China’s Embrace of Markets Is Responsible for its Growth

China’s long-term economic growth since reform began is largely the result of the emergence of a dynamic private sector. The de facto privatization of agriculture early in the reform period, via contracting to households and allowing the reemergence of rural markets, led to an unprecedented acceleration of farm output in the first half of the 1980s. In the 1990s and 2000s, private industrial firms became the major driver of economic growth. These firms expanded so rapidly that the share of industrial output produced by state firms fell from four-fifths in 1978 to less than one-quarter by last year. Even after 2008, when many have charged that there was a resurgence in the role of state firms, private firms expanded by an average of 18 percent per year, twice as fast as state firms. Similarly, in the types of services that have been opened to competition – retailing, wholesaling and restaurants – private firms have displaced state firms as the dominant service providers.

As a result, in urban China private firms account for almost all the growth of employment since 1978. In the enterprise sector, the share of workers employed by state and collective firms combined fell from 100 percent in 1978 to 18 percent today, of which the state firm share is only 13 percent. In rural China, the change is even more dramatic. Employment in agriculture is almost entirely private. While agricultural employment has fallen, this has been offset by a 60 million expansion in the number employed in registered private enterprises and family non-farm businesses in rural China. Private firms now also account for most of the expansion of China’s exports, displacing the role once played by state enterprises and, after that, foreign-invested firms.

The dramatic rise in the role of private business in China was made possible by three factors: an improving regulatory environment for private firms, higher productivity of private firms compared to their state competitors, and increasing access by private firms to bank loans and other sources of finance. In the 1980s and well into the 1990s, the policy and regulatory environment for private firms was quite unfavorable. Early on, the government allowed the emergence of family businesses, but these firms were limited by a provision that they could not hire more than seven non-family members. The government promulgated provisional regulations on private enterprises in 1988, but these regulations allowed only private sole proprietorships, meaning that an entrepreneur’s wealth could not be legally separated from the assets of his or her business. Limited liability for private firms was not possible until after the Company Law took effect in 1994. And not until the government revised this law in 2006 was the minimum capital required to register a private limited liability company reduced from 300,000 yuan to a more manageable 30,000 yuan. The same revisions allowed, for the first time, the creation of single-person limited liability firms. In more recent years, the government has provided a more favorable tax regime for more than 6 million small and micro-enterprises that are overwhelmingly registered private companies and family businesses.

A second factor accounting for the displacement of state by private firms is that the latter group of firms has been far more efficient than the former. Particularly by the all-important metric of return on assets, private firms have consistently outperformed their state counterparts. In industry, for example, the gap between private and state firms has widened significantly over the past six years and is now almost 3:1, with return on assets of private firms of almost 15 percent versus less than 5 percent for state firms. This productivity differential is critical because more efficient firms have higher retained earnings, which have become the single most important source of finance for the expansion of non-financial enterprises. For the years 2000 through 2008, for example, retained corporate earnings accounted for seven-tenths of investment. Even when the growth of credit from banks and non-financial intermediaries exploded in subsequent years, retained earnings financed over half of the investment made by non-financial corporates. In short, retained earnings since 2000 have consistently been a far more important source of investment finance for Chinese corporations than the sum of the funds firms borrow from both banks and nonbank financial intermediaries; through the sale of stock on the Shanghai, Hong Kong and other global equity markets; and through the sale of debt instruments both at home and abroad.

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