China and Japan in the Process of Economic Reforms


This paper assesses the process of reform of China and Japan. In case of China we see that even though free market practice was not prevalent, it emerged with a more structured reform policy than Japan due to its corrupted free market capitalism. We base our study primarily on the works of Richard Katz and Barry Naughton to evaluate the road to reformation for Japan and China respectively. We first discuss a few terms and ideas used in their books and then we go ahead to discuss the different problems that ailed the Chinese and the Japanese economies and ultimately their roads to reform.

State-Owned Enterprises (SOE)

While the People’s Republic of China has been implementing a series of state owned enterprise (SOE) reform policies since 1979, only since 1993 has the emphasis of reform turned to changing the structure of enterprise ownership. The current reform policy is known as corporatization, or adopting the “modern enterprise system.” It involves the transformation of SOEs into shareholding corporations, in which the owners elect a board of directors to oversee the daily operation of the firm by professional managers. This ownership structure is intended to clarify the property rights in SOEs and to free them from administrative interference. Some of these corporations then go on to list shares on the Chinese stock exchanges in Shanghai and Shenzhen.

Naughton states that the central government’s protested industrial sector was relaxed in 1979. But even in the 1980s the local governments sponsored state-owned enterprises. Naughton argues that even after 1980s the state monopoly remained intact. This according to him was done to maintain control over the prices and to retain control of some of the crucial sectors of the economy. Hence the reforms in the Chinese economy did not follow the big bang approach as the economists did not want to create short-run shocks to the economy. Though some economists recognize that State Owned Enterprises (SOEs) played a positive role in the transition process, they believe time has come for China to privatize the SOE sector (Naughton, 1994a).

China’s corporatization policy draws upon the functions of property rights and corporate governance. The goal of this reform program is to establish a “modern enterprise system” through restructuring the ownership and management of SOEs. This approach to reform is the most recent in a series of experiments over the past two decades. Under the central planning system, state ownership and control of production was carried out through the ministerial hierarchy: “enterprise managers were seen as merely the bottom level of government appointees taking orders from their superiors.” (World Bank, 19) Early reforms increased the autonomy of managers with respect to production decisions. Successive reform experiments addressed the incentives of both enterprise managers and workers. (Naughton, 1996) For example, instead of submitting all profit to the state, an early policy change permitted enterprises to retain a proportion of above-quota profit. Nevertheless, after more than a decade of reforms, SOE performance remained poor. The implementation of the modern enterprise system is intended to transform SOEs from a part of the state bureaucracy into separate legal entities run by professional managers.

Township and Village Enterprises (TVE)

These rural enterprises first appeared in the 1950s, but it was only in the Deng era that they multiplied. After reform, commune and brigade owned enterprises were reclassified as township and village enterprises (TVEs), but the development and dramatic growth of the TVEs can only be understood in the context of China’s transition strategy. TVEs are viewed as a natural response to a strategy of transition that first liberalized the product markets, without liberalizing factor markets (Naughton, 1994a).

With the liberalization process, the rural areas in china underwent a tremendous growth process. New township and village enterprises (TVE) went into business, manufacturing goods, building houses, and shipping and selling goods around the country. The role of China’s TVEs is unique in the context of an economy in transition. In no other such economy has public ownership played such a dynamic role. However the collective ownership form, which TVEs are classified as being, does not have a precise definition in the country, leading to uncertainty about ultimate ownership rights.

Naughton (1994) argues, on the other hand, that the success of the TVEs has been largely due to a set of external conditions to which they have been an effective adaptation. They have been an effective response to a distinctive feature of the Chinese transition process that saw the early development of product markets, without well developed markets for factors of production and assets. The latter in fact only developing gradually, such that even in the 1990s it is still at a very early stage of development. Naughton therefore argues that the TVEs were a flexible and effective but basically ordinary adaptation to this environment. Such a view would suggest that TVEs may not represent an enduring organizational form and that as underlying economic conditions change rural industry will lose ground to large domestic firms, enterprise groups, and joint venture companies during the course of the 1990s and beyond.

Economic reforms further favored TVEs. State monopoly of several economic sectors (such as manufacturing) was relaxed and barriers to entry removed, enabling TVEs to engage in activities previously denied to them (Naughton, 1994a). Local governments were given greater powers and more incentives to develop local market economies based on private or collective ownership. Collectives became the main source of local revenues, forging a mutual dependence between local enterprises and local governments.

In many TVEs ownership can be characterized as “fuzzy.” But according to Naughton, though they lack a clear legal definition, the property rights are pretty clear. most TVEs the township and village officials possess all the key components of property rights, namely control of residual income, the right to dispose of assets, and the right to appoint and dismiss managers and assume direct control if necessary.

However, although predominantly owned by local government, an increasing number of TVEs are now privately owned. Many are now involved in joint ventures with SOEs and foreign companies and a high proportion incorporate a complex network of affiliations and alliances involving scientists, engineers, academics and business entrepreneurs. This has enabled them to gain access to technology and to become competitive. It is these evolving alliances that will be essential to the sustainability of the TVE form of enterprise, and is discussed further below.

The Danwei

A greater source of stratification in income in urban China originates from an organizational level lower than the city and industries. This is the urban Chinese work organization, or danwei. Whereas under socialism better work organizations meant better welfare provisions and higher prestige, in the era of reforms the role of danwei has become more crucial to many urban residents, often serving as a lifeboat. Workers and their whole families become urban poor when their enterprises go broke. At the same time, those working in profitable work organizations can enjoy all kinds of benefits, from better pay, jobs for children, to virtually free apartments. It is widely known that all organizations have their own “little coffers” (xiao jiinku), or secret/semi-secret accounts, evading auditing from the government. Funds deposited in these accounts are not only used for entertainment by officials but also used to accumulate and to distribute bonuses to employees. Urban Chinese work units in other words have been using the resources they possess to protect first the welfare of their employees and their families.

Even before recent reforms, unequal status of the danwei in the Chinese economic and political hierarchies formed a basis of inter-group inequality. Naughton put it this way: “Even though the danwei was required to turn over virtually all its surplus to the government, the reality was that the danwei had at least initial control of a large revenue stream, and the diversion of even a small proportion of that revenue could have a significant impact on the workers’ standard of living. … ‘Collective’ benefits were seen as being ideologically preferable to individual wage increases.” (p.175)

Devolution of public ownership from the state to work organizations has resulted in a rapid increase in the economic resources of the minor publics. An example to illustrate this point is the changing composition of revenues reported to the government. According to Naughton (1997) in 1985, on a per capita basis, employees in heavy industry work units (danwei) enjoyed 80 percent more housing, more than twice health care resources, four times within-danwei schooling for children, and almost twice the recreational space than those worked for non-heavy industries (Naughton p.180). As revealed by Naughton, “Voluntary job turnover was about a hundred times more common in the Soviet Union than in China under the danwei system. Moreover, in the Soviet Union two-thirds of all hiring was done directly by the enterprise (at the factory gate, in the case of industrial enterprises) and another 10 percent considered of voluntary matches arranged by municipal labor bureaus” (p.173).

Soft Budget Constraint

A “soft budget constraint” problem arises when the state-bank is unable to make a credible commitment not to refinance bad projects once some investment costs are sunk. In such a situation, if a consumer good is also demanded by firms as an input and the seller cannot separate firms from households, the high market-clearing price would lead to welfare losses because too many bad projects would start and crowd out household consumption.

Soft budget constraints not only have “direct” effects on state-owned enterprises, but also “indirect effects” to the extent that they affect the competitive environment vis-à-vis the non-state sector. Some sanguine authors such as Naughton suggest that SOEs will simply “shrink away”. Naughton argues that overall economic reform will result from the growth of the non-state sector – causing a phasing out of the state sector as the economy “grows out of the plan.” There are two varieties of this argument. The first refers to a simple phasing out. Accordingly, with the incipient growth of the non-state private sector, “capitalist” or entrepreneurial interests are created which are invested in economic change. At the same time, such change demonstrates to policymakers the utility of encouraging private sector growth. The second argument is reminiscent of the Lewis dual sector model except that the new private sector is supposed to draw labor and capital out of the old SOE sector – thereby “modernizing” the economy. In this type of model, the SOE sector does not simply whither away but is a resource for a burgeoning private sector. In the first model, SOE performance may remain constant over time (if at a lower level than the private sector) while in the second model SOE performance must decrease over time to release resources to the private sector. Soft budget constraints then either would only artificially prop up performance or hasten the decline the SOE sector.

The declining productivity of the SOE sector, along with its negative effects on non-state private sector development, suggests that SOE reform must be undertaken. One way to treat such reform would be to privatize the SOE sector. Noughton suggests that now, unlike in the past, privatization would be possible due to the progress already made. Privatization would help reduce the budget problems plaguing the public sector through generating sales revenue and reducing subsidies. Privatization would also help capitalize the equities market and provide funds for the developing private sector. Privatization would moreover provide a way to help capitalize SOEs which does not rely on soft budget constraints – thus helping to provide hard budget constraints.

The Company Law (1994)

Naughton observes that China’s transition to a market economy has produced remarkable growth rates and fundamental changes in the organization of economic action. Though lacking the fundamental institutional shifts that have defined many transforming socialist economies around the world, China’s gradualist reforms have nevertheless been radical and deep. The implementation of the Company Law promulgated in 1994 has altered both the quality and intensity of state intervention in the firm, depriving the government of its former unchallenged monopoly rights and control over former state-owned enterprises. In the 1990s, state-crafted institutional change established the framework for the conversion of state-owned enterprises into public corporations. The objective was to transform loss-making state enterprises into profit-making firms through corporatization and listing on stock-exchanges. With the Company Law, the government sought to bring organizational standards in line with western style corporate governance shifting power from the party and government to the board of directors and the CEO as major decision-makers within the firm. State involvement in firm decision-making, however, was not completely abolished. In an effort not to lose all control rights over China’s industrial key sectors, specific aspects of established political governance structures were maintained.

According to Naughton, the policy changes that have driven China’s reforms forward, research in this area will benefit from more deep thinking about the shape and construct of evolving institutions in China. Naughton points out that the interdependence of these sectors here: as state-owned enterprises were placed on the dual track system, private firms were allowed to emerge in the economy, becoming a force that essentially forced the state sector to compete.

State Asset Supervision and Administration Commission (SASAC)

One of the most important economic issues playing out in China today is the control of state enterprise profits. State firms have become very profitable over the last several years, so there is a lot of money on the table. At the same time, control over profit is a central component in a network of interlocking issues, including corporate governance reform, fiscal reform and even social security reform. The State Asset Supervision and Administration Commission (SASAC) have taken major steps in 2006 toward establishing a claim on these profits and advancing its own agenda for reform of the state sector.

The firms owned by central SASAC are organized in a distinctive fashion. First, most of the firms are engaged in limited market competition. There are usually two or three firms that compete with each other, but are protected from new entrants, domestic or foreign. SASAC sometimes tries to moderate competition (to keep profits up), but tries not to let any single firm establish a monopoly position. This pattern is evident in all of the seven sectors designated for continued state ownership. The institutional setup of the “SASAC system” includes not just SASAC itself, but also the characteristic network of holding companies and subsidiaries that links together corporate entities in the state sector. The essence of the SASAC system is that there are usually three tiers of ownership, and sometimes more. At the top is SASAC itself, the “ownership agency,” with the formal powers of ownership, including personnel and financial authority. At the bottom are hundreds of joint stock corporations, many of them listed on the Chinese stock market. In the middle is a layer of holding companies which possess controlling stakes in the base-layer corporations. This middle layer is heterogeneous. In some cases, the middle layer companies are simply empty shells, grouping together the worthless and money-losing assets that bureaucrats tried to keep out of the corporations that were being listed on the stock exchanges. In other cases, though, the middle layer consists of wealthy and powerful corporations, descended from the industrial ministries. The middle layer companies own their subsidiary corporations, although they themselves are owned by SASAC.

These firms have privileged access to bank credit. Most household and corporate saving, which is robust, is channeled into the banking system, creating a bank-dominated financial system, one that is “deep but narrow.” (Naughton 2007: 449-60). Government influence on this system, still predominantly state-owned, has been strong. Since the mid-1990s, an effort has been made to concentrate government influence on three policy banks, in order to free the other state-owned commercial banks to make decisions on a more strictly commercial basis.

Thus, the SASAC system is an extremely important part of China’s development strategy, because it ensures that domestic investment is high, and domestic infrastructure development rapid enough to support China’s rapid growth. However, the actual implementation of this investment policy is in fact compartmentalized and subject to capture by organizations over which the government may have only limited supervisory capacity. The SASAC system ensures that China has enough power, roads and telecommunications capacity. But it is not a very effective system for shaping the future development of the Chinese economy.


Katz argues that Japan is the only industrial economy that has a one-party state. LDP has ruled Japan since 1945. Katz states the ‘structural corruption” in Japan is due to the LDP.

Japan has a parliamentary system, which is typified by a fusion of powers between the legislative and executive branches. As is the case with the parliamentary system, it tends to lead to more discipline among political party members and party members in parliaments almost always vote strictly along party lines. However, Japan’s current reform delay is largely due to the very absence of the discipline within the ruling party and strong executive authority, which is caused by the fragmentation within the ruling conservative Liberal Democratic Party (LDP) and uncooperativeness of and internal division within its bureaucracy.

According to Katz, small-medium companies have also been part of the LDP’s important reelection constituency. The small-medium business sectors serve as a base of wide political support for the LDP, in general, as they provide voters, campaign funds, and under-the-table payoffs for the ruling LDP. Small-medium manufacturers would also be hurt by deregulation of the economy, especially if deregulation were to include easier access for imported products. These small-medium firms have existed within the context of the vertical Keiretsu system, in which they have supplied labor-intensive parts to larger firms in the vertical hierarchy of the keiretsu groups. If structural reform dismantles the keiretsu system, enabling large manufacturers to easily substitute imported parts for those currently purchased from small-medium domestic manufacturers, this segment of the manufacturing sector would contract. Because a more deregulated and internationally open environment would negatively affect small-medium firms, small-medium business interests, as well as the labor related to that sector, are likely to oppose economic reform.

The emergence of Koizumi has brought about the talks of big bang economic reformation, but many believe that once this phase is over, LDP will reinforce its reign to move forward the engine of growth through a slow and steady incremental process. (pp. 7-10)

Junichiro Koizumi

Koizumi, like Gorbachev, according to Katz is “doing the right thing in the wrong order”. His primary error lies in prioritizing the budget cuts over and above eliminating the bad bank debts. Kauzumi chose fiscal austerity when Japan was moving towards recession. Katz puts forward the question that why does he commit these errors? Katz thinks that Koizumi correctly identified that the LDP abused government spending as a substitute fro reform and that this failed because fiscal stimulus alone cannot cure Japan’s ailments.

But Katz feels that Koizumi’s policies do not show good economics or good politics. As Katz exemplifies his original plans called for reduction of the fiscal 2002 deficit by an amount equal to 1% of GDP. But those cutbacks were already reduced by half and further retreat was only a matter of time. Katz argues that Koizumi failed miserably in the banking actions. He stuck with LDP’s plan for a limited write-off of bad debt. In a key litmus test in 2002, Koizumi intervened to stop the bankruptcy of Daiei, a retail company, and pressed banks to keep it afloat. The dilemma with Koizumi, as Katz identifies is he cannot cut budget and solve the bad loan problem at the same time. Dealing with bad debt will cost lots of money. The banks require a lot of money under stringent conditions as was during 1999. Further there should be tax cuts for individuals and not companies. So the Koizumi made the wrong choice, budget. A private economy cannot achieve self-sustained growth while it remains tied down with bad debts and bed debtors. The argument that Katz puts forth to solve the debt problem in a private economy is that debts causes immense excess capacity and inefficiency. This excess capacity is an anchor on new investment and growth. Moreover, to survive the bad debtors slash down prices to survive, this forces healthy companies to get into a price war. This causes downward pressure on wages and consumer spending. Thus, keeping bad debtors alive makes marginal companies losers and good companies marginal companies. (p. 12)


Katz shows that the zero interest rate policy (ZIRP) used to save the banks and their borrowers had wrecked havoc on life insurers and pension funds. From 1980 till 1992, life insurers guaranteed a return of around 6% a year on new policies. Then, as bond market interest rates and the stock market tumbled, the insurers steadily lowered their guaranteed payout, reaching a low of 1.5% in 2001. But these reductions affect only new policies. The firms still used to pay the contracted amount on policies already in force. However, the negative interest-rate spread between the benefits that the insurers are obliged to pay and what they can earn these days has made several insurers bankrupt. In mid-2001 the Financial Service Agency announced it might recommend legislative changes that would permit life insurers to cut payout rates below the contracted amount before they go bankrupt.

Katz suggests that Japan should have combined ZIRP, as a money stimulus, with aggregate demands fro corporate restructuring. In this case, the ZIRP would have provided a critical breathing space fro reform. Instead the policymakers had used ZIRP to help companies, especially well-connected companies, avoid restructuring.

According to Katz’s own calculation, the percentage of loans extended by the government has grown from 16 percent in 1965 to more than 35 percent today. Publicly owned financial institutions account for 45 percent of deposits compared to 16 percent in 1965.

ZIRP itself has the purpose of allowing zombie companies to survive,” Katz lamented, on top of which he said the Financial Services Agency, Japan’s financial regulator, exerts pressure on the banks to continue to lend money to moribund companies rather than pull out the plug on the life support system.

Hollowing Out

The Japanese economy is characterized by the existence of a dual structure in which efficient manufacturers and inefficient service-related sectors co-exist. This is one of the main reasons for the high-cost structure. Some of the industries of Japan are moving their lower level operations out of Japan to take advantage of cheaper labor and other factors. This is called the hollowing out of Japanese businesses. The corporate headquarters and top level functions remain in Japan but these become more and more like a shell of the companies.

Even as late as the mid-1990s, Japanese intellectuals and officials were promoting the merits of Japanese-style capitalism. Just a few years later, however, confidence in ‘Japan Inc’ was undermined by the depth and severity of the economic crisis in the wake of the bursting of the ‘bubble economy’ and the hollowing out of its manufacturing base. A reform ideology has instead come to dominate debate, one which advocates wholesale abandonment of government administrative guidance, deregulation of markets and supply-side ‘restructuring’. Katz has argued that even if the Japanese system had been effective in catching up with the west in the post-war period, it had outgrown its usefulness by the 1990s. Katz blames a system that has ‘turned sour’ chiefly by excessive government involvement and a neo-mercantilist industrial policy. The prescription offered is to deregulate and become like other western, ‘free market’ economies.

In attempting to understand Japan’s manufacturing hollowing out, Katz takes the view that even if the Japanese system had been effective in catching up with the west in the post-war period, it had outgrown its usefulness by the 1970s and 1980s. Japan was suffering from a ‘Japanese disease’ caused by excessive government involvement. This has arguably been stimulated by the export competitiveness of manufacturing sectors such as automobiles, coupled simultaneously with barriers to imports arising from government intransigence against deregulation. As a result, export expansion was not accompanied by import expansion, the yen continuously over-appreciated during the 1970s and 1980s, and ‘efficient’ sectors ended up being penalized.

Dual Economy

Dual economies are most often found in emerging nations that have developed some niche industries that resemble industries found in developed nations. Along-side the perhaps powerful economic components of the niche industries continues the more traditional and rudimentary economy of agriculture and exploitation of natural resources. Japans dual economy is not quite in this mold but exhibits a distinct duality even so. Japans dual economy is one of a dominant (but weakening) export sector stumbling alongside an entirely inefficient and weak domestic sector. Moreover, the strongest of the export sector industries are being gutted by economic pressures to move offshore.

Lacking the proper market force of competition that evolves from both importing outside goods and allowing new industries to arise, the economies of scale often became diseconomies of scale. The ever growing service sector, lacking outside competition, became wholly inefficient and non-competitive by international standards (Katz p.37). The drive for self sufficiency set Japan to fostering industry in which Japan lacked comparative advantage. One example is the inefficient refining industry. Japan until recently could not import refined goods, relying on their own poor refining capabilities (Katz 33). The market economic force in most countries would lead to imports of gasoline and other refined products, keeping cost down for consumers and industry alike. Another notable example is the cost of steel to Japan’s industries. With limited choice for steel, pressures mount to move offshore to those that rely on it.

The lack of imports kept industrial inputs at too high a cost. Many of Japan’s most efficient export industries have therefore been forced offshore, “hollowing out” the few remaining jewels of the Japanese economy (Katz p.52). The ministerial solutions to these hugely threatening economic evolutions have been to throw good money after bad. This has further weakened the banking position. Rather than spurring new competitive industry, Japan has pumped scarce bank capital into faltering, non competitive industry. As well, Japan has over invested in an attempt to grease the economy. From 1973 to the 1990s Japan invested 35% of its GDP and attained the same rate of growth as a country investing far less (Katz p.71). The banks, operating on thin margins already, were finally led by MOF in the 1980s to rapidly increase the money supply in an ill-advised attempt to keep the miracle alive.

Ministry of Economy

Katz criticized the Ministry of Economy of being complacent. He said that they a re not eager to promulgate reforms. If the economy does well, they say there is no need for reform, and is if the economy is in a downturn they say the economy is too weak for reform to be initiated. Labor-market change and reform is ongoing, with the Ministry of Economy, Trade, and Industry and the Ministry of Labor proposing retraining and placement programs to assist those workers who have left their old jobs, as well as to improve job matching and investment in human resources. The realization by many unemployed, underemployed, and out-of-the-workforce Japanese—especially women and recent college graduates—that they must take more initiative and show more flexibility to get the best opportunities in today’s Japan will have lasting beneficial effects. This realization has already resulted not only in a growth of part-time employment in Japan but also in a decline of the average unemployment rate since the recession trough of January 2002.

Trade and Industry (METI)

In Japan METI (earlier known as MITI) is on eof the most powerful ministries in Japan. According to Katz METI is now pushing Abe to weaken antitrust policy even further. Today, the Japan Fair Trade Commission (JFTC) almost automatically approves mergers so long as the merged firm’s market share would not exceed 35%. METI wants to raise the threshold to 50%. Lately, some companies have revived cross-shareholding to fend off potential buyouts. No hostile takeover has ever succeeded in Japan. Eventually, some will. Although such takeovers should remain rare, as they are in the United States, merely allowing for their possibility would help deter bad management.

Cartels, or conglomerates, were not new to Japan but the occupation had tried to breakup large family controlled conglomerations of businesses called zaibatsu. This was carried out with minimal success and a new type of conglomerate began to form with the direction of METI even during the occupation. These new “Keiretsu” and the tightly woven interrelationships they entail are the primary source of Japans present troubles. During the high growth period (1952-1973) the keiretsu system could be defended as the protector of an emerging industrialization, with a tight banking, keiretsu and MITI/MOF relationship.

In the 1960s, when international rules compelled Japan to begin liberalizing foreign investment, the Ministry of International Trade and Industry (MITI) urged firms to buy one another’s shares so that they could veto any buyout. The rate of cross-shareholding rose from 40% in 1965 to 60% by the early 1970s and reached a peak of 72% in 1988. As cross-shareholding increased, dividends steadily fell: from 4 percent in 1970 to less than 2% by the late 1970s to a negligible 0.5% by the end of the 1980s.

Ministry of Finance (MOF)

High public confidence has also been betrayed in the 1990s by a succession of corrupt scandals and policy misconduct. Not only had an official of Japan’s MOF been accused of taking bribes in exchange for leaking privileged information to banks, but the Daiwa bank scandal also illustrates problematic practice of bureaucracy in MOF. Leaking privileged information induces the development of a distorted economic system in which personal ties and money take precedence over price and capability in executing businesses. Bureaucrats in the MOF on their parts enjoyed the perks of high social status and generous money donations when they could act on their discretion in dealing with industrial polices. However, personal and financial ties in such cases will be a hard pressure when the same bureaucrats have to destroy certain relationship in the name of deregulation or liberalization.

Moreover, bureaucrats’ vested interests are institutionalized in the practice of amakudari – “descending from heaven” – whereby bureaucrats retire from government ministries and agencies into executive posts in semipublic organizations and onto the board of banks, industry associations, and big corporations. Systems of regulation require that corporations maintain good connections with regulators; hence the need to give posts to ex-officials who can provide access to the ministry. Therefore, they fear the perceived loss in ability to engage in industrial policy if the amakudari system disappears. In the absence of industrial policy, bureaucrats would have difficulty putting pressure on firms to accept amakudari employees. They want the personal connections between government and private sector to grease communication channels with the private sector.

The new banks that came from this system were instrumental in industrial growth. The Japan Development Bank (JDP) was created and eventually this bank had access to the government postal savings system, a lightly taxed personal savings system that eventually became a huge pool of capital. The JDP was perhaps the most influential of all high growth period banks, using its funds to create great new industries. As well, during the beginning of high growth, MOF tightened its hold on all banking procedure. The keiretsu became groups of industry that integrated horizontally and vertically, each keiretsu developing ties with one specific bank. The bank was responsible to the industries of the keiretsu and visa versa. Such cross share holding is dubious at best and illegal in America. Moreover, the banks debt risks were ultimately covered by the central bank, Bank of Japan. In a system of over loans, the industries could borrow (from banks) more than they could repay, and the banks in turn, could borrow from the Bank of Japan more than they could repay.

Total Factor Productivity (TFP)

Overtime the concept of total factor productivity (TFP) growth is more emphasized in research. The advantage of this concept relies on its ability to explain productivity for the whole inputs used in the production process. TFP can also reflect technological progress that takes place in a country. Even though TFP growth does not merely mean technological improvement, but also improvement in the quality of inputs or efficiency due to other factors like HRD and HRM, many researchers argue that TFP growth is an approximate measure of technological advancement (Katz). Therefore, many researchers use TFP growth that obtains from the residual of the production function as a measure of technology.

As Katz points out the irony is that Japan has simultaneously too much and too little investment. Too much investment for the investment to be productive, profitable, and sustainable. Too little investment to surmount declining TFP. To really raise growth on an ongoing basis, the need is fro more investment driven by zero interest rates, but fro improved TFP growth. That, in turn, requires productivity-enhancing structural reforms. The days of using investment to make up for sagging productivity are gone, according to Katz. Even interest rates at zero are not good enough to bring them back.

Economic Anorexia

Japan suffers from what Katz calls economic anorexia, a chronic insufficiency in private domestic demand that is the cause of deflation. He argues that keeping zombie firms alive is a deflationary policy, and thus to stimulate demand, productivity and economic growth, they must be shut down.

The fundamental demand-side problem is this: Since Japan has a mature economy; its growth should be led by consumer demand. But that cannot happen because households have too small a share of national income.

Corporations still rake in cash flow (profits and depreciation) as they did in the high-growth heyday. But they no longer plow that money back into the economy through investment. There is nothing wrong with that. As any economy matures, its investment needs to slow down. But, in contrast to other countries, in Japan personal consumption did not rise enough to take up the slack. Had Japan’s markets been working properly; much of those profits would now be returning to households via higher wages, dividends, and interest. That, in turn, would drive higher consumption. Unfortunately; instead of rebounding, the household share of national income has continued to decline. Consumption is low not because households save too much, but because they earn too little.

Structural defects cause both supply-side inefficiency and demand-side anorexia. Compare Japan to a company as it goes from its takeoff phase to a mature phase. If Microsoft earns a 25% return on assets (ROA), it can plow these profits back into the company to expand assets by 25% because its market is also growing that fast. Stockholders reasonably forgo dividends because the value of their shares will skyrocket. Now take a mature firm like GM. Sales growth is, at best, only a few percent a year. If GM tried to plow all of a 25% ROA (or even a 15% ROA) back into the firm, it could do so only by making grossly unproductive investments. ROA would plummet, and so would the stock price. A properly functioning market forces GM to return most of its profits to shareholders, bondholders, and bank depositors. Stockholding households can use the dividends from GM in two ways: (1) They can invest some of it in new companies, like Microsoft – that process seamlessly shifts capital from low-return firms and industries into higher-return ones; and (2) they can spend it as consumers.

But, in cartelized Japan, nothing forces firms to return their excess cash flow to the household saver/investors. Nippon Steel invests in amusement parks. Matsushita invests in Hollywood studios. Banks invest in shaky (and shady) real estate ventures. No heads roll when these investments turn sour. Instead, households, in their role as taxpayers, are asked to bail out the deadbeats.

Non-Performing Loans (NPL)

The government put nonperforming loans (NPLs) amounting to 4.3 trillion yen, or 8 % of GDP, which according to financial analysts, have not only crippled conventional monetary policy but also limited the benefits of aggressive government spending.

Katz points out that behind every NPL is a non-performing borrower. Writing down the bad loans is no solution if the companies themselves – mostly in the highly regulated, uncompetitive sectors of Japan’s dual economy – are not allowed to fail. His solutions, though undoubtedly valid, are hardly novel: greater imports and more foreign direct investment will force competition. The industries that have followed this path in Japan have created world-beaters. More fluid labor markets will permit companies to reorganize for faster growth.

Analysis of the post bubble period in Japan indicates that varying combinations of fiscal contractions, lack of financial supervision, and excessive monetary tightness killed recoveries in 1997 and 2000. At least as important, the overwhelming accumulation of nonperforming loans (NPLs) in the Japanese banking system and the behind-the-curve response of mone­tary policy to recessionary forces throughout the 1992–2002 decade were an ongoing drag on the Japanese economy.

By 1998, however, following the aborted recovery of 1997, the NPL problem had become a major macroeconomic problem in its own right, if not the dominant problem of the Japanese economy, and its size grew markedly through 2002. The ongoing political pressures for the rollover of loans to politically favored but bankrupt enterprises, in hopes of preserving jobs, and the near total erosion of bank capital between loan and equity losses created incentives for the problem to keep growing.

Zombie Firms

Japan cannot look at counter cyclical macro policies alone as a savior. Japanese banks have obscured non-performing loan problems through essentially lending to insolvent firms. Funding zombie firms on an ongoing basis is nothing more than a dissipation of capital. Katz argues that improved corporate and state governance can resolve Japan’s substantial problems and emphasizes that there is no way to avoid dealing with the massive bad debt problem.

Cleaning up bad debts matters because as long as zombie debtors are kept on life support they represent a huge drag on the economy. Katz argues that behind the bad debt stand the bad debtors, the majority in sectors suffering from immense excess capacity and inefficiency. This excess capacity is an anchor on new investment and growth. Moreover, just to survive, the bad debtors are slashing prices, forcing healthier companies to match them. This adds to downward pressure on wages and consumer spending. Keeping bad debtors alive turns marginal companies into losers and good companies into marginal ones.

Pulling the plug on the zombies is problematic because the safety net in Japan is very porous. On paper it seems that there are relatively generous unemployment programs in place for retrenched employees, but these are geared toward full-time employees, leaving the most vulnerable workers (part-time and temporary staff) with the least protection.

According to Katz, only about one-half of Japan’s 64 million workers are eligible for government unemployment insurance, compared with 130 million eligible American workers, of the 140 million in total. Ironically, the U.S. is often cited as a nation with miserly unemployment benefits. Katz also cites a study that indicates that only about 1 million Japanese a month receive unemployment benefits, even though 3.4 million are eligible. In this situation, the real safety net for many workers is the current job. Those who lose that face considerable difficulties.

Long Term Credit Bank of Japan

The facts show that the Bank of Japan (BOJ) has lowered discount rates (collateralized overnight call rates) from a post-bubble high of 8.3% in March 1991 to virtually zero in June 2004. It has also begun, somewhat belatedly, an aggressive quantitative easing of its so-called high-powered money, or base money, in the 2000-2002 periods. The latter move forced nominal interest rates to fall completely to zero by 2002. Since then, annual base money growth slowed down further in June 2004 (3.2%), marking the fourth consecutive month of deceleration. Growth rates of both the current account balance and bank notes continued to decelerate as well; annual growth of bank notes fell to 1% yoy in June 2004 for the first time in 13 years.

Japan faces a “liquidity trap”, where short-term nominal discount rates are zero, but people continue to hoard money rather than consumer or invest. Against this backdrop, the Bank of Japan argues that it does not have the necessary instruments to achieve inflation in the current liquidity trap environment.

Many critics of the BOJ have argued that it should adopt an explicit inflation target. This would involve specifying a target range for the inflation rate and a time period for achieving the target. Countries such as Australia, New Zealand, the UK and Canada are all currently employing such targets. The BOJ has consistently counter-argued that it does not have the necessary instruments to achieve an inflation target in the current liquidity-trap environment with a floating-exchange rate regime. Rather, it has “committed” itself to maintaining its current policy stance of quantitative easing until prices have turned “positive” as measured by the core CPI—although BOJ Governor Fukui’s meaning is unclear in this instance. What does “positive” mean? How long must prices remain “positive” before policy changes?

In what form will this change of policy take? Recent bond market movements suggest either a belief in the BOJ’s commitment to price stability or an optimistic view that inflation is around the corner, depending on the time-frame. A steeply rising yield curve, say, from May-October 2003, suggests that short-term interest rates are expected to rise. At its low in May 2003, a 10-year JGB had a yield 0.54% while a 5-year JGB and 2-year JGB had yields of 0.16% and 0.05%, respectively. Effectively, the market continued to believe that the BOJ’s current “wait and see” policy of inflation through quantitative easing would take place. By October 2003, 10-year JGBs had risen to 1.46% and 5-year and 3-year yields had risen to 0.64% and 0.155%, respectively. These yield increases imply not only the possibility the BOJ would slow monetary easing (so-called tightening), but rather quickly judging from the 48bps (5-year) and 10bps (2-year) moves of the JGBs.

However, post-October 2003 yield slope movements (moderately steep vs. very steep yield curves) suggest that the market is no longer sure that inflation is imminent. If anything, deflation may persist.

Why does the market believe that deflation may persist? Nominal interest rates may be zero, but there are few profitable investment opportunities in post-bubble Japan that could induce businesses to borrow or banks to lend. Structural reform and deregulation are needed. Richard Katz has adopted this view.

Shinsei Bank

Shinsei Bank is the successor of a trust bank, the Long-Term Credit Bank of Japan, which had a government monopoly on the issuance of many long-term debt securities. Following the collapse of the Japanese asset price bubble in 1989, the bank was riddled with bad debts: the government nationalized it in 1998, and it was delisted from the Tokyo Stock Exchange. After several proposed mergers with domestic banks, LTCB was sold to an international group led by US-based Ripplewood Holdings in March 2000 for ¥121 billion, the first time in history that a Japanese bank came under foreign control. Investor Christopher Flowers also played a major role in the buyout syndicate and remains a key shareholder of the company today.

As part of the purchase and sale agreement, the government included a defect warranty provision to the effect that Shinsei could demand within the next three years that the government purchase any claims which had fallen by twenty percent or more from book value. A similar provision was afforded Aozora Bank, the successor of LTCB’s similarly beleaguered sister company Nippon Credit Bank.

LTCB was re-launched as Shinsei Bank in 2000, with new management and services. Shinsei used the defect warranty provision to dispose of all the worst debts owed to the bank. Several companies which had used LTCB as their primary bank went bankrupt as a result, including Sogo and the Dai-Ichi Hotel. This created a furor in Japan: politicians especially criticized Goldman Sachs, which advised on the sale of LTCB, for not warning the government of the risks inherent in the defect security provision.

Shinsei then raised 230 billion yen in an IPO on February 20, 2004. The purchase of Shinsei thus turned a profit of over 100 billion yen within four years. The success of the IPO intensified criticism of Shinsei, however: the government was estimated to have lost 4-5 trillion yen on the deal between lost investments and forced purchases of bad debt, and the profits from the deal even escaped Japanese taxation through the use of a foreign investment partnership.

Convoy Capitalism

The LDP adapted to a gradual waning of the intensity of the divide over security policy and the emergence of new concerns about the costs and risks of modern capitalism by embracing policies designed to protect economically-vulnerable segments of the population. It supported a dramatic expansion of public pensions for the self-employed in the 1970s, along with “free health care” for the elderly. It also boosted spending on public works projects in rural areas so that the construction industry could serve as a social safety net in areas lacking vibrant private sector employment opportunities. After progressive local officials won some local elections by offering “no collateral loans” to small businesses who had trouble getting loans from private banks, the LDP one-upped progressive local officials by creating national programs that channeled private savings deposited with postal financial services toward public financial institutions tasked with providing subsidized loans to small and medium sized firms. These public financial institutions were just a part of what became an LDP supported policy of “convoy capitalism” that was designed to cushion firms from market forces so that they could live up to their lifetime employment commitments to their workers

If the Japanese political system could have started over in the 1990s, it might have developed a party system that pitted a neoliberal, pro-defense party against one that favored using social welfare programs and regulations to cushion market forces and supported a more dovish security policy. Instead, because the LDP occupied the SE corner, supporting a relatively hawkish security policy and favoring the Japanese convoy system of social protection.

The LDP during the 1990s found it difficult to appeal to voters who cared about the new issues of political and economic reform. Its support base, especially the construction industry and farmers, demanded large expenditures on public works and farm subsidies. Banks and their borrowers pressured the party to keep the “convoy” system going so that they would not face bankruptcy. The inability of the LDP to escape from the feedback loops that reinforced this “mobilization of bias” created the opening that enabled the DPJ and other new parties to challenge the party from the reformist direction. As late as 2000, the LDP was moving away from neo-liberalism, rather than toward it.

Financial Socialism

As defined by Kartz, “financial socialism” is the share of deposits and loans mediated by government banks had, which had soared to 45% and 35% respectively. In Katz’ view, the only concrete reform in Japan so far, the financial markets’ so-called Big Bang, has been more than offset by other things that prevent a better allocation of resources. It is a case of one step forward, three steps back, he argues, adding economic statistics showed that Japan is mired in financial socialism.

According to Katz’s calculation, the percentage of loans extended by the government has grown from 16 percent in 1965 to more than 35% today. Publicly owned financial institutions account for 45% of deposits compared to 16 percent in 1965.

The zero interest rate policy itself has the purpose of allowing zombie companies to survive, on top of which Katz believes the Financial Services Agency, Japan’s financial regulator, exerts pressure on the banks to continue to lend money to moribund companies rather than pull out the plug on the life-support system. Mergers and acquisitions are supposed to promote competition and speed up the replacement of uncompetitive enterprises by new entrants.

But in Japan, the mobility rate for companies (entrants and quitters compared to all businesses in operation) is the lowest in the Group of Seven most industrialized nations, at around 7%, against a ratio which ranges from 16% in Germany and Italy to more than 25% in the UK, according to Katz’s own estimates.

Merger and acquisition activity is resisting restructuring, in Japan, he said, citing as examples the creation of four monolithic banks since 1999 and the increased market share of two or three market leaders in numerous protected and uncompetitive sectors of industry. One of the few glimmers of hope for Japan, as far as Katz is concerned, is the increased foreign presence in Japan. Katz also regards the increase in the amount of Japanese savings entrusted to foreign fund managers as significant. It is estimated that by 2003, more than 20% of public pension funds and 17% of private pensions will be in the hands of foreign managers compared to just one percent in 1987.

Lifetime Employment

Katz’s pessimistic view of the possibility for near-term reform is based on the fact that the obstacles to growth are also tied to the pillars of the Japanese system—lifetime employment, anti-competitive behavior, and high domestic prices. A safety net for workers will be needed if this system is to be transformed, but the Japanese have a welfare society rather than a welfare state. The welfare society has worked well in the past but is not designed for the mass unemployment that is likely to accompany true structural reform—it is estimated that 10 million workers will have to lose their jobs in order to bring the Japanese economy up to world standards. Overall, the characteristics of Japanese industrial relations have been viewed as ‘three sacred treasures’ of seniority-based wages, lifetime employment, and enterprise unions. The view was confirmed by the 1973 OECD report. Seniority-based pay is explained with livelihood guarantee (people with higher age need much money) and the degree of specific skills (people with longer experience have high skill). Lifetime employment should be accurately expressed with ‘long-term stable employment within an enterprise.’ The formation of co-operative attitudes of enterprise unions took place from the 1960s onwards.

Katz sees the LDP one-party state as a major cause of Japan’s inability to make needed changes. He argues that true political competition will be necessary for reform and that several more political realignments will have to take place before real changes are implemented. Thus he predicts that in the future the LDP will split again and that true reform will not occur for at least five more years. Given the seriousness of the current situation, Katz does not believe that reform will wait much longer than that.

In such Japanese strategies as seeking growth and market share, mass production and process-oriented innovation were most important. As a result, human resource strategies could focus on training and development of generalist workers able to absorb and improve existing technologies rather than specialists or workers focused on innovative technology. These human resource strategies could easily implemented because of the stable labor force based on lifetime employment practices and seniority-based pay and promotion. Therefore, it can be said that the corporate strategies of Japanese companies could succeed because of the consistent policies among companies, financial institutions, government, and labor relations.

Seniority Pay

Japan’s industrial relations are rapidly changing these days. For example, many large companies have begun to introduce the pay for performance systems instead of older seniority-based compensation practices. As a result, the traditional practice of industry-wide wage negotiations called “syunto” or spring offensive has also begun to change. Although these changes were accelerated by a long recession after the burst of “bubble economy,” there seems to be a fundamental structural transformation continuing before the bubble economy. We have to understand and explain this transformation process in Japanese industrial relations.

Overall, the characteristics of Japanese industrial relations have been viewed as ‘three sacred treasures’ of seniority-based wages, lifetime employment, and enterprise unions. The view was confirmed by the 1973 OECD report. Seniority-based pay is explained with livelihood guarantee (people with higher age need much money) and the degree of specific skills (people with longer experience have high skill). These human resource strategies could easily implemented because of the stable labor force based on lifetime employment practices and seniority-based pay and promotion. Therefore, it can be said that the corporate strategies of Japanese companies could succeed because of the consistent policies among companies, financial institutions, government, and labor relations.

The labor market has changed. First, the percentage of employees in white-collar jobs with much slower productivity growth than blue-collar workers has risen. The percentage of total white-collar workers increased dramatically from 36 percent in 1970 to 50 percent in 1990. It caused the serious problem of productivity in Japanese companies. Second, workforce has been aging rapidly, with an excess of older workers. Some 25 percent of the Japanese will be 65 or older in 2020. These factors caused the rise of labor cost because the older workers were given high salary because of the seniority pay system. Katz points out that larger firms, however, give considerably less support for the future maintenance of the seniority-based pay and promotion system. In fact, a majority of companies support its gradual weakening and, in many cases, complete abolishment. From 1983 to 1993, the difference between the average wages of older and younger workers decreased, indicating a flattening of the wage curve and thus a weakening of wages based on seniority. Thus, while lifetime employment will be retained, seniority-based pay and promotion will generally be phased out.

Structuralist versus macroeconomic policy explanations for Japan’s prolonged slump

According to Katz the answers to all of these problems lie in the kinds of corporate governance reform, structural reform and even political reform that have proved so hard to achieve in Japan over the past decade. And even Katz himself says the country’s report card so far has been largely discouraging.

His optimism, however, is not based on any reforms that have been proposed or implemented to date. Rather, it is because, “while inertia is on the side of the resistance, time… is on the side of reform”. In essence, the genie of reform is out of the bottle. It has captured the country’s imagination, even if there is not yet any credible program or institutional-political vehicle to implement it.

But Japan, Katz argues, “abounds with bright, ambitious individuals who know what is wrong and who are capable of leading the new Japan. It does not have the feel of a failed state.” So, while he cannot offer any roadmap, he is nonetheless confident that Japan will find its way – eventually.

Financial deregulation and low interest rate policies are viewed as deliberate attempts to delay deeper reforms. Katz thus argues that after the 1985 Plaza Accord, “which sent the yen soaring” and “cut off the trade surplus route to growth,” Japanese authorities “responded by artificially pumping up real estate, stocks and capital investment…”30 Katz, on his part, blames the growth of corporate surpluses on the overregulation and overprotection of less advanced sectors and firms. Together with the inflexible employment arrangements in core corporations (which inhibited any reallocation of labor), such government restraints are said to have prevented the channeling of corporate surpluses toward productive investments in the less advanced sectors. Meanwhile, the protection of inefficient producers fostered “excess savings” among households by raising the prices of consumer goods and services compared to a more market-friendly regime. In this way, Katz blames both the bubble economy and Japan’s “demand-side problem” on the same anti-market institutions that have (in his view) created a “deformed dual economy” in Japan. Moreover, unstable monetary and fiscal policies (whether misguided or deliberate) for creating a climate of heightened macroeconomic uncertainty that increased the weight of speculative investments compared to productive investments.

The boom generated by the bubbles of the late 1980s worked to delay the required transformation. Since structural reform requires adjustments in employment, it is not something that can be rushed. But just when companies should have been gradually carrying out these adjustments, they ended up making a wave of investments that were directed at the old style of manufacturing in response to the bubble-generated boom. Now they’re feeling the heavy weight of this investment activity.

A structural reform was not enough to take Japan out of the trap. by increasing unemployment, business bankruptcies, and economic insecurity, neo-liberal reforms could further reduce demand and worsen stagnation. This last point highlights the most important antinomy in the anti-capitalist capitalism interpretation: despite its emphasis on a transition to a “mature” capitalism in which growth is driven mainly by technological advance and not by the growth of physical capital and labor inputs, it refuses to recognize the logical implication that advanced capitalism has a structural tendency to generate more savings than it can productively and profitably invest anytime it approaches full employment. Both stagnation and the channeling of economic resources into speculative activities may be viewed as symptoms of this underlying tendency.

A superior strategy, from this perspective, is to directly undercut the historical basis for the expectation of a higher yen through a structural change in U.S.- Japan relations. To effectively “unravel the syndrome of the ever-higher yen,” this regime change must involve joint actions by the two governments. More specifically, the two governments should sign a “commercial agreement to limit future bilateral sanctions in trade disputes” and a “monetary accord to stabilize the yen/dollar rate over the long term.” What is crucial, in this view, is not so much the precise level of the dollar/yen exchange rate but rather the need for “a formal pact to provide long-term assurance that American policy truly has changed permanently so that the future dollar value of the yen is likely to be no higher, and the Japanese (wholesale) price level no lower, than they are today”. Indeed it is in this context that structural reform is most needed.” Moreover, such free-market reforms should be implemented now, when companies are still repairing their balance sheets.

The origin, nature and extent of Japan’s banking crisis and bad loans problem

The banking system fell into crisis as the number of bad loans mounted in the wake of Japanese recession. Putting a price tag on the nonperforming loans was difficult Ð estimates ranged from $550 billion to $1 trillion but there was no doubt serious action was needed. Investors responded to the crisis by reducing the average price of bank shares by 30 percent from June to September 1998. After enduring months of criticism for failing to tackle the problem, the government began to take dramatic steps in mid-1998. The government nationalized two banks, created two watchdog agencies, and agreed to spend some $500 billion on the problem. The amount was 10 percent of Japanese GDP and nearly four times the $130 billion price tag of the US savings and loan bailout of the 1980s.

In Japan, according to Katz, the reason of origin of a banking crisis is its debt crisis. Japan’s banks have been used as a kind of public utility, forced to keep rolling over loans at ultra cheap rates to insolvent firms so as to avoid mass unemployment. 17% of all loans carried an interest rate charge under 1%, 7% less than 0.5%.

When firms could pay even these rates, they were granted debt forgiveness. In 2002, Koizumi pressured the banks to give retailing giant Daiei yet another bailout, including debt forgiveness of 400 billion yen ($3.2 billion), on the explicit grounds that a firm employing a hundred thousand people is too big to fail.

The root of the problem is not only the NPLs alone but nonperforming borrowers (NPBs) behind each loan. The overall problematic bank debt was estimated to be 100 trillion yen ($806 billion) which was 20% of Japan’s GDP.

Katz believes the only solution to Japan’s problem is foreclosing on the bad borrowers.

The banking problem is so big that the NPLs exceed the banks’ capital. In other words, the banking system is technically insolvent. Katz used government figures and found that the total of problematic debt adds up to 20% or 30% of GDP, depending on whether interest is the weak point of the lenders or the viability of the borrowers. The former problem adds up to 100 trillion yen and the latter to 140 trillion yen.

To further this problem is the problem of ZIRP and zombie borrowers. Katz has estimated that then there are the official NPLs, which are a different subset of the original 141 trillion yen in problematic debt.

The financial services agency (FSA) puts debt into four categories, but there is a confusing wrinkle: separate ratings for quality of the borrower and the quality of debt. Problematic borrowers are those already in arrears at least three months or those at risk of defaulting in future. The latter, sometimes called the “watch list”, are currently paying on time, but they’ve shown red ink over a lengthy period of time. Borrowers at risk owe 108 trillion yen ($871 billion) to the banks and an astronomical 141 trillion yen ($1.1 trillion) when nonblank lenders are included.

However, the FSA deducts about 60 trillion yen from this 141 trillion yen total because these loans are covered by ‘superior collateral’, such as cash and government bonds, or because the loan is backed by guarantees from the government or a parent firm. The reasoning is that such collateral could be seized by the bank. But 14 trillion yen I sowed by nearly bankrupt borrowers.

The banks have good incentives to underestimate risk. The riskier the category, the larger the required lone loss reserves and thus the bigger the deduction from bank profits.

NPLs at the big banks are supposed to shrink from 18 trillion yen to 7-10 trillion. But this is a difficult task to be done when FSAs also say that banks’ disposal efforts (the total write-offs pus new reserves) will have fallen from 2.7 percent of loans in 1998 to only 1 % a year during 2001-03 and the miniscule 0.3% during 2004-07. To answer the question, how can the banks get better results than before with less effort, Katz says, “It appears to be a number designed to keep the banks’ credit under their operating profits.” (p. 88)

By the end of Japanese fiscal year, March 31, 1999, banks were to have completed all additional writing off of bad loans. Fifteen of Japanese major banks applied for a capital infusion. In exchange, the Financial Reconstruction Commission required the banks to submit plans for fundamental restructuring and encouraged mergers to strengthen profits and increase competition. The bank bailout plan was not the only government effort to try to pull Japan out of recession. The government also adopted some $227 billion in economic stimulus packages.

The fiscal challenge of budget deficits and the national debt in Japan

The fiscal remedy tried on Japan, observed by Katz, has failed completely. Starting with a surplus equal to 3% of GDP in 1991, the deficit grew to a peak of 8% of GDP by 2000 (p. 105). By other measures, the deficit was even higher – for instance, 11% of GDP in 1998 on a national accounts basis. Some of the deficit simply reflected recession (decreased tax revenues, fro example), but the majority of it – referred to as the “policy effect” – represented increases in spending or cuts in taxes aimed at stimulating demand.

Japan’s fiscal policy has been an unintended real-world experience, one whose results are clear. Fiscal stimulus helps growth when it is applied and hurts when it is withdrawn. The ups and downs of GDP growth mirror the application and removal of fiscal stimulus. In fact, Katz argues, there exists a 61% correlation between change in the deficit in one year and GDP growth the following year. (p. 107)

Thus, we see that Japan requires fiscal stimulus to avoid chronic recession. Katz observes that this is Japan’s dilemma. He says that no budget deficit, doesn’t matter how big can add up to new growth. It increases in the deficit that stimulates new growth. A deficit increase equal to 1% of GDP, whether from 3-4% or from 6-7%, provides equal stimulus. Conversely, a budget deficit that is largely shrinking, i.e. from 9% of GDP to % of GDP, detracts from growth. Hence to sustain a constant amount of stimulus the overall size of the deficit has to keep increasing year after year. That’s how Japan became prone to ever larger fiscal deficits. And that, in turn, led to increase in public debt at exponential rates. The only way out of thus dilemma, according to Katz, is “growth enhancing reforms that raise tax base.” (p.107)

In terms of public debt, Katz believes that Japan still has lots of safety valves that can carry it for the medium run. He argues that Japan does not suffer from a simultaneous balance of payment deficit. (p. 114) Of course, the debt-to-GDP ratio cannot grow indefinitely; at some point there will be a break.

Katz points out that Japan’s problem is not the size of the debt. Citing the example of the USA and UK he argues that Japan’s level of debt is same as that of these other countries, yet the financial markets in these countries did not revolt fro they were presumed to be temporary results of the war. But in Japan’s case, the mounting public debt is not the cause of Japan’s problems but symptom, caused primarily by falling tax revenues ina weak economy as well as the need to pump up deficits to avoid depression. Katz points out that without fast growth in the private sector that improves the tax base; there is no solution to the budget dilemma. (p. 114)

Japan’s monetary policy, liquidity trap, and deflation

Katz believes that Japan is fighting a deflationary spiral, but there is no deflationary spiral. Though there is deflation, i.e. a slow decline in prices. But there is no deflationary spiral. Japan’s deflation is quite mild. The Gross Domestic Product (GDP) deflator has been falling about 1.5 percent to 2 percent since 1999. The consumer price index is falling at an even milder, 0.5 percent rate. In the U.S., by the way, wholesale prices fell 2.6 percent last year; yet, the economy is in recovery. The key point is this; while weak demand is causing prices to fall in Japan, those falling prices are not, in turn, causing demand to weaken further. Deflation is a symptom of Japan’s problems, not their cause. Deflation does have some side-effects, but these marginal in the overall economic picture.

There are those who claim that the BOJ could cure deflation any time it wanted to–simply by creating more money. They argue that hiking in money supply growth directly leads to faster inflation while tightening money directly slows inflation. But this cannot be the whole story. In reality, the data from Japan show that the ability of monetary ease to engender price hikes depends on the state of the real economy. In normal periods when Japan was operating around full capacity, such as 1977-90, faster money supply growth did indeed lead to faster inflation. That’s because easy money stimulated demand beyond the capacity of the economy to respond. So, monetary stimulus accelerated both real growth and inflation.

During 1977-90, using statistical regressions, we can explain about half of the ups and downs of inflation just by looking at money supply growth. However, if we also factor in real GDP growth and import prices, we can explain almost 90 percent of the variance in inflation.

The situation changed in the early 1990s, when the economy started operating far below capacity. From 1991 onward, once GDP growth is held constant, faster money growth had no independent power to accelerate inflation. What influenced inflation most was growth in real GDP? Holding other factors constant, each 1 percent rise or fall in GDP was followed eight quarters later by a 0.25 rise or fall in inflation/deflation. Money supply growth was statistically insignificant.

Contrary to the advocates of “inflation targeting”, it was not inflation that produced growth, but growth that produced inflation. It did so because growth narrowed the demand-supply gap. This does not mean that monetary policy was irrelevant. What it does mean is that, to the extent that monetary ease promoted inflation in the last decade, it did so only via its power to raise real GDP growth. Unfortunately, the monetary arsenal has just about run out of bullets. Interest rates are already at zero. Besides, a company with 30 percent excess capacity is not going to borrow to build more just because interest rates are low or just because there’s some inflation. The BOJ’s power to create inflation is most impotent just when the “inflationists” say it is most needed. The fact is that over the last three years, the BOJ has created new money, the so-called “monetary base” at record rates. The problem is that neither the broader money supply nor prices are responding in the normal fashion. Like any central bank, the BOJ has direct control only over the monetary base. Normally, this base is multiplied through the banking system into the broader money supply known as M2 plus Certificates of Deposit. The latter reflects not just the BOJ’s willing to provide money, but the economy’s need for it. In the 1980s, as is normal, the monetary base and the broad money supply grew in tandem, and prices rose. But today, despite record money-printing by the BOJ, bank loans are falling, money supply is limping along, and prices are dropping. If Japan wants to address weak demand, and its symptom deflation, it needs to start with a combination of consumer tax cuts, continued monetary ease to finance those cuts, and resolute action on the bank debt front. Recent Japanese history has shown that, if you put money in people’s pockets via tax cuts, they will spend.

The limits to export-led recovery for Japan

In 1973-77 and again in 1980-85, Japan intended to use rising trade surplus to propel about 40% of Japan’s GDP growth. But after that episode Japan’s trade surplus never came close to a 4% of GDP mark. In 2001, despite a relatively cheap yen, the merchandise surplus was the lowest in eighteen years. Japan was never again successful in expanding the surplus to solve its problems. the flexibility of Japanese labor power that, combined with industrial policies, enabled a series of export-oriented industrial restructurings that helped power the country’s relatively rapid growth until 1990. These restructurings each involved a strategic shift of the economy’s industrial-export core toward newer sectors and a large-scale “scrapping” (and movement offshore) of previous core activities. The 1960s shift from light-manufactured exports toward heavy and chemical industries was thus followed by the scrapping of the latter in favor of machinery production (especially automobiles, advanced consumer electronics, and office machines) in the mid to late 1970s.

Subsequently, in the late 1980s, competitive pressures from the rising value of the yen led to a significant movement of machinery production offshore. This third round of “scrap-and-build,” like earlier rounds, featured the imposition of significant downward “adjustments” in wages and work conditions. The main difference from earlier rounds was the third round’s failure to build a new domestic industrial core that could provide an adequate basis for continued growth of output and employment. Attempts to focus domestic production on the most technologically advanced consumer and capital goods were not successful in this regard—although this outcome was fully revealed only with the end of the bubble economy. The failure to find sufficient productive outlets for Japan’s investable resources was thus manifested not only in the sequence of bubble and stagnation but also in the overall hollowing-out of Japanese industry, as the country’s total manufacturing employment fell from 15.7 million workers in 1992, to 14.6 million in 1995, and roughly 13 million by 2001.

Though some economists believe that Japan can expand its exports as much as it wants Katz does not believe so. If the economies of all the countries are slowing down, they will not buy Japanese exported goods even if the yen is somewhat cheaper.

Katz compares the Japan with South Korea. In 1998, when both the countries strove for export-led recoveries, Japan’s trade surplus was $73 billion, not quite twice Korea’s surplus of $42 billion. Together they accounted for 13 of their GDP, whereas that of Japan was only 2%. With only half the burden on the world’s absorption capacity, Korea obtained double the growth.

Katz clearly argues that “Quite aside from any protectionism, the pure economics of the situation veto Japan’s efforts.” (p. 139)

According to Katz one of the major hurdles is the hollowing out of Japan’s most powerful export industries. To the extent that people want to buy Japanese cars or TVs or machine tools, they increasingly buy from factories outside on Japan. Hance, a given yen level no longer packs as much punch.

Besides the yen depreciation that helps factories in the home islands hurts Japanese owned factories overseas, creating mixed emotions among big export houses. There is a growing conflict of interest between the needs of Japan’s home islands and the needes of big multinationals. Squaring the circle is getting tougher.

Further, Japan’s incapability to control yen rates has made the surplus problem worse. Though Japan promises to bring down the yen but it also implies that the Japanese stocks too will drop by the same rate. And consequently American securities will rise by the same ratio. Then why shouldn’t Japan just sell it stocks? Katz says, that if stock market were still a domestic affair a weakening yen would not lead to falling share prices. But with globalization, foreign investors account for up to half of all trades. They have become key factor. When they loose confidence in Japan, or when they expect the yen to drop, they sell Japan – and the market tumbles. Starting in the late 1990s, stock prices and the yen began moving tandem. From 1996 through mid-2002, there was a 43% correlation between monthly ups and downs of the yen. The exchange-rate-based analyses add an essential international dimension to any perspective on Japan’s stagnation decade. Despite their inadequate explanation of the bubble economy, they effectively highlight the importance of exports for Japan’s continued growth up to the 1990s. They also draw attention to the conflictive, unsustainable character of Japan’s export-led growth, in particular its dependence on the willingness of the United States and Europe to accept growing trade deficits with Japan. Thus, Katz concludes that Japan’s efforts to boosts the recovery engine through a trade surplus expansion is not plausible.

Globalization, imports, foreign direct investment, and financial integration as remedies for Japan’s structural problems

Katz believes the key to Japanese reform is globalization. He puts forward three reasons fro this:

  • Global experience suggests that wherever reform has been a success globalization, which is an increase in competing imports and foreign direct investment (FDI), has been indispensable.
  • Katz argues as inadequate globalization is one of Japan’s major problems, increased globalization, must be the core of its solution.
  • The politics involved in reform becomes much easier with globalization. (p.147)

In Japan, Katz observes that some progress has been made in terms of FDI and financial integration. Katz argues that countries which are more open, i.e. with a greater trade to GDP ratio and more inward FDI grow faster. The reason behind this is competition and economies of scale breed faster productivity growth. Katz points out that increased FDI was the key to the market growth in countries like China, Poland and India. Financial integration is critical because it increases the odds that money will be allocated according to its most efficient use, not outdated ties. The foreign presence in Japan’s stock market has made it harder for banks to cover up their NPL problems with stock price manipulation.

Globalization is resisted by some in Japan by putting the Asian calamity o f1997098. Though Katz argues that crisis was “90% unnecessary” which was a “result of tragic and correctable policy errors rather than either globalization per se or internal structural flaws (as in Japan).” (p. 149)

Katz believes that the most difficult times for regulated financial regimes is when they start reforming, as was the case of Japan’s bubble economy. From this some take the easy way out of not deregulating. Katz strictly believes that is wrong. He believes the proper sequencing of the reform process is the key to success.

Japan’s weakness was a major contributor to the 1997 financial meltdown in Asia, which, in turn, provoked the scariest global financial crisis in decades. For one thing, Japan’s recession led to a 15-percent cut in its imports from Asia between mid-1997 and mid-1998. Added to that was the weak yen. Convinced in 1995 that economic stagnation posed a threat to the Japanese banking system, the U.S. Treasury helped Tokyo weaken the yen to stimulate Japanese exports. The collateral damage was a steep drop in the export earnings of countries such as South Korea that directly compete with Japan. Finally, due to their own shaky finances, Japanese banks were less willing than others to partially write-off and/or roll over short-term loans. Japanese banks withdrew half of their loans to Asia from mid-1997 to the end of 1999, twice the 22% withdrawal by U.S. and European banks. Japan’s malaise did not cause Asia’s catastrophe but did make it significantly worse.

Japan’s recession led to a 15-percent cut in its imports from Asia between mid-1997 and mid-1998. Added to that was the in 2000 China slapped a 100% tariff on Japanese imports of cars, air conditioners, mobile phones; etc after Japan restricted increasing imports from China as well as other Asian countries.

In a host of countries, globalization has proven to be a major ally of reform. Imports and FDI act as a battering ram against cartels and protective regulations. Reformers in Japan have often used U.S. pressure to create changes that Japan’s one-party state could not achieve on its own. Until recently, even reformers in Japan commonly failed to see imports and FDI as an ally. That is beginning to change.

Japan’s bank-led financial system and deregulation and reform following the “Big Bang”

Japan also needs to balance its bank-dominated financial system with stronger capital markets. It has made some progress in this area in recent years, especially thanks to the foreign-asset managers who were unleashed by the “Big Bang” reforms in 1998. But Japan’s cash-rich corporations remain largely immune to market discipline, and there are no strong capital markets to force them to return their excess cash to households, where it could be spent or invested in better companies. In the 1950s, Japanese households held a majority of the country’s stocks. But in the 1960s, Tokyo began encouraging corporate cross-shareholding to fend off foreign acquisitions. As a result, Japan’s households today own only a fifth of all shares. Meanwhile, foreigners have upped their ownership of Japanese shares to a quarter of the total, sparking talk of increased shareholder power. But most Japanese corporations have rebuffed pleas to pay dividends comparable to those in the United States or Europe. And little corporate governance reform has been conducted. Most outside directors on Japan’s corporate boards still come from the firms’ own banks, insurers, or allies.

In addition, Japan’s recent economic recovery remains severely unbalanced. Business investment has accounted for a record 40% of GDP growth since 2002. But investment cannot grow several times faster than GDP indefinitely. A rising trade surplus, aided by the weakest price-adjusted yen since 1985, has supplied 38% of growth since 2002. That cannot continue either. By contrast, Japanese consumption has lagged, due in part to a surge of low-paid “irregular workers”, who now represent an unprecedented one-third of Japan’s labor force. Near-zero interest rates on savings and the fact that total price-adjusted compensation for all workers was only two percent higher in late 2006 than it was in 1997 have hurt the incomes of Japan’s consumers. Despite lower unemployment, which usually boosts real wages, pay per worker fell again in 2006 in real terms. Consumers have accrued some additional income from temporary tax cuts and government payments such as social security. But Tokyo is now rescinding these tax cuts, hiking pension and health-care premiums, and cutting benefits. To get by, Japanese households have had to lower their savings rate from 10% in 1996 to 3% in 2005. Almost 25 percent of all households now have no savings left, up from 8% a decade ago.

Financial deregulation and low interest rate policies are viewed as deliberate attempts to delay deeper reforms. Katz thus argues that after the 1985 Plaza Accord, “Which sent the yen soaring” and “cut off the trade surplus route to growth,” Japanese authorities “responded by artificially pumping up real estate, stocks and capital investment.” Katz, on his part, blames the growth of corporate surpluses on the overregulation and overprotection of less advanced sectors and firms. Together with the inflexible employment arrangements in core corporations (which inhibited any reallocation of labor), such government restraints are said to have prevented the channeling of corporate surpluses toward productive investments in the less advanced sectors. Meanwhile, the protection of inefficient producers fostered “excess savings” among households by raising the prices of consumer goods and services compared to a more market-friendly regime. In this way, Katz blames both the bubble economy and Japan’s “demand-side problem” on the same anti-market institutions that have (in his view) created a “deformed dual economy” in Japan.

The idealized and epicyclical nature of the conservative narratives is clear from their treatment of financial deregulation as a poor substitute for “real” reforms and from their simultaneous appeal to overregulation and excess competition as key weak points of the Japanese system.

Corporate reform and competition policy and indicators of progress

Japan’s dilemma is that the obstacles to growth are woven into the very fabric of the nation’s political economy. Decades of corporate collusion and protective regulations have steadily eaten away at productivity, limiting potential economic growth to around one percent a year, even at full capacity. Worse yet, Japan cannot even come close to full capacity despite enormous budget deficits and zero interest rates, because high prices suppress real household income and therefore consumer purchasing power.

Until the 1990s, “peaceful coexistence” between growth and Japan’s structural flaws was possible. That is no longer the case. Japan’s average annual growth since the spring of 1997 has been a negligible 0.3%. Manufacturing output is 10% below its 1991 peak. In a dramatic reversal, Japan’s share of both global output and exports is shrinking for the first time in a century.

In the recent years the Japanese reform process has underwent a satisfactory change. Much of the success can be attributed to corporate reform and competition policy that Japan adopted. Improved economic expectations and financial-market conditions have finally released pent-up investment demand. While Japan’s capital-output ratio remains high, years of underinvestment have made the capital stock anti­quated and aided corporate balance sheets. The net growth in capital stock has been low, since old capital is being retired at record rates. A financial accelerator has generated a two-way improve­ment in corporate balance sheets and equity prices. The inflow of funds from those abroad who viewed Japan as underweight (and a way to play into China) has also driven up the stock market. Therefore both bank capital and borrower creditworthiness have improved, while inter­est rates have stayed low, combining to stoke investment demand. Corporate governance has begun to shift toward tighter control of managerial abuse of free cash and even occa­sionally to contests for corporate control.

The current strong recovery emerged – and has a chance to be ongoing – because the Japanese government got out of the economy’s way and did something to recapitalize the banking system. Tales about the Japanese system’s structural decline are unnecessary to explain Japan’s Great Recession, because most of the structural problems today are the same as those always present in postwar Japan, and economic production has not changed fundamentally.

Anemic competition at home leads to atrophy. In food processing, for example, productivity is one-third of U.S. levels. Yet, more people work in food processing than in the automotive and steel industries combined. All anecdotal evidence, however, is in the direction of structural improvements over the last 20 years, which should raise productivity. These improvements are partial even within sectors and do not represent the kind of structural transforma­tion and rebirth that some commentators like Katz on the Japanese econ­omy have deemed a prerequisite for sustained recovery in the absence of fiscal stimulus.7 These structural improvements are nonetheless positive steps and should be taken into account when assessing Japan’s potential growth rate. A short list includes financial deregulation (albeit initially mismanaged when drawn out), energy price deregulation, retail restructuring, and entry of international competition in some areas.

Katz believes that Japan cannot gain greater competitiveness without more competition. And yet the Ministry of Economy, Trade, and Industry and the Japan Fair Trade Commission are backsliding on competition policy. Both have encouraged these oligopoly-strengthening corporate mergers. The JFTC has even loosened the criteria for judging monopolistic bargaining power. Officials say that economies of scale are the key to competitiveness. Although that claim was true back in the 1950s and 1960s, today’s competitive pressure is the dividing line between the dark and bright sides of the dual economy.

Labor market rigidities, tax code distortions, and electoral bias and possible reforms to alleviate them

The financial weakness of SOEs destabilized the macroeconomy by increasing money creation through three channels. The first channel is the monetization of the growing state budget deficits caused by declining financial contributions from the SOE sector. SOEs paid income taxes that amounted to 19.1 percent of GDP in 1978, 6.6 percent in 1985 and 1.7 percent in 1993; and they remitted gross profits of 19.1 percent, 0.5 percent and 0.1 percent respectively. The second channel for money creation is the financing of mounting SOE losses by bank loans. The third channel is the disbursement of investment loans to the SOEs to make up for their shortage of internal funds to finance capacity expansion and technical upgrading. Direct state involvement in decision-making at the firm level has a negative effect on performance; on the other hand, firms will not openly reject state involvement as they still rely on state actors to ease resource constraints of China’s regulated markets. Because market transition creates conditions of decreasing resource dependence on the state, politicized capitalism is inherently in disequilibrium. Where private firms compete in open markets, entrepreneurs prefer to be free of the communist party. A tipping point is reached when a critical mass of entrepreneurs no longer depends on state-controlled resources, and growing reliance on tax revenues contributed by private enterprises reinforces incentives for government to make resource allocation decisions based on assessment of their effects on local economic performance and on their prospects for career mobility.

Following the privatization of small and middle-sized state-owned enterprises in the early 2000s, local governments are less involved in influencing economic decisions within the firm as they attempt to improve the business environment to attract entrepreneurs and investments to their region. It is not too far of a stretch to imagine that reformers might eventually want to include in their ambitious reform agenda a national commitment to constructing a modern polity wherein open electoral politics moves China beyond an out-dated communist party dictatorship. It would take such a reform for China to move decisively beyond politicized capitalism to emerge as a mature East Asian developmental state, where the state and its bureaucrats operate within the framework of an independent legal system, which guarantees clear and distinct state firm boundaries where private actors are shielded against arbitrary state interference.

State involvement is further exacerbated through the persistence of politicized vertical command structures within the firm. While the official policy-line was to encourage a complete separation of government and business functions (zhengqi fenkai) to support a rationalization of the economic sphere7, the reforms in actuality revealed a high degree of ambivalence and inconsistency. In spite of the official propaganda, which claims to constrain the state’s role to a normal shareholder without any priority rights to interfere into the firm’s organization and governance, China’s new company legislation reveals a more ambivalent position towards depoliticizing the former SOE. To begin with, Article 14, Company Law, still calls for a supervision of enterprises by the government and social masses. Inevitably, this claim may create conflicts with the intended enterprise independence. Even more serious deficits of the official depoliticization strategy result

from the continuing influence of the “three old political committees,” i.e. party committee, labor committee and trade union, placed within the firm. Despite the creation of new organizational and governance structures, such as shareholders’ meeting, board of directors and supervisory committee alongside the position of the CEO, the old political organs were not abolished. Instead, the Company Law guarantees and regulates their future involvement and responsibilities. Although the “old three” lost a large amount of their inherited coordination and control rights, their survival invites a continuation of political involvement in the firm’s decisions. Particularly their long tradition as central political bodies within the firm provides fertile grounds for continuing informal involvement.

The reasons for reform in China in 1978

China is both a developing economy and a transitional market economy. Financial development in China reflects the influence of both these contexts. Economic development is generally accompanied by a gradual process of financial deepening. The ratio of various financial assets to GDP increases steadily with development. Transition to a market economy from a planned socialist economy is also expected to lead eventually to financial deepening, but for most European transitional economies, this process was not unidirectional. In many European transitional economies, economic transition was preceded or accompanied by substantial inflation that wiped out accumulated financial balances. Many households lost their life savings.

In those countries, transition took place in the context of a major disintermediation process: in Russia, broad money declined from 80% to only 20% of GDP between 1990 and 1993, and bank credit to enterprises and households declined from 40% to about 16%. At the same time, economic disruption caused a decline in current saving. Saving by government and enterprises collapsed, and households were unable or unwilling to increase saving rapidly.

The growth accounting exercise is based on the three sectors – primary, secondary (industry and construction) and tertiary – as defined by Chinese statistics. Labor reallocation is singled out for attention because the bulk of the Chinese labor force is peasant farmers, a third of whom lived below the absolute poverty line in 1978. Naughton has argued that this “surplus labor” feature has made China’s transition from centrally planning fundamentally different from the transition of Central and Eastern Europe and the former Soviet Union (CEEFSU). Specifically, they argued that the marketization of a centrally-planned economy means normal economic development for China but structural adjustment for a CEEFSU country. The intersectoral shift of labor (away from agriculture) increases aggregate output when the marginal product of labor (MPL) in the primary sector is lower than the respective MPLs in the secondary and service sectors. There could have been further refinements to the preceding decomposition formula but the absence of data prevented them. Net TFP could have been decomposed further; for example, to get the contribution from the inter-sectoral shift of capital and the contribution from change in ownership structure. But both of these contributions would require making bold assumptions; the first would require knowledge about the sectoral distribution of capital, and the second would require knowledge on the distribution of capital and labor by ownership in each sector.

The growth accounting exercise is conducted for the entire 1979-1993 period and for two sub periods, 1979-84 and 1985-93. The delineation of the sub periods correspond, one, to the policy regime change toward accelerating reforms in the nonagricultural sectors, and, two, to the emergence of industry as the undisputed primary engine of growth. The growth performance of the 1985-93 sub periods may be a better guide (than that of the entire period) to understanding the future growth prospects of China. This is because future Chinese growth is likely to be led by the agricultural sectors as in the 1985-93 periods.

Major elements of China’s first-phase reforms through the early 1990s

Financial systems had to be rebuilt from the ground up. In China, national saving was high before, during and after reform. However, the composition and institutions of saving changed dramatically. Government saving, as in most transitional economies, has dropped sharply, in response to the deteriorating financial position of state-owned enterprises. However, household saving has increased very rapidly in response to the new opportunities created by transition. Total household saving—including both in-kind and financial saving—jumped rapidly from 7% of household income in 1978 to 17% in 1982, and have continued to increase steadily since.1 Even more crucially, financial saving tripled, increasing from 2.3% of household income in 1978, to an average of 6.8% in the years 1980-83.. As of 1995, households were generating 70% of domestic saving, over 25% of GDP.

In response to these changes in saving behavior, China’s financial system began to diverge from the standard command economy model, and resemble that of most market economies. Saving surpluses in the household sector were transferred primarily through the banking system to fund investment in the enterprise and government sectors. The banking system has been fundamentally transformed. M2 increased from 32% of GDP in 1978 to 112% in 1996. By this measure, since 1992, China has had a “deeper” financial system than any other major transition economy. Changes in household balances were the largest part of financial deepening, as household saving deposits increased from 6% to 57% of GDP between 1978 and 1996.

During this period, China has put in place the basic administrative structures that govern a modern financial system. The People’s Bank of China (PBC) was made into a central bank, with the potential to control lending and monetary aggregates through reserve requirements and central bank lending. The beginnings of competition were introduced into the banking system. Stock markets were established in Shanghai and Shenzhen in 1990, and enterprises were given authority to issue various kinds of stocks and bonds. Government bonds of various sorts have been issued since 1981, with Treasury bonds making up the bulk of issuances. During 1996, important steps were taken with the government bond market. The Ministry of Finance designated fifty authorized bond traders in an attempt to begin marketizing the primary issuance of securities. The Ministry also began issuing Treasury notes of less than one year maturity, and the PBC launched open market operations on April 9, 1996.

FFEs account for less than 9 percentage points of output growth in 1985-93, their effect on economy-wide TFP is small even if there is significant direct TFP growth in FFE production. FFEs’ contribution to economy-wide TFP is increased to the extent that competition with FFEs and emulation of FFEs’ management practices by domestic firms increase their efficiency. This externality is likely to be small. The international trade sector has increased from 10 percent of GNP in 1978 to 36 percent in 1993. This unusually high trade/GDP ratio reflected the tremendous explosion of processing and assembly operations attracted by cheap Chinese labor. The international trade sector has created positive TFP growth by moving labor from low-productivity agriculture to higher-productivity industrial production. Given the large pool of low-cost unskilled rural labor, the positive TFP rate from labor re-allocation is sustainable in the medium run.

Major elements of China’s second-phase reforms since the early 1990s

For a period after 1990—when the stock exchanges in Shanghai and Shenzhen were established—capital market development proceeded rapidly. But after 1993, development slowed markedly, and the atmosphere shifted from one of financial permissiveness to a renewed stress on control and regulation. As we shall see, that slow-down was intimately related to shortcomings in the existing financial system. Figure 2 shows the development of the Chinese stock exchanges, relative to GDP, as well as several comparison economies. At the end of 1995, government bonds (including treasury bonds and all other

government-backed investment bonds) amounted to 6% of GDP, also virtually unchanged since 1992. There had even been a contraction in the stock of enterprise bonds outstanding, which peaked in 1992. Between 1992 and 1996, then, the incipient growth of China’s capital markets was drastically slowed, while the real economy—and the banking system—continued to grow. As a result, as of 1996, the financial system still displayed the same fundamental characteristics that have marked its development since the beginning of reform: it is a system that has undergone very substantial financial deepening, but in which virtually all of the deepening has been channeled into the banking system. It is a bank dominated system, and the growth of competition to the state-owned banking system has been real, but much too slow.

Despite these achievements, the development of capital markets in China has not been impressive to date. This is somewhat ironic, given the attention that has been paid to China’s nascent stock markets as symbols of capitalism. However, it is indisputable that, at least if we limit our attention to formally recognized and regulated institutions, the development of capital markets has been much less steady, and much less impressive than the growth of the banking system. There was very little capital market development during the 1980s. For a period after 1990—when the stock exchanges in Shanghai and Shenzhen were established—capital market development proceeded rapidly. But after 1993, development slowed markedly, and the atmosphere shifted from one of financial permissiveness to a renewed stress on control and regulation. As we shall see, that slow-down was intimately related to shortcomings in the existing financial system. Figure 2 shows the development of the Chinese stock exchanges, relative to GDP, as well as several comparison economies.

At the end of 1995, government bonds (including treasury bonds and all other government-backed investment bonds) amounted to 6% of GDP, also virtually unchanged since 1992. There had even been a contraction in the stock of enterprise bonds outstanding, which peaked in 1992. Between 1992 and 1996, then, the incipient growth of China’s capital markets was drastically slowed, while the real economy—and the banking system—continued to grow.

As a result, as of 1996, the financial system still displayed the same fundamental characteristics that have marked its development since the beginning of reform: it is a system that has undergone very substantial financial deepening, but in which virtually all of the deepening has been channeled into the banking system. It is a bank dominated system, and the growth of competition to the state-owned banking system has been real, but much too slow. However, there is one important caveat to this generalization. Informal financial markets in China are large and important, and little studied. At the “bottom”, informal rural credit mechanisms—including credit clubs, money lenders and unregistered private banks—are very significant. In a recent court case, it was decided that private money-lenders were not usurious so long as interest rates were not more than four times officially regulated lending rates. According to the best available estimates, rural informal financial markets surpassed formal rural institutional lending in size in 1986.

Moving up a level on the scale of enterprise size, many firms have issued various kinds of promissory notes and stocks. Since 1992, the central government has attempted to regularize the hitherto chaotic form of joint stock corporations, and created a new registry of joint-stock corporations. By the end of June 1994, there were 5,964 registered corporations (compared to only a couple hundred firms listed on the stock exchanges). But fully 62.5% of the registered capital of these corporations was held by the government and or by government subsidiary entities. Finally, government statistics on fixed investment reveal that “other” financial sources of investment (outside of bank lending, government funds, or private or enterprise retained funds) equal about 4% of GDP annually, about half as much as formal bank lending. These funds are generally intermediated by local government officials or entities set up under their control. Thus, there is a large amount of financial intermediation occurring in China which is captured very imperfectly—or not at all—by officially reported statistics.

Property rights in China, migration and the urban-rural divide; trends in per capita consumption, living standards, and urban-rural differences

Before 1978, China was one of the poorest countries in the world with 60 percent of the one billion people living below poverty, earning less than $1 per day. Almost all of the poor were in the agricultural sector, which provided livelihoods to nearly 75 percent of the total population. Since 1978, the world has seen a different China—a China with an economy growing consistently at red-hot speed. The growth started in 1978 with the implementation of the household responsibility system and was later fueled by the development of rural township village enterprises.

Agriculture, however, which was a clear leader in reform, is now lagging behind other sectors. China’s rural economy faces many serious challenges. The gains of economic growth have not been fairly shared between urban and rural residents. Many parts of the agricultural and rural sector remain underdeveloped. Rural residents confront tremendous barriers when they enter the non-farm sector and find jobs in cities. Women assume a disproportionate share of those rural residents who have to rely on agricultural production for a living. Land holdings are so small that farming cannot raise enough income for most rural households. The improvement of agricultural productivity is further hindered by the lack of well-functioning credit, land rental, and insurance markets. Managing the post reform rural development needs to change the role and organization of the government. Establishing efficient governance at the local and regional levels while increasing accountability, however, remains a major challenge.

Patterns of economic growth in China since 1978 and the changing sectoral composition of China’s output since then; rural and urban labor market changes

China’s economic performance since economic reforms were initiated in late 1978 has been truly impressive. GDP grew 9.3 percent annually in the 1979-93 period: per capita net income of farmers increased by 239 percent, and the per capita income of urban households increased by 152 percent.2 The incidence of absolute poverty declined dramatically in the rural area, from 33 percent in 1978 to 12 percent in 1990. This achievement must count as one of the most successful poverty alleviation programs in the twentieth century.

China’s economic growth can be divided into two analytical phases by their sources of growth. The first phase is the 1979-84 period where the agricultural sector was an important contributor to growth. Comprehensive liberalization of the primary sector was initiated at the end of 1978 by expanding the use of agricultural markets, and de-collectivizing agriculture. Some production incentives (notably, profit-retention and bonus) were introduced for some classes of secondary and tertiary activities during the first phase of reform. The average annual growth rate for the 1979-84 periods was 8.8%. Agriculture and industry made almost equal contribution to the output expansion, 32 percentage points and 34 percentage points respectively.

Economic growth came with a rush to the countryside after 1978 with the dismantling of the commune system, the raising of the purchase prices for grain, and the legalization of free markets for many agriculture products. Rural income jumped 17.6% in 1979, and income growth stayed at the two-digit level until 1985. The dynamic growth of rural income ended in 1985 when income grew only 4%. The average annual rural income growth rate was 2.6% in the 1985-94 period compared to the average growth rate of 15 percent in the 1979-84 periods.

The course of rural income growth is largely the result of the sharp rise in grain yield in the 1979-84 periods and the stagnation in grain yield from 1985 onward. The evidence suggests that yield growth was artificially suppressed in the pre-1978 period by the chaos of the Cultural Revolution that lasted from 1966 to 1977. When economic liberalization of the agriculture sector occurred at the end of 1978, there was a one-time gain in production efficiency, raising the growth in grain yield to 5.7% from the 3.1% of the preceding twelve years. The drop in grain yield after 1984 was across the board; rice yield growth dropped from 5.1% to 1.3% from 1985 onward, and wheat yield growth dropped from 8% to 2%. The troubling aspect is that yield growth in the 1985-94 periods is lower than in the 1966-77 periods. One reason why yield growth is lower now may lie in the reduced amount of rural infrastructure investment since 1979. Real public capital construction is lower in 1994 than in 1978, and this has been true for every year since 1980.

China’s demographic trends, and the effects of the One-Child Policy

China’s family planning policy has prevented 400 million births. The phrase one-child policy is commonly used in English to refer to the population control policy (or Planned Birth policy) of the People’s Republic of China (PRC). Since the regulations were introduced in 1979, China has kept its population in check using persuasion, coercion and encouragement.

The Chinese government introduced the policy in 1979 to alleviate the social and environmental problems of China. The policy is controversial both within and outside China because of the issues it raises; because of the manner in which the policy has been implemented; and because of concerns about negative economic and social consequences. The rising demographics trend in China has made the economy more robust for labor intensive production, but such demographic pressure may derail the wheel of growth. Naughton believes that this is a mistake and will result in a number of serious demographic problems in the future.

Change in rural China: evolving agriculture, the development and eventual privatization of TVEs

These rural enterprises first appeared in the 1950s, but it was only in the Deng era that they multiplied. After reform, commune and brigade owned enterprises were reclassified as township and village enterprises (TVEs), but the development and dramatic growth of the TVEs can only be understood in the context of China’s transition strategy. TVEs are viewed as a natural response to a strategy of transition that first liberalized the product markets, without liberalizing factor markets (Naughton). TVEs gave rural communities (townships and villages) the ability to transform control over assets into income in the “absence of asset markets.” This could be done without resorting to privatization. And the profits of those enterprises could then be used for the benefit of the entire community. These local government units also facilitated the channeling of funds (mostly from households) in the absence of a well functioning banking system.

Though the proliferation of the TVEs was to a large extent a reaction to China’s transition strategy, it was only made possible by the pre-reform existing conditions. In contrast to the Soviet-type model that favored centralization and specialization at the “country” level, the Maoist view of local self-sufficiency resulted in substantial decentralization and specialization at the province and local level. Only 6% of Chinese industrial enterprises could be classified as large or medium scale prior to the market reforms, while seventy-eight percent of Chinese enterprises were small scale, labor-intensive collectives controlled by local governments. Also, decisions concerning distribution of resources and products were made on a multi-tiered level, with the central government delegating authority to regional and local governments.

Moreover, the difficulty in the implementation of central planning in China fostered relationships between township enterprises and SOEs early on, which helps explain the rapid development of township enterprises (Hua, Zhang and Luo, 1993), and the subsequent expansion of subcontracting ties between SOEs and TVEs.

Economic reforms further favored TVEs. State monopoly of several economic sectors (such as manufacturing) was relaxed and barriers to entry removed, enabling TVEs to engage in activities previously denied to them (Naughton, 1994a). Local governments were given greater powers and more incentives to develop local market economies based on private or collective ownership. Collectives became the main source of local revenues, forging a mutual dependence between local enterprises and local governments. This “partnership” effectively energized and enabled the local firms and collectives to compete against large SOEs for resources and markets. Also, of special significance was the reform of foreign trade and its subsequent decentralization to provincial and local level. This measure led to the “internationalization of the countryside” (Zweig, 1990) and resulted in dramatic increases in TVEs’ exports.

Most studies have concluded that the TVE sector is more efficient than the SOE sector (Woo et al., 1994; Chen et. al, 1992). Tian (1997) suggests that TVEs and other non-state owned enterprises allocate inputs more efficiently than state-owned enterprises. Using data for the 1979-91 period, Weitzman and Xu (1984) found that TVEs’ total factor productivity grew three times as fast as the corresponding SOEs’. The following, in addition to higher flexibility and autonomy, have been identified as advantages of the TVEs: shorter information channels between principals and agents, greater focus on financial objectives (lower costs), harder budget constraints, and special ties with the state sector (Jefferson and Rawski, 1994).

Some attribute the economic success of the TVEs to advantages that stem from their peculiar “internal institutional form” which facilitates cooperation through implicit contracts among community members locked into an ongoing relationship (Weitzman and Xu, 1994; Nee, 1992). It has been suggested that it is the interaction of these enterprises with the whole community through a “set of interlocking financial, administrative, personnel, and other ties” (Byrd, 1990), the existence of a strong “cooperative culture” (Weitzman and Xu, 1994), that is behind their success. Undoubtedly, local government sponsorship brings certain advantages such as privileged access to capital and coordination with urban firms. On the other hand, these special ties between government, community, and TVEs usually result in a “redistribution of income.”15

Others instead (Naughton, 1994a) emphasize the external conditions to which TVEs are an effective adaptation. Zhang et al. (1994) attribute the “rural enterprise boom,”16 of which TVEs are a major part, to the existence of barriers to factor mobility, price distortions and the abundant labor in the rural areas. Their study shows that exports contributed to rural enterprises growth.

China’s SOE privatization: groundwork in the first reform period and implementation in the second

The Chinese economic reforms have made a conscious effort to protect the character of public ownership of the economy. Instead of privatizing the SOEs, the government attempted to create a more competitive environment for the enterprises, expecting that competition would lead to efficiency improvement in the state sector. To achieve this end, it has offered profit incentives to SOEs and encouraged the growth of the non-state sector, which is composed of: (1) collectively owned enterprises; (2) township and village owned enterprises; (3) private enterprises and (4) joint venture enterprises. It is worth emphasizing that the non-state sector includes more than private enterprises. A majority of the enterprises in the non-state sector are collectively owned, and the allocation of the property rights within them is also vague and problematic. However, between non-SOEs and SOEs there is one crucial distinction: the non-SOEs face relatively hard budget constraints. Therefore they are sensitive to price-cost conditions and motivated to improve operation efficiency.

During the economic reforms, the non-state sector has experienced significant growth: its output share rose to 66% in 1995 from 22% in 1978. This growth record can be attributed to the competitive advantages of non-SOEs over SOEs: the collectivelyowned, township and village-owned and private enterprises have lower costs, especially lower labor costs,21 and joint venture enterprises produce output with better quality.22 As the extent of their comparative advantages varies from one industry to another, so does their market share in different industries. The growth of non-SOEs is affected by such determinants as the presence of resource constraints, the scarcity of capital, and the prospect of profit, etc. It is especially noteworthy that the growth of non-SOEs is inversely related to the efficiency level of SOEs: non-SOEs capture large market shares where state sector’s productivity lags behind the industry average. Increasing competition from the non-state sector has driven down product prices and eroded industry profitability.24 Its impact on other enterprise behavior, such as the wage and employment decisions, however, is not as unambiguous.

It depends on the adjustment processes of wages and employment within the enterprises. When maximizing utility is the main enterprise objective, it can be shown that the responses of wage rate and employment to price movements are indeterminate.25 Although they are likely to move in the same direction as product price and enterprise profit, their magnitudes depend critically on how profit, wage rate and employment enter the utility function, and on the specification of the production function. When management attaches more importance to workers’ welfare than to profit, it may be tempted to keep wage rate as high as possible and employment as large as possible at the expense of profit. Therefore even at a time of declining profit, the enterprise may not adjust wages downward rapidly to the market level and to eliminate labor redundancy aggressively.

This situation seems especially plausible when the enterprise is under soft budget constraints and can expect governmental support in financial difficulties, which reduces its sensitivity to its own profitability. It also seems to be consistent with the observations of Chinese SOEs that have made little effort to actively lower labor costs even when experiencing financial difficulties.26

Because of its potential weak effect on wages and size of employment under soft budget constraints, competition may fall short of enhancing productivity in the short run. With increasing competition, enterprises are likely to see their market shares shrink and product elasticity increased, which is likely to lead to output reduction. Without conscious effort to improve their operational efficiency, such as eliminating labor redundancy and adopting least-cost practice, competition may in fact precipitate falls in labor productivity and total factor productivity in SOEs. Thus, the impact of competition on productivity may be ambiguous for SOEs under soft budget constraints.

As a result of these ambiguities, the actual impact of soft budget constraints on enterprise behavior and performance can only be ascertained by empirical evidence. The second focus of this paper is to study how competition has affected wages, employment and productivity of SOEs. The hypotheses are: given that the enterprises are not sensitive to efficiency when under soft budget constraints, competition may not be effective in (1) curbing wage rate, (2) restraining the wage share in enterprise income, or (3) improving labor and total factor productivity.

Energy sources and uses in China; energy intensity in production; implications of energy and technology policy for growth

In China, due to rapid economic growth, total primary energy consumption increased from 400 Mtoe in 1978 to nearly 1320 Mtoe in 2004, with an annual average rate of increase of 4.7% (China Energy Year Book 2002-2003, 2004; China Year Book 2004, 2004). Coal is the major energy source, providing 70.7% in 1978 and 69% in 2004 of total primary energy use. Recent years have witnessed a dramatic surge in the rate of increase of energy use in China and widespread energy shortages. The major reason for surge increase of energy demand in China is rapid extension of energy intensive production. For example, steel output increased from 131million ton in 2000 to 297million ton in 2004. This is similar for other energy intensive products. China is the largest coal-producing and -consuming country in the world. Between 1980 and 2004, total raw coal output increased from 620 Mt to more than 1900 Mt, with an average annual growth rate of 4.8% per year.

Prior to 2000, the share of coal use in total energy use decreased, but it increased again from 66% in 2000 to 72% in 2004. The heavy dependence on coal has led to serious environmental problems and represents a burden for the transportation system. Power shortage appeared after 2002 is a key driving force for very large newly installed capacity in China in recently years. It is reported there were 24 provinces (all together China has 31 provinces, not including Taiwan, Hong Kong and Macao) suffered from power shortage in 2004 during summer time. Energy efficiency improvement and energy conservation are given high priority in the energy development strategy in China, as is the efficient and clean use of coal and other fossil energy sources. The objective of developing clean coal technology is to improve coal utilization efficiency, to reduce environmental pollution and to promote economic development. High efficiency and clean technology will be crucial for China to achieve a low-emission development path.

China’s institutional settings and policies have played a crucial role in shaping China’s energy system. Chinese institutions and policies have been very responsive to short-term energy needs but do not necessarily support effective long-term strategies. Some institutional changes and policies displayed conflicting and perverse effects from a long-term perspective. Incremental adjustments in policy implementation during the transition from a planned economy to a market economy reduced the risk of serious mistakes in policy making and implementation, but distorted market signals in energy production, distribution, and utilization activities. The coordination issues among government agencies and between local and central governments in China have always been complicated and challenging, limiting the efficiency of policy implementation in China’s energy sector. Development, environment, and security concerns in the 1990s encouraged policies to promote cleaner and more efficient use of energy, with particular attention to the use of coal and the development of oil, natural gas, and electric power. This shift has led to a number of strategic changes and policies. However, a lack of detailed implementation rules and targets, an ineffective monitoring system, and a lack of proper regulatory or market-based policies to create a favorable condition for the commercialization of clean and efficient energy technologies have reduced the effectiveness of these policies.


According to Naughton, Chinese growth has been due to increased privatization and diversification and reached its peak in the years 2004-2007. During that period, the entire world economy grew and “China played an important role in this global process.” Looking forward, however, Naughton emphasized that China’s economic fate is aligned with that of the United States. In addition, Naughton noted that the endless supply of low-wage rural labor was beginning to dry up. Further, the Chinese economic leadership shows signs of uncertainty, in part due to the fact that there are more politicians and fewer technocrats among new state council members. Moreover, signs suggest that trade surpluses will likely level off. And Katz found out that in case of Japan, the need lies in globalization which can bring the country to true economic growth.


Katz, Richard. Japanese Phoenix: The Long Road to Economic Revival. Armonk, New York: M.E. Sharpe, 2003.

Naughton, Barry. The Chinese Economy: Transitions and Growth. Cambridge, MA: The MIT Press, 2007.

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