, openly fight against central government reform policies. This is obviously unprecedented. Finally, in many cases, the increased international exposure of the Chinese economy make it more challenging for the reform. When the economy is open, part of the benefit of reform goes to outsiders. It is much more difficult to collect taxes on the outsiders so as to compensate the losers of the reform. For example, compare the reform of allowing FDI into an industry with that of allowing only entry of new domestic firms to compete with SOEs in the industry. In the first case, international practice must be honored with respect to the FDI firm for the sake maintaining China’s international credibility. Therefore, there are limits to taxes on the FDI firm. In the latter case, there are much more ways to squeeze the profit of the new domestic entrant to compensate the loss of the SOEs. 3. Pitfalls of New Reforms There are two major pitfalls that threaten to stall the reform or to take the course of the reform astray. The first pitfall is letting short-term problems take 15 For an outstanding recent case, see Ian Johnson (1999). priority over long-run objectives. Currently, there are a few seemingly urgent shortrun issues that beset the central government reformers: a slowing down of economic growth, a rising high unemployment rate, a surge of income inequality, and massive complaints about corruption. Painful as they are, such short-run issues should never overwhelm the efforts of pushing for fundamental reforms. After all, all such problems are nothing but manifestations of the need of fundamental reforms. They are at most a part of the cost of reform. Unfortunately, because of the ever more vocal representations of the losers of reform and diminishing authority of the reformist government, resources and attentions tend to be devoted to the short-run issues. A case in point is the on-going drive in China to stimulate domestic demand. In the name of stimulating growth, many non-viable SOEs are subsidized and their debt burden relieved. Taxes on interest of household savings are levied and price competition among producers is curbed. These are squarely in the wrong direction of economic reform. The second and perhaps the most deceiving pitfall is to introduce improper reforms or even anti-reform measures in the name of “convergence to international practice.” Examples are the newly devised taxes on interest on bank deposits, the possible implementation of real-name bank accounts (abolishing prematurely the existing Swiss-style anonymous bank accounts), and enforcing progressive personal income tax. These are extremely counter-productive for the reform. One has to bear in mind that there critical infrastructural institutions in modern market economies that make many of the so-called “international practice” exist and function well. Top on the list of such infrastructural institutions are democracy, rule of law, and division of powers that together constrain and curb the tendency of state predation. Without these important institutions limiting the behavior of the state, a lot of the so-called “international practice” may well become convenient instruments for the government to interfere in economic activities of citizens and hamper private incentives. Moreover, one must also bear in mind that some of the “international practice” is simply inefficient institutions that today’s mature market economies themselves are trying to reform away. 4. Concluding Remarks We have made three main arguments in this article. First, we argue that China’s economic reform, which started twenty years ago, is far from being finished. Instead, many reforms have been delayed until now. Without strong efforts to finish these reforms, the Chinese economy may not be able to stay on its growing path. Second, we argue that there are many challenges facing the reformers. The challenges can be summarized as how to find credible ways to compensate those ever more vocal losers of the reforms. Third, facing these challenges, the reformers must watch out two pitfalls of reform. One is that short-run issues tend to overwhelm long-term objectives of reform. The other and more deceiving one is that in the name of “convergence to international practice”, many inefficient and actually counter-reform institutions are introduced. 16 As Hayek (1944) argued long ago, the root of the doomed experiment of socialism is a unconstrained and totalitarian government. Thus of first order importance to the post-socialist reform is to find ways to reduce the scope of control of the government rather than simply copying superficially many secondary institutions of modern market economies.