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December 1, 2009

How China Won and Russia Lost

Two dissimilar economic paths


On a dark November night in 1978, 18 Chinese peasants from Xiaogang village in Anhui province secretly divided communal land to be farmed by individual families, who would keep what was left over after meeting state quotas. Such a division was illegal and highly dangerous, but the peasants felt the risks were worth it. The timing is significant for our story. The peasants took action one month before the “reform” congress of the party was announced. Thus, without fanfare, began economic reform, as spontaneous land division spread to other villages. One farmer said, “When one family’s chicken catches the pest, the whole village catches it. When one village has it, the whole county will be infected.”

Ten years later, in August of 1988, Mikhail Gorbachev lifted his nation’s 50-year-old prohibition against private farming, offering 50-year leases to farm families who would subsequently work off of contracts with the state. Few accepted the offer; Russian farmers were too accustomed to the dreary but steady life on the state or collective farm. Thus began reform of agriculture in Soviet Russia.

The results in each country could not have been more different. Chronically depressed Chinese agriculture began to blossom, not only for grain but for all crops. As farmers brought their crops to the city by bicycle or bus, long food lines began to dwindle and then disappear. The state grocery monopoly ended in less than one year. Soviet Russian agriculture continued to stagnate despite massive state subsidies. Citizens of a superpower again had to bear the indignity of sugar rations.

As farmers brought their crops to the city by bicycle or bus, long food lines began to dwindle and then disappear.

These two examples point to the proper narrative of reform in Gorbachev’s Russia and Deng Xiaoping’s China. Our narrative contradicts much received doctrine. The standard account is that China succeeded because a wise party leadership deliberately chose gradualism, retained the monopoly of the Communist Party after rebuffing democracy at Tiananmen Square, and carefully guided the process over the years. The narrative says that Russia failed because the tempestuous Gorbachev ignored the Chinese reform model, moved too quickly, and allowed the party monopoly to fall apart. This standard account is incorrect. Deng Xiaoping and his supporters, contrary to popular legend, did not agree on a reform program at the Third Plenum of the Eighth Party Congress in 1978, which installed him in power. A Chinese reform official by the name of Bao Tong later admitted as much: “In fact, reform wasn’t discussed. Reform wasn’t listed on the agenda, nor was it mentioned in the work reports.”1

Throughout the reform process, the Chinese Communist Party simply reacted to (and wisely did not oppose) bottom-up reform initiatives that emanated largely from the rural population. Deng Xiaoping’s famous description of Chinese reform as “fording the river by feeling for the stones” is not incorrect, but it was the Chinese people who placed the stones under his feet.

Mikhail Gorbachev became general secretary of his party in March of 1985. By that time, he knew that the Chinese reforms were successful. His reforms, contrary to the popular narrative, closely mimicked China’s. He proposed to lease land to peasants, establish free trade zones, promote small cooperative businesses, and set up joint ventures. The difference was that Gorbachev imposed these changes from above, on an urban economy in which virtually all citizens worked for the state. Gorbachev’s reforms either were ignored or they were enacted with perverse consequences. Bottom-up reforms worked in China; top-down reforms failed in Russia.

Both countries began serious reform after the passing of a leader (or leadership) that abhorred reform. Deng Xiaoping and his allies succeeded Mao in 1978 after a brief power struggle with hardliners. Gorbachev succeeded the initial beneficiaries of Stalin’s purges of the 1930s, who rose quickly as young men to replace those who were executed. The forgettable Konstantin Chernenko was the last in line; there was no choice but to turn to a relative newcomer when he died. For Gorbachev, the horrors of the Stalin era were in the distant past. For Deng Xiaoping and his supporters, the excesses of Mao — the starvation of the Great Leap and the “reeducations” of the Cultural Revolution — were recent and personal experiences. Whereas Stalin had physically annihilated independent-minded party officials, Mao permitted them to survive, subsequently to take over after he was gone. Gorbachev worked his way up the party ladder as a typical apparatchik; although touted as a reformer, he had few reform ideas. His Politburo and Central Committee comrades had no real stomach for reform. Deng Xiaoping also had not worked out a reform program, but he knew enough not to oppose reforms that work (“I don’t care if it is a black or yellow cat as long as it catches mice”).

Real reforms, whether dictated from the top or bubbling up from below, require a reform constituency. In the Chinese case, a large percentage of the population was recovering from the catastrophes of the Mao years. Rural dwellers, in particular, had witnessed the chaos of the Great Leap and had seen their parents and children die from starvation during the 1958–61 famine. They learned they had to take care of themselves. The urban elite had been ripped from the cities to a life of work and reeducation in the countryside during the Cultural Revolution, and a whole generation had been deprived of schooling. In the Russian case, the last famine lay three decades in the past. After the war, few people were executed for political crimes (political dissent became instead a mental disorder); the Gulag had been gradually dismantled after Nikita Khrushchev’s secret speech of 1956. All lived under the motto, “We pretend to work and you pretend to pay.”2 Surveys show that Russians were basically content with the system, comfortable in the bosom of their state enterprise or state farm.3 China had a reform constituency; Russia did not. Gorbachev had few reform-minded aides. He listened to the bad advice of his economists. He was opposed by an entrenched bureaucracy but supported by enterprise managers eager to cash in on ill-conceived reform.

Agriculture

Both chinese and Soviet Russian agriculture were collectivized by force. In Russia, the forced collectivization and dekulakization campaigns of 1929–31 set off a civil war in the countryside that was brutally repressed. The more prosperous farm families were either imprisoned or exiled, leaving behind dispirited peasants herded into collective farms strictly controlled by rural political bureaus and machine tractor stations. Agriculture had to dance to Moscow’s tune. In China, the land was first taken away from land owners between 1950 and 1953 following rural purges that cost between 2 million and 5 million lives. The land reform distributed plots to farmers for use but not ownership, despite resistance of the peasantry. Between 1950 and 1951 alone, 712,000 people were executed, 1,290,000 imprisoned, and 1,200,000 sent to labor camps.4

Despite observing the catastrophe of Russian collectivization, Mao forced his peasants into huge communes starting in 1958. All property, sometimes including furniture and even knives and forks, became communal. In both cases, collective farms had to deliver farm products to the state at the very low prices it dictated. They had to obey harebrained directives from Moscow or Beijing, such as massive switching to corn, planting grain on land suited for fruits, or halting the production of “decadent” tea. Although intermittent efforts were made to suppress private plots in both countries, private plots kept farm families alive and provided some meat and dairy products, fruits and vegetables, to the cities, which were peddled by peasants on street corners.

Both Deng Xiaoping and Gorbachev inherited nonproductive collective agricultures. Soviet Russia’s farm sector had sunk to such depths that a traditional grain exporter was now importing grain from Australia and America. By Gorbachev’s time, the farm population had shrunk to a quarter of its former size; only older workers remained, working perfunctorily on state land or tending their private plots. They had long been converted into wage workers and received pensions and socialized medical care, albeit of a low quality. In China, rural dwellers accounted for 80 percent of the population; compared to Russian farmers they were young and vibrant. They lived without the social guarantees of Russian farmers. In China, only the young had not experienced private agriculture. Small private plots had existed in China for 2,000 years. An elderly farmer in Jingshan village succinctly captured this historical memory: “Family farming is as natural as human desire to eat, to have sex, and to love grandchildren. We loved family farming because it gave us some freedom. The leaders thought they knew better how to live our lives. But it is our lives, isn’t it?”5 In Russia, few farm dwellers could even remember the last experiment with private agriculture in the 1920s.

The deal that Gorbachev offered his farmers in 1988 was that they could have their own plots of land with 50-year leases from the state. His offer was a “contracting system” whereby land leasers would deliver quotas to the state but could keep what was left over. He had virtually no takers. Russian farmers were embedded in state agriculture, from which they could “take” seed, fertilizer, and tools under the principle “they belong to everyone and hence to no one.” Chinese farmers were not made such a generous offer. Instead they began to quietly distribute the land, with each family delivering production for the state quota. Gorbachev called for decollectivization from above; China’s farmers decollectivized spontaneously from below. They created their own “contract responsibility system,” initially at risk of severe punishment. There were no leaders; there were no face-to-face confrontations. It just happened. As agricultural production soared, Deng Xiaoping and his party realized they could not resist and could take advantage of something that was working. By 1982, more than 90 percent of rural dwellers were engaged in the household production system. Even after Deng Xiaoping officially supported grassroots rural reform, he did not give farmers long-term commitments, as did Gorbachev. Farmers were given one- to three-year contracts in 1982. It was only in 2003 that the state gave long-term leases in its Rural Land Contracting Law.

Entrepreneurs

The spontaneous creation of an agricultural contract system meant new supplies of agricultural products that needed to make their way to a market that still had to be created. Again Russia’s and China’s paths diverged in the reform of trade.

At the time Deng Xiaoping and Gorbachev came to power, domestic trade was dominated by state trading networks. Russia had largely outgrown rationing, although Russians had to stand in line for specific products, particularly alcohol. There existed a small “nonstate” trade network. Farmers were allowed to sell products from their private plots, and a thriving “second economy” provided goods and services that the planned economy did not. Because they operated in the shadows, it is difficult to compare respective magnitudes, but we do know that Russia’s shadow economy was well-developed. If Russian citizens wanted an experienced doctor, a car repaired, or color television, they turned to the black market. China was even more lacking in markets. Consumers received coupons for different types of goods and stood in long lines for each rationed product. In Wuhan, Hubei Province (where one of us lived for 30 years), there were more than 80 types of ration coupons for items like soap, cooking oil, meat, eggs, fish, tofu, grain, watches, bikes, furniture, and matches. At least in Russia, consumers could buy without coupons; the price was standing in line or getting scarce goods through “connections.”

Gorbachev, dissatisfied with the status quo, initiated reforms to expand markets and private trade. His reform failed. Deng Xiaoping was presented with an unsanctioned market by Chinese traders as a fait accompli. All he had to do was legalize it after its success was obvious. With millions of farmers selling, competition drove prices down to reasonable levels for urban consumers.

At the time Deng Xiaoping and Gorbachev came to power, domestic trade was dominated by state trading networks.

Gorbachev saw Russia’s shadow economy as an asset he could build upon. His May 1987 Law on Cooperatives was designed to legalize many activities that had been illegal. The new cooperatives could use property and own equipment, and they could sell at market prices; the main restriction was that they could not employ hired labor. The first “New Russian” wealth was, in fact, a product of the cooperatives.

Gorbachev hoped that the cooperatives would be the source of entrepreneurship. Following the May 1987 decree, cooperatives formed right and left, many within state enterprises, others under the auspices of social organizations. The cooperative law indeed brought the shadow economy out into the open. Its unanticipated consequence, however, was that cooperators added little to consumer welfare. Instead, they took advantage of loopholes offered by the planned economy to redistribute profits from the state sector into their own pockets. Cooperatives were formed within state enterprises under the guise of “small business”; they commandeered materials from state enterprises at low prices and then sold the output at high “cooperative” prices. They used influence to buy and then resell scarce foreign goods by bribing trade officials. A typical cooperator was a former kgb officer (known to one of us), who used his connections to buy personal computers at low prices from a state trading company and then resold them to consumers, all under the “roof” of the Academy of Sciences. He went on to become a respected deputy in parliament. Like this former kgb officer, the New Russians, spawned by cooperative laws, provided Russians with their first bitter taste of “capitalism,” which Russians subsequently associated with illicit gains (and still do to this day).

Another stark contrast should be emphasized: The Russian “entrepreneurs” of the cooperative movement were primarily city dwellers. Russian farmers, who rejected Gorbachev’s agricultural reforms, were not players. They did not produce goods that needed to be transported and marketed. China’s first entrepreneurs hailed primarily from the countryside, and they got their start by marketing farm products in the cities.

Private trade developed in China at the grassroots level, emerging from rural regions and prospering because it filled a vital need. The rural contract responsibility system created huge agricultural surpluses which had to be marketed outside the state system. Farm products had to be moved over long distances, either directly or through intermediaries — in violation of laws and without contracts that could be enforced in courts. A herculean task. But it was done by the tens and then hundreds of thousands of entrepreneurs pushing the frontier of what was allowed. In effect, Chinese farmer-trader-entrepreneurs had to create completely new institutions for transporting and selling agricultural products. Once in place, they could be used to do the same for other goods and services. These initial entrepreneurs were not beneficiaries of state reform. Instead, they had to find ways to destroy socialist institutional barriers and create markets. The Chinese entrepreneur had to juggle profits and security. For most, a mistake meant confiscation, a jail sentence, or worse.6 The entrepreneur, operating in the grey area of legality, had no access to state capital. The state banks refused to serve any private businesses until June of 1988 and even then with tight restrictions.

China’s early trader-entrepreneurs had to first overcome the problem of distance between producers and consumers. Since the late 1940s, the state regarded long-distance trade as a speculative, capitalist activity and branded those involved as criminals. In the early 1960s, such traders were labeled as “bad elements.” Some lost their jobs or were sent to labor camps while others were put on neighborhood watch lists to be supervised closely. Even in the late 1970s and early 1980s, the sight of policemen chasing and confiscating a rural peddler’s goods was common.7 One Chinese entrepreneur compared his early business ventures to an untrained acrobat walking a tightrope: “I was excited about the huge market opportunities while scared to death of returning to a prison cell. I lived a life of constant sweat, sleepless nights, and thumping heartbeats.”8 Throughout the early 1980s, farmers in north Jiangsu packed their bikes with chickens, ducks, and other fowl, crossed the Yangzi River, and shipped their products by rail to urban centers in the Yangzi basin. “A million roosters cross the mighty Yangzi” was the expression of the day.9 By 1983, the majority of consumers in major cities purchased their products in free markets rather than in government stores. Within one year (between 1979 and 1980), most state vegetable markets, except the highly subsidized Beijing and Shanghai markets, were out of business.

Most of China’s early entrepreneurs had farming backgrounds or, at a minimum, were from farm families.

The creation of a vast market in farm products was only the start. Once one institution was created, others had to follow. Private traders operated without permission to travel and could not stay in state-run hotels. Thus, entrepreneurs developed a network of private hotels. Remarkable stories of hardy entrepreneurs providing goods and services not available from the state economy abound: A rural minority woman from Hunan began her business by buying shoes in major cities and selling them in her hometown, Baojing. She had to leave her three children behind during her one- or two-month journeys. She lived frugally and invested in building new houses. When returning from her mountain sales trips, she bought herbs, mushrooms and other local goods and resold them in county markets. After a decade of hard work and helping her children get college degrees, she settled down and collected rent every month from the six houses she had built over the years. She is one of the nouveau riche in her hometown.

Most of China’s early entrepreneurs had farming backgrounds or, at a minimum, were from farm families. The richest Chinese citizen in 2007 was the daughter of a poor farmer from the southern province of Guangdong, whose family became wealthy after acquiring large tracts of land and distressed assets in the countryside, where there was no real estate business, in the early 1990s. In the mid-1990s, her father developed affordable townhouses and holiday homes for China’s growing middle class.10 Other rural entrepreneurs did not make their way into a top ten list, but their success stories are equally striking. After their release from the communes in the early 1980s, rural entrepreneurs left their villages to establish restaurants, laundries, and small manufacturing businesses in major cities. Friends and relatives followed, as explained by a Wenzhou entrepreneur: “My neighbor set up a small laundry shop in Shanghai and made some money. My brothers and I borrowed 80,000 Yuan from relatives and friends, plus our 21,000 Yuan in family savings. When we went to Shanghai in 1995, we found out that there were already too many shops of this kind. This is why we turned to dry cleaning.” Like entrepreneurs elsewhere, Chinese private entrepreneurs set up their businesses through the three Fs (friends, family, and fools).

Corruption served as an unexpected weapon of entrepreneurs, without which they could not have navigated the narrow channel separating success from prison. Entrepreneurs had to “wear a red hat” (register a family business as a part of a formal legal organization), set up their businesses as sham collective enterprises, or find “big shots” or “mothers-in-law” to serve as patrons to give them protection. Without such cover, they could not issue receipts, keep books, pay taxes, write contracts, or open bank accounts. Many rural private businesses could not have survived the tax burden on private companies without such devices. Two farmers in a village of Fujian Province set up a packaging factory. Everyone in the village knew that the factory belonged to them but the factory was officially a village collective. By using the collective’s name, the private village factory paid lower taxes and even received low-interest loans. After paying 5,000 Yuan in “management fees” to the village head and another 1,000 to the township government, the village factory went about its business unhampered.

The success of China’s entrepreneurs in creating the institutions of private markets is told by some remarkable statistics. In 1978, state enterprises generated about 80 percent of China’s gdp, while the rural commune produced the other 20 percent.11 There were no private businesses. By 1997, there were 961,000 private enterprises and 28.5 million small family private firms. By 2002, the nonstate sector’s share exceeded two-thirds of gdp, with the share produced by truly private companies comprising more than half. By 2004, there were more than three million private companies employing more than 47 million workers.12 Before 1980, entrepreneurial activity in China was illegal. Today, there are over 40 million entrepreneurs, whose businesses employ over 200 million and generate two-thirds of industrial output. The state had no choice but to accept the reality of burgeoning farmers’ markets and private trade. The improvement in product quality and the disappearance of long food lines convinced urban residents, as well as government leaders, of the power of grassroots entrepreneurial activities. The state could not curtail such activities without inflaming the entire populace, although it periodically tried. In 1988, the government made it theoretically legal to own private businesses but in practice imposed strict controls over private urban markets, including steep fees to regulate them.

Private business originated in agriculture, spread to the cities, and then returned to the countryside as rural-based industry. Many large private manufacturing firms developed in predominantly agricultural provinces (Zhejiang, Shandong, Guangdong, Hunan, and Sichuan). China’s largest agribusiness, the Hoep Group, was founded by the Liu brothers, who left the city to found their company in a rural part of Sichuan province. Wang Guoduan, a rural entrepreneur from southern Guangdong province, built the largest refrigerator maker, Kelon Group; Huanyuan, China’s largest air conditioner maker, is based in the agricultural province of Hunan. China’s first automobile exports will likely come “from the agricultural hinterland of Anhui province, where Chery is located.”13 Rural Wenzhou entrepreneurs provide capital and consumer goods to the cities, and their private capital financed its airports and highways.

Globalization and fdi

Let us now turn to the two countries’ quite different experiences with respect to international trade. Both China and Russia began from the same starting point. Each had a strict system of centralized controls exercised by a foreign trade monopoly. Both Mao and Stalin believed in self-reliance and were reluctant to depend on other countries. Soviet Russia had carved out a trading bloc of communist states in Eastern Europe, which limited reliance on the West. Both countries missed out on the huge postwar expansion of trade as they turned inward.

China’s success in attracting foreign capital and know-how and selling manufactured products in foreign markets is well documented, and the steady hand of Deng Xiaoping and his successors in promoting Chinese globalization cannot be denied. Opening an economy to world markets is not something that can be done from below. China’s leaders were not without a model. They could not but notice the remarkable transformations of the nearby Four Tigers of Southeast Asia. China’s entry into the global marketplace dates to 1980, when the first free trade zones were established, bordering Hong Kong territory. The rest is history. In 1978, China’s trade accounted for less than 1 percent of the world economy. China is now the world’s third-largest trading nation with 6 percent of world trade. China’s economy is more dependent on trade than even Japan’s and South Korea’s.

Gorbachev could not help but be impressed by China’s successes in international markets. The globalization of the Russian economy was to serve as a centerpiece of his reform program. Gorbachev’s January 1987 joint venture law (accompanied by proposals for free trade zones) mimicked the Chinese laws of a few years earlier and for good reason. By the time he took office, China was attracting the largest amount of foreign direct investment of any emerging market country. Gorbachev hoped that opening Russia would make reform painless. In his first years in office, he anticipated an “acceleration” of output based upon the utilization of new technologies largely acquired from Western partners.14

Both China and Russia had a common communist past and both had abundant human resources. Russia was initially better off because of its trained scientists and engineers. Gorbachev threw open the doors to Russia but no one came, contrary to the Chinese experience. This puzzle is easily explained, but it makes the Chinese success even more intriguing.

Why did Russia fail in attracting foreign direct investment? Western investors had to cast a dubious eye on investments in Russia. Only a few Russians had experience in world markets, and they had all worked for the foreign trade monopoly. There was no one who could credibly explain to foreign business what would happen if contracts were violated, how investments could be secured in the absence of private property laws, or how these investments were to be integrated into what was still a planned economy. Western concerns were being asked to make huge infrastructure investments in energy in the absence of any law on subsoil resources. There was simply no credible intermediary to stand between Russia’s desire for foreign investment and the willingness of the West to risk its capital in Russia.

Russia lacked a Russian Diaspora. A few Russians had emigrated to the United States and Israel. But China had a “Greater China” that numbered in the millions of Chinese in Hong Kong, Taiwan, Macau, Southeast Asia, and North America. These “Greater Chinese,” especially in Hong Kong and Taiwan, still had roots on the mainland. They had demonstrated their business acumen, and they understood the potential of a low-wage country with abundant human resources strategically situated in the heart of booming Southeast Asia. These Greater Chinese intermediaries could explain to investors how to invest and with whom. Who could be trusted? Who could not? Which government officials are reliable? Equally important, these intermediaries were successful and had business and property outside of China that could be used as collateral for doubting foreign investors.

The largest number of overseas Chinese, most of whom were refugees from China, resided in Hong Kong and Taiwan, and China’s first lesson in global exchange was from nearby Hong Kong. Before communist rule, the inhabitants of the capital of Guangdong (adjacent to Hong Kong), were considered city slickers, while Hong Kong was full of country bumpkins. As Hong Kong surged, several million Guangdongese escaped to Hong Kong, where they participated in its economic miracle. Friends and families lined up in long queues in Guangzhou to receive hand-me-downs from their Hong Kong friends and relatives. Young urban women wanted to marry only men with overseas family relations.15 When the Chinese government first set up Special Economic Zones in Shenzhen (near Hong Kong), Zhuhai (near Macau), Shantou (the hometown of Hong Kong refugees), and Xiemen (near Taiwan), the Chinese borrowed their new rules and regulations directly from Hong Kong. Guangdong entrepreneurs copied the Hong Kong model of “Front Shop, Back Factory,” while others set up joint factories together with Hong Kong small business owners. Using family and cultural ties, Hong Kong cousins were able to overcome red tape. Hong Kong business tycoon Gordon Wu (a Princeton graduate) built the first toll expressway linking Guangzhou to Hong Kong by promising to cede it to the Chinese government after 15 years. Hong Kong, with the largest container port in Asia, provided both hard and soft infrastructure for China. It was through Hong Kong that Chinese goods first reached global markets. Taiwanese investors began to flood into China in the early 1990s, circumventing a ban on business with China by going through Hong Kong. They used China for manufacturing bases to contend with increasing world competition. By 2004, Taiwanese investment comprised close to three percent of China’s gdp. In 2001, the Chinese state itself took a giant step towards further globalization by becoming a member of the World Trade Organization (wto). wto membership gave China incentives to be a responsible global trade partner.16

State-owned enterprises

Gorbachev inherited an economy in which virtually the entire citizenry worked for the state. State-owned enterprises (soes) dominated industry, trade, and even agriculture. The notorious collective farms had been de facto converted to state farms. In China, the majority of citizens did not work for the state when Deng Xiaoping took over. They worked instead for collective farms, which had to meet delivery quotas. If things went bad, there was no state bailout. They were on their own. In Soviet Russia, proposals for reforming soes had been floated since the early 1960s. In Mao’s China, the “word ‘reform’ wasn’t even in the vocabulary of state leaders.”17 Despite these different backgrounds, Gorbachev and Deng Xiaoping devised very similar reforms of soes with similarly poor results. Gorbachev incorporated earlier reform ideas in his Law on Enterprises of July 1987. Deng Xiaoping and Zhao Ziyang initiated an urban contract responsibility in 1984 based on the success of rural reform, as Deng Xiaoping decided “to apply the rural experience to urban economic system reforms.”18

In both countries, soes formed the core of the planned “commanding heights” of heavy industry, defense, transportation, and finance. They could not be turned over to private owners without destroying both the planning system and the socialist foundation of society. Insofar as soe production was integrated into a national plan, they could not be allowed to fail. Instead, they operated under “soft budgets” under which their losses were automatically covered. They were managed by powerful ministries, regional officials, and party leaders; they employed millions of relatively pampered workers who depended upon them for wages and benefits. All of these formed a powerful interest group against meaningful reform, or to turn reform perversely in their favor. Gorbachev had no choice but to address the problem of soes from day one of his reforms. China’s leaders could afford to postpone dealing with their soes.

Gorbachev inherited an economy in which virtually the entire citizenry worked for the state.

In both cases, the remedy applied was to reduce the tutelage over soes, give them more decision-making authority, and provide incentives to operate their enterprises more efficiently. In spite of their different settings and backgrounds, both reforms did the same things: soes were still required to deliver planned outputs to the planning system but they could keep above-plan output, which they could sell at higher prices. Managers and employees could retain more profits for bonuses and investment. They could increasingly buy inputs and sell outputs through “direct links” with other soes. In both cases, planners fixed the prices of goods that went through the planning system, which were exchanged among soes. Thus, the same product (say, steel) could be bought and sold at two or more prices, the lowest one being the state official price.

Unwittingly, both Russia’s and China’s soe reforms created a “perfect rent generating machine.”19  In both countries, managers set up small businesses and cooperatives within their factories, which they used to strip state assets. They diverted production from the planned to the cooperative sector where they could sell at higher prices. Easy profits were made by buying inputs (often from oneself) at fixed state prices, diverting them to cooperative production, and then selling at much higher prices.

The remedy to such blatant rent-seeking and corruption in both countries was a tough bankruptcy law. Gorbachev’s 1987 enterprise law actually required soes to cover their costs; there were to be no bailouts, supposedly. But there were no bankruptcies. Unprofitable state enterprises argued that closing them would put restive workers on the streets and would deprive the state of essential production. Bailouts continued unabated. In 1986, the Chinese government under Zhao Zhiyang and Deng Xiaoping introduced a bankruptcy law, which mobilized vested interests to remove reform-minded leaders like Hu Yaobang and Zhao Zhiyang (both party secretaries). When the state again started to force bankruptcies in 1998 and 1999, local government officials sold assets (mostly for real estate) to rapacious ex-officials and politically linked private companies for their own use.

The failure of the enterprise law produced catastrophic results in Russia. Planned production collapsed, soes refused to supply each other, and the planned economy ceased to function for all practical purposes.20 Unlike in China, where hardliners still had the power to undermine reform, Gorbachev retained the power to push his reform through. He even went so far as to break up the party bureaus that oversaw the economy, prompting an abortive coup by hardliners. In December of 1991, the ussr split up into 15 separate republics that began their own independent reforms.

China’s SOEs continued to operate inefficiently and corruptly, but they did not cause China’s economy to collapse.

China’s soes continued to operate inefficiently and corruptly, but they did not cause China’s economy to collapse as they did Russia’s. Technically insolvent soes continue to be bailed out. Although the state sector currently accounts for a third of gdp, more than 70 percent of state bank loans go to soes. Despite their decreasing share of the economy, soes continue to control most natural resources, including land, mineral deposits, forest, and water resources. They are a major source of corruption. According to one estimate, rent seeking and official profiteering take between 20 and 30 percent of China’s gdp.21

How can China thrive with such inefficient and corrupt soes? China’s fabled growth is the combination of the high growth of agriculture, private business, and international companies with the slower growth of the state sector. Moreover, China’s soes are probably not as inefficient. In Russia, there were no benchmarks for soes. In China, soes coexist with joint ventures and foreign banks, and they face competition from private businesses encroaching on their markets. Joint ventures provide yardsticks to measure soe performance. In 2006, labor productivity in foreign-invested enterprise was nine times that of other companies (primarily soes).22

The strength of the rest of the economy has given China’s leadership breathing room to experiment with remedies, such as restructuring SOEs into conglomerates (something Gorbachev tried without success), setting up shareholding companies, and creating stock markets in Shenzhen and Shanghai to raise capital for key state factories. The soe problem is also solving itself through attrition. The number of soes fell from 118,000 in 1995 to 27,477 in 2005.23 Since 1996, soe employment declined by 44 million jobs, more than half of which were in manufacturing. Part of this attrition is simply due to corruption as managers “spontaneously privatized” soes by diverting their assets into their own pockets.

Lessons for the present

China and russia in the 1980s offer a unique case study in why some reforms work and others do not. The contrast refutes the notion that a strong, perhaps totalitarian state, is required for successful reform. In the Russian case, a one-party state attempted to impose reform from above and failed. In China, a one-party state opened the economy but resisted grassroots reforms, which it grudgingly accepted after their success could no longer be denied. For decades, a small group of Russian liberals lobbied in vain for reform. They finally got their chance when a reform-minded party leader was elected, but there was no real constituency for reform. In China, there was a massive grassroots constituency which clearly understood reform’s potential benefits. They acted quietly on their own, according to the Chinese saying, “Do more but say less; do everything but say nothing.” The Chinese rural population, as outsiders, had nothing to lose. With more than 80 percent of Chinese people pushing for change, reform could not help but penetrate the social and economic psychology of the Chinese mind.

Bottom-up reform cannot be resisted because it requires no negotiations, avoids confrontations, and it spreads like an unstoppable plague. Top-down reform can be killed easily by ridding the leadership of reformers or by high-level sabotage. Chinese-style reform was made possible by special circumstances — the tradition of small private agriculture and trading, the recent catastrophes and purges, and China’s backwardness as an agricultural economy. If Chinese leaders had faced the same circumstances as Gorbachev, they would have failed as miserably. Gorbachev had to confront the insoluble problems of large state industrial enterprises; the Chinese could afford to wait and watch them shrink in relative size.

Each country’s present is affected by its past. In both cases, their initial reforms began more than a quarter century ago. China’s leaders subsequently did not change course: Each new party leader honored the policies of his predecessor. In Russia, the Soviet Communist Party was disbanded. There was a burst of democracy and market economy under Yeltsin, followed by a retreat on both fronts under Putin. Russia is now ruled by a duumvirate, one of whom has a kgb background and who reinstated a form of totalitarian rule.

The paths of China and Russia continue to diverge: China’s communist leaders watch the state-controlled commanding heights shrink. China’s entrepreneurs have built, against all odds, private manufacturing. Large state companies cannot compete against private domestic or foreign companies. They are kept alive by state subsidies and preferences, but there may come a day when this is no longer the case. Russia’s corporate giants are direct descendants from Soviet enterprises; none have been built from the ground up. They were privatized to urban, politically connected insiders under Yeltsin. Most stripped assets, but some began to create shareholder value after then-President Vladimir Putin promised them secure property rights. In a fateful reversal, Putin concluded that the commanding heights belonged to the state, and Russia’s large companies were renationalized. Those that remain in private hands do so with the understanding that they serve state interests, not those of shareholders.

Each country seems to have learned the wrong lesson from the other — China that political reform will destroy the Communist Party and Russia that only a strong authoritarian leader can make reform succeed. China’s ruling party continues to resist political change. Putin and Medvedev continue to strengthen authoritarian control.

Both Russia’s and China’s histories reveal that politically-operated and state-owned enterprises cannot compete. Russia’s current leaders are compounding their problems as they take control of more and more of the industrial economy. These new Russian soes face little or no competition. Russia’s new leaders have driven out foreign ventures, and private entrepreneurs would face physical danger if they encroached on their markets. It’s likely that Russia’s giants — Gazprom, Lukoil, Rosneft, and the like — will become even more inefficient and operate for political rather than economic gain.

China’s leaders face an interesting dilemma, the resolution of which will affect their future. Starting in 2001, the Communist party began to co-opt business leaders into the party-state network. As members of the party-state elite, China’s entrepreneurs gained the opportunity to earn profits by using connections rather than entrepreneurship. In 2007, the party and state passed China’s first property law, which legalized private property. How this law will be enforced remains to be seen, but it represents a key step towards creating a rule of law in place of political arbitrariness. China’s entrepreneurs face a choice: Will they compete as entrepreneurs in the even playing field of a rule of law, or will they become like party apparatchiks, using their party status to gain “unearned” profits? If they choose the latter, they will kill the competitive goose that lays the golden eggs. The result could be a China that falls into a stagnant oligarchy like that of Russia. Napoleon once said, “Let China sleep, for when she wakes, she will shake the world.” It depends which China will awake — a nation of entrepreneurs or oligarchic party officials.


Paul Gregory is the Cullen Distinguished Professor of Economics at the University of Houston and a research fellow at the Hoover Institution, Stanford University. Kate Zhou is Professor of Chinese Political Economy and Comparative Politics at the University of Hawaii. She is the author of How the Farmers Changed China (Westview, 1996) and China’s Long March to Freedom, Grassroots Modernization (Transaction, 2009).


1 Bao Tong, “A Pivotal Moment for China,” Radio Free America’s Mandarin Service (December 12, 2008), available at http://newsblaze.com/story/20090106100021zzzz.nb/topstory.html.

2 Mikhail Gorbachev, Perestroika: New Thinking for Our Country and the World (Harper and Row, 1987), 19.

3 Michael Ellman and Vladimir Kontorovich, The Destruction of the Soviet Economic System: An Insiders’ History (M.E. Sharpe, 1998), xxi–xxiv.

4 Xinwen wubao, “The New China’s Oppression Campaign against Counter-reactionaries,” China.com (2006).

5 Kate Zhou, interview with Chu Bo, farmer in Tongxi village (February 1986).

6 Keming Yang, “Double entrepreneurship in China’s economic reform: An analytical framework,”  Journal of Political and Military Sociology  (Summer 2002); Douglas North, Institutions, Institutional Change, and Economic Performance (Cambridge University Press, 1990).

7 The struggle between urban police and street vendors was common in major cities. On many occasions, one of the authors personally witnessed police chasing and then beating street vendors in the early 1980s in Wuhan and Beijing (1983 to 1984).

8 Kate Zhou, interview with Mu in Beijing (July 1997).

9 Kate Zhou,  How the Farmers Changed China: Power of the People (Westview Press, 1996).

10 Robin Kwong, “China’s billionaires begin to add up,” Financial Times  (October 22, 2007).

11 Guojia Tongjiju.  Zhongguo tongji nianjian 1987 [Statistical Yearbook of China]  (Zhongguo tongji chubanshe, 1988).

12 “Private enterprises expanding quickly,” People’s Daily Online  (February 04, 2005).

13 Yasheng Huang, Capitalism with Chinese Characteristics  (Cambridge University Press, July 2008).

14 Gorbachev,  Perestroika, 19.

15 Kate Zhou, interview with Professor Ouyang in Guangzhou, (August 5, 1986).

16 Nicolas Lardy, “China Enters the World Trade Organization,”  Integrating China into the Global Economy (2002), 2.

17  Bao Tong, “A Pivotal Moment for China.”

18 Deng Xiaoping, “To Speed up Reforms,”  Selected Works of Deng Xiaoping  (People’s Press, 1988), 1444.

19 Anders Aslund,  Russia’s Capitalist Revolution: Why Market Reform Succeeded and Democracy Failed  (Peterson Institute for International Affairs, 2007), 58.

20 Paul Gregory, “Bureaucrats, Managers and Perestroika: The First Five Years. Results of Surveys of Soviet Managers and Officials,” in  The Soviet Economy Under Gorbachev  (nato, 1991), 188–202.

21 Wu Jinglian, “shichanghua congnanlai? Daonanqu?” [“Whither the Reform of Market?”] (September 12, 2008).

22 John Whalley and Xian Xin, “China’s fdi and Non-fdi Economies and the Sustainability of Future High Chinese Growth” (National Bureau of Economics, May 2006); Matt Nesvisky, “Will Super-High Chinese Growth Continue?” NBER Digest  (November 14, 2006).

23 Wayne M. Morrison, “China’s Economic Conditions,” Congressional Research Service Report to Congress (May 13, 2008).