• China at the Crossroads: Can the Communist Regime Break the Social Contract to Carry out Reform?

    by  • September 30, 1999 • 程晓农文集 • 0 Comments

    Xiaonong Cheng

    [The Article is published in Dilemmas of Reform in Jiang Zemin’s China
    (Eds. By Andrew J. Nathan, Zhaohui, Hong and Steven R. Swith. Boulder, CO: Lynne Rienner Publisher, 1999) as Chapter 7 with the title of “Breaking the Social Contract”]

    At the 15th Congress of Chinese Communist Party in September 1997, Jiang Zemin consolidated his power and appeared to be the consensus head of a collective leadership. Both inside and outside China, this “third generation of leadership” is seen as weaker and less authoritarian than its predecessor. The current conduct of the leadership, however, seems more courageous and capable than that of Deng Xiaoping, because it has dared to conduct “shock therapy” reform. In the past two decades, under Deng’s leadership, China has achieved striking economic progress in reforming state socialism, but it carried out unbalanced reform, i.e., partial marketization under communist political rule. Since the death of Deng, the government has shown its intention of altering the strategy. It has announced a radical reconstruction of the state sector which will lead to the laying off of more than thirty million workers, which even Deng, the iron-fisted leader, declined to adopt. Why does the regime now choose an obviously risky course of action that may immediately lead to social tension and political instability? Has Jiang really become stronger than Deng, or has he obtained new instruments to control the social and political situations? Can China’s economic progress under “shock therapy” help the regime retain its power over the next decade?

    Discussion of these questions requires a comprehensive understanding of the reform strategy. China’s reform over the past two decades is often considered a good example of putting economic reform ahead of political reform, in contrast to Gorbachev’s Soviet Union which gave priority to political reforms. Supported by the Chinese case, pro-authoritarian theory suggests that market reform can be successfully introduced only under an authoritarian regime and thus economic reform must precede political reform. The argument is that an authoritarian state is less dependent on popular support than a democratic state, enjoys a greater capacity to implement unpopular policies, and can thus behave as the universalistic agent to ensure efficient economic performance.

    This conventional wisdom ignores the fact that the Chinese communist regime is dependent performance legitimacy and, therefore, upon welfare oriented state-society relationship to sustain it during the period of economic reform. The Chinese strategy of reform is restrained by the state-society relationship. That strategy has not only reduced significantly the capacity of the regime to implement unpopular policies for economic efficiency, but also has exhausted almost all available financial resources and thus has shaken the legitimacy and survival of the regime. The “shock therapy” program is not a well-prepared project with a clear goal for constructing a real market economy, but an urgent response to the failures of Deng’s reform strategy.

    This essay employs the concept of a social contract that provides a clue to the relationship between reform politics and the economic situation in the past decades. Unlike an analysis based on power struggle or factionalism at the top, which may help to explain some events, this approach brings society into the analysis of reform politics, focuses on how economic reform is restrained by societal responses, and, therefore is able to offer a new explanation of the Chinese road to reform. The discussion focuses on urban reform and the interaction between state and urban society, because the decisive part of the state-society relationship in China’s polity is the one between those parties.

    The essay begins with a review of economic reform over the past two decades and employs the concept of a social contract to explain how the state-society relationship during this period has changed from “command and obedience” to “feeding and cooperation.” Following is an explanation of why this social contract sustains, as well as restrains, economic reform. Relying on the social contract, the more the authoritarian state “buys” societal support and political stability, the weaker the state is. Consequently, the social contract has exhausted its financial resources and necessitates radical reform. The essay concludes with discussion of the current reform efforts. Any further economic reform has to break the social contract, and, in turn, may damage the cooperation between urban people and the regime and undermine political stability. Solving the puzzle seems difficult for the third generation of communist leadership. Very probably, the “honeymoon” between urban society and the regime under the social contract may come to an end, and be replaced by rising social tension. Under the pressure of such tension, it is uncertain whether the government can continue economic reform of the state sector and at the same time maintain political stability.

    Reform under a Social Contract in China

    Reform in a socialist country is a process of institutional transformation, which involves redefining the interests of, and the relation between, state and society. To understand the transformation process, social scientists have tried various methods. Applying the state-centered approach, some annalists emphasize the predominance of the party-state over society, and explain the reform path mainly through the intentions and options of the policy-making elite and negotiations among them. Other annalists, adopting the society-centered approach, see the emerging civil society as an important determinant for the evolution of reform. The former may overlook the possible societal alienation from the state and the influence of popular responses on the direction of state policy, and thus overestimate the state’s capacity of realizing its policy goals. Bu contrast, the latter often give little attention to the structure of state power and decision-making, and may have difficulty in explaining when, why and how reform will take place.

    The reform process and the transormation of institutions are not simply manipulated by state, they are also shaped by society. Success or failure of a reform depends upon both the actions of state and responses of social groups. One way to better understand the possible evolution and result of the reform is to introduce interaction of state and society into analysis of the reform. The concept of a social contract borrowed from Soviet studies can be used to describe the evolution of state-society relationship in China. It is useful to explain how the political relationship between state and society helped China achieve progress in the economic reforms of the past two decades, and why the relationship finally undermined the efforts to maintain economic and political stability.

    To understand the state-society relationship in the reform era, it is necessary to know how societal actors and the state related to each other within the state socialist institutions before reform. The state-society relations of Mao Zedong’s era were “Command and Obedience.” Monopolizing all political power and economic resources and building up the people’s worship of Mao and his revolutionary ideals, the Communist Party favored loyalists and punished dissidents in continuous political campaigns; thereby the regime secured the loyalty and obedience of much of the populace. The socialist system with a “Command and Obedience” relationship strangled independent thought and creativity and allowed the rulers to act arbitrarily. Consequently it brought great waste and low efficiency in the economy and a low standard of living for the people. Since rulers could not satisfy the people with a better life, they had to suppress the masses by ideology. Maintaining such a state-society relationship, the rulers relied heavily on spiritual instruments, and citizens only came to expect the satisfaction of minimum interests. From an economic view, the obedience seemed to be at a low cost for rulers, since people’s material demands were suppressed and the rulers did not have to provide a higher standard of living for ordinary people.

    Great institutional differences could be observed between Chinese urban and rural societies. While peasants were deprived of almost every opportunity to live and work in cities without security, urban society was dominated by the public sector economy. That sector inckuded hundreds of thousands of state-owned “unit (danwei),” industrial enterprises, stores, schools, institutes of research and scholarship, in a pyramidal structure of primary sociopolitical and economic entities under strict state control. These units not only produced goods and services, but also distributed urban welfare benefits and shaped the political attitudes and the behavior of state employees. They were responsible for a wide range of “cradle-to-grave” welfare services on which state employees and their families depended. This system did not allow employees to obtain from outside the system the essentials of life—jobs, food, housing, health care, pensions. Their very survival would be in question were they to reject or even attempt to alter substantially this state of dependency. Through “organized dependency,” i.e., state employees’ economic dependency on their “units” and political dependency on party and management, the Communist party was able to force them to maintain control.

    The differences between rural and urban areas have contributed much to the patterns of reform and have led to different results in rural and urban reform. Rural reform liberated peasants from the “People’s Communes,” giving economic freedom at no cost. In this way, the government exchanged economic freedom for political support of the rural reforms with little risk for either the government or peasants.

    Urban reform was not so easy reconstruction project, not only because the “hard core” of state socialism is located in the urban areas and the majority of the urban population live in “organized dependency,” but also because urban society is politically more sensitive. The urban population receives more education and information and is more influential politically than the rural population. Urban people work in the modern sector, which sustains the daily operations of the system, and are more easily organized and, therefore, carry greater weight in determining political stability. They have been prohibited from any unofficial organized activities, but are usually treated well in terms of welfare provisions. Among the urban population, those who live in the largest cities often get special treatment because of their larger potential influence.

    Private businessmen benefit when retail trade is freed from regulation and peasants benefit from price and land reform, but neither group is politically powerful enough to promote thorough reform of the state sector. Urban reform must confront the vested interests of urban state employees. More than eighty-five percent of the urban population in the 1980s and the first half of the 1990s worked for the state sector or affiliated organizations. These are people eager to adopt a modern life style but also anxious to protect the benefits they derive from state socialism.

    Encouraged by the success of early reforms, the government decided to reform the urban economic system in 1984. The motivation was utilitarian; the government wanted partial reform without undermining the political infrastructure and power of the party. The regime never intended a thorough reform of the socialist economic system, nor an abandonment of the basic aspects of the system.

    The main thrust of reform was the transfer of management decisions from governmental departments to factories, which was intended to increase industrial efficiency as drastically as the rural reform. Decentralization would improve efficiency, but centralized management was only one of the reasons for low efficiency. Without eliminating the “soft constraints” relations between the government and state sector, efficiency might improve slightly though decentralization, while severe inflation might occur.

    Government protection of the state sector and the socialist welfare system were considered the “soft constraints.” From the purely economic point of view, these constraints should have abandoned, but for the political reasons, the government refused to withdraw protection and to reform the welfare system. Economic problems between the regime and the state employees could become political problems between the state and the people. Protection of the state sector and the welfare system are an important instrument for the government in controlling the populace and in maintaining its legitimacy.

    Though the communist regime is an authoritarian one, the imbalance between state and society appears to be favorable to society. The ability of the state to control has been weakened, without the personality cult and without terror or political mobilization. The regime has had to shift its claims to rule from teleological beliefs to an emphasis on economic benefits to the people, i.e., seeking performance legitimacy, just as the post Stalin Soviet regime did. The shift first led to intensive utilization of welfare measures to maintain political rule. These measures turned out to be more and more important as an instrument to control and influence the urban people, and political intervention became a weapon in reserve, while political repression was used only as a tool to suppress dissidents. The shift also led people’s evaluation of the regime to focus on the role of government in providing social and economic benefits for its citizens, thus shifting unconditional societal obedience to a conditional pattern.

    While the reform regime relied upon the performance legitimacy and, therefore, carried out only partial reform, this reform strategy was actually welcomed by the urban society. Urban residents are mainly employees of the state sector and their families, and they have a quite different motivation for reform from that of peasants. Rural reform was stimulated chiefly by peasants’ pursuing economic freedom, whereas urban reform has been largely motivated by materialism. Urban workers, however, had two motives. On the one hand, they want to continue their vested interests, i.e., relaxed work disciplines, frequent promotion to redundant positions and unemployment-free life in the state sector, which could only come from the old socialist system. On the other hand, they are eager to embrace new interests, i.e., higher living standards and more opportunities to make extra money, which are only available from the developing market system.

    These two expectations are not compatible, such expectations are politically useful to the regime. The government’s intentions and the people’s expectations are related. While the people worried about the risks in the reform, the regime worried about how its legitimacy might be shaken by thorough reform and the possibility of unrest when people lose their vested interests. Wanting to exchange economic benefits for political support, the government avoided talking about the losses and risks, and promised more benefits to console the people, and, in this way, encouraged their high expectations and gained their confidence. Expecting reform benefits promised by the government, the urban population kept a positive attitude toward economic reform, and became accustomed to have benefits delivered by the government.

    To carry out economic reform, the regime needs not only people’s obedience and obedience, but also their cooperation. First of all, the reform requires the creativeness of state employees in implementing policies of the government, as decentralization provided them more independence and power in decision making. Second, when labor discipline is tightened and productivity targets are increased, workers’ cooperation is necessary. Third, and most important, the government has to expect the forbearance of state employees once the reform damages their vested interests. Traditional psychological instruments such as worship of the supreme leader and propaganda about the necessity of the policies no longer work, and the goal of economic reform and modernization could never produce enough incentives to make people work harder or sacrifice for the ruling party and the state. The regime has had to appeal to economic interest to elicit people’s enthusiasm for reform and to secure their cooperation.

    Since the end of the 1970s, the state-society relationship of “Command and Obedience” has been replaced by a new pattern of “Feeding and Cooperation.” In the new pattern, the state must offer people more and more economic benefits and has to compensate for any losses produced by the reform. Thus the government seeks public cooperation and confidence in the reform, instead of simply showing severity and the people accept and support the economic and political requests of the state through cooperation, in return for obtaining economic favors from the state. The urban reform path is constrained by the state-society relationship.

    The state-society relationship in “Feeding and Cooperation” may be defined by the concept of a social contract as used in Soviet Studies. Early in the 1970s, the concept was developed to explain the stability of the Soviet political system, and the perspective has been developed further recently. The basic idea is derived from a distinctive feature of the state-society relationship in the Soviet Union. The state-society relationship is based on exchange: both the regime and the population contribute something the other needs for its survival. Thus a social contract relationship between the state and society is maintained, when rulers provide benefits and security, and the people agree to acknowledge the legitimacy of the government, and to support, at least passively, the established political order.

    Application of the social contract concept to China can aid in understanding not only the recent state-society relationship, but also the reform strategy. In pursuing economic modernization, post-Mao leaders adopted new political and economic policies, and these policies led to a reconstruction of state-society relations. A key question for the social contract is how the populace in the social contract can prevail upon the state to grant economic interests in a non-democratic country. Obviously, the state-society relationship can not be defined as a social contract if the government bestows favors on the people, the people can not influence decision-making. The Chinese have had no opportunities to choose their leaders by democratic elections. A strict vertical social control system still works, and officials appointed by the party are both the supervisors of the people and nominally the political representatives for the people. In such a political system, people can not influence decisions of the state by political participation. Only the government’s aversion to social disaffection restrains decision-making.

    In the 1980s, such a state-society relationship had never been fully and officially planned, promised, or claimed, but was actually institutionalized as operating principles guiding not only economic and social policy, but also political policy. After the Tiananmen demonstration of 1989, the social contract was openly admitted by the government. For example, in his meeting with the mayor and other local officials in the early 1990s at Shanghai, Jiang Zeming, the General Secretary of the Communist Party, suggested that “buying political stability with money” was a key policy that local officials should understand. After the early 1990s, one can also find the expression in the official mass media about “loans for political stability (an ding tuan jie dai kuan).” It implied that local governments ordered local branches of the state banking system to make loans to state enterprises as part of the social contract.

    The usual manner of making concessions to the people’s economic demands may take two forms. When decision-makers become aware of serious dissatisfaction, those most eager to stem dissatisfaction can prevail by making concessions, which generally means offering people more benefits or taking fewer vested interests from them. Alternatively, the central government may tacitly consent to the local governments making concessions to the people by abandoning some aspect of the reform policy, so that the policy loses its efficacy. Almost every official, even a factory manager at the lowest level, understands and plays the game of politics quite well. In such a way public attitudes have gained greater influence on decision-making than ever before.

    In the post-Mao era, a significant difference from before is the weakened state capability to control social disaffection, while more and more disaffection appears in the course of reform. From the beginning of the 1980s, the ruling party has gradually changed its old social control method, and the state’s ability to satisfy people’s material needs has become a self-imposed standard of the party’s legitimacy. The nature of “organized dependence” has seemingly changed from Andrew Walder’s original definition to a new type of dependence in the social contract. In the past, employees were dependent on the workplace for lack of any alternative; now they are dependent as a result of high opportunity costs. When consumer markets appeared and control of labor mobility was loosened, employees of the state sector were able to get necessities and services outside of their workplace and could shift to other workplaces. In the social contract, however, almost every state-owned work unit delivers a great deal of welfare benefits, from luxury goods to free travel, which are not available from private firms. The high welfare benefits have rapidly raised opportunity costs of shifting to the non-public sector, and maintained the economic dependence of state employees on the state sector.

    This state-society relation creates a self-reacting process for both the government and the people. Though the “exchange relationship” of the government offering economic interests and the people offering cooperation has never been presented in any official document, both parties to the “exchange” know their own obligations clearly from the behaviors and responses of the other party. Once the sociopolitical relationship, “Feeding and Cooperation,” has been formed and stabilized, both parties are inclined not to destroy it. Today many state employees firmly support the official claim about keeping the current system stable because this means to them a stabilization of their social-economic status under the social contract. The longer the government maintains authority in this way, the more difficult it is for them to find another strategy which would be more effective in preserving its political power and achieving its goal of economic development as well.

    The social contract has limited the goals of reform. Under the social contract, the very nature of urban economic reform strategy became an effort to straddle two systems: a gradually developing market system and a remaining core socialist system. Some aspects of reform, such as trade reform and tax reform, are relatively easy, since these reforms need an effective central authority and the authority is well maintained in the social contract. Other aspects such as price reform, can be handled as long as people’s real income keeps growing, as is required by the social contract. But some aspects of reform, such as bankruptcy of the state enterprises or reform of the state banking system, are completely constrained by the social contract and have made little progress because these reforms may undermine the institutional foundation of the social contract.

    The government recognized the necessity and urgency of enterprise and employment reforms, and made decisions in support of these reforms several times, but each time it has silently withdrawn. In 1986, when the Bankruptcy Law, pushed by some reformers, was discussed in the National People’s Congress and met resistance from both local governments and the official labor unions, the central government agreed to add some restrictions to the law so that it would not operate over the next six to eight years, except in a few designated cases. In 1991, Deputy Prime Minister Zhu Rongji, who was in charge of economic policy, supported a local reform experiment to lay-off redundant workers in the state-owned mining enterprises of Jiangsu province and urged the entire state sector to follow the model. His instructions were implemented by some managers, but soon several managers were threatened by angry workers and one was actually killed. Zhu, frightened by the workers’ responses, simply gave up.

    Can the Social Contract Continue?

    Maintenance of the social contract and partial reform has had both positive and negative effects. Reform has created opportunities for the non-public sector and has stabilized the polity and economy for a certain period, permitting economic growth and foreign trade. But, reform has protected the institutional legacies of the past, blocked further reform, allowed corruption, and, most importantly, exhausted resources for the social contract. Diminishing resources, a result of the social contract, makes it more and more difficult for the government to keep the social contract working.

    Reform usually requires a strong state as well as societal support. In a politically and economically centralized system, reform implies reducing the original state capacity. If societal support or cooperation with the state is not available, the state may have to “buy” societal support with economic benefits. An authoritarian Communist state is strong in promoting some economic reforms within the state apparatus and strong in implementing political control or repression over dissidents, but is weak in carrying out thorough reform within the state sector and is feeble as well in protecting its remaining resources. A dilemma may then appear: the more the state “buys” societal support, the weaker is the state capacity; the weaker the state capacity, the more the state relies upon “buying” societal support for reform. This is exactly the situation today.

    The country has received advantages from partial urban reform protected by a welfare-oriented social contract. The reform has been “sweet” for most state employees, since all their losses due to the reform were compensated by other welfare measures, and, furthermore, their total real income and consumption level maintained annual increases of more than 5 percent since 1985. Their standard of living rose, not because of any rise in their productivity or any rise in the profit rate of the state sector, but because the state was able to pay the costs of welfare. Reform convinced the government that the more benefits offered in a reform program under a social contract, the more stable the reform process would be. The social contract and partial reform were coexisted and were mutually supportive.

    The social contract produced the effects of political and economic stability, which in turn led to confidence among the domestic population and foreign investors, and, therefore, encouraged more domestic savings and foreign investment, which were critical to economic growth. The social contract thus sustained not only the reform effort, but also political and economic stability and a good growth record. This may also explain why the transformational recession, which Janos Kornai suggested would be inevitable in any transition, has not been seen in China, even in the state sector.

    The institutions of the dominant state sector experienced only gradual change as following. First, workers were able to influence wage raises and promotions, and the distribution of bonuses and welfare. Second, decentralization gave firms greater control over their revenues and incentive payments, and factories sought to increase their services and benefits for employees, which actually increased the employees’ dependence on the state sector. Third, the state budget continued to provide subsidies, not only serving old welfare aims, but also compensating for losses due to reform. Fourth, the goods and services in the new market economy were much more expensive, raising the opportunity costs for state employees to make the decision to switch from the state sector. As the state in exchange for the citizens’ cooperation with the communist regime offered more benefits such as jobs, housing, healthcare, consumer and durable goods, and free travel for vacations, the social contract not only strengthened people’s dependence on the state, but also shaped people’s expectations and behavior. This social contract worked for performance legitimacy, but was unfavorable for marketization and economic efficiency.

    With that social contract, Deng appeared to have found a balance between political stability and partial economic reform, but balance was achieved at a cost to the state and the public sector. Providing social benefits proved more expensive than the cost of ruling before the reform. Once the government had complied with demands for better living conditions, the government has no choice but to offer more economic benefits to the people.

    A welfare-oriented social contract may buy stability, but can not buy efficiency or productivity. The social contract leaves workers limited incentives to work hard and has actually encouraged economic inefficiency. Using material incentives in the social contract is not an effective stimulation for working, but is the government’s way of securing public support. Under the social contract and in the reform effort, the government plays a dual role; it is the “boss” of the state enterprises in managing their business, and the “father” of state employees responsible for their well being. The two roles are contradictory. To play the role of the “father,” the government should guarantee people shared wealth. At the same time, in its role as “boss,” it ought to distribute income according to people’s differing abilities.

    As solving this dilemma proved impossible, the government chose to emphasize its role as “father,” distributing income relatively equally. People usually thought of the new benefits they managed to obtain as welfare or “free lunch” from the government, not as rewards for hard work. So workers were not motivated to work harder. In most situations, rising wages did not increase productivity, but reduced wages would definitely decrease it; the “material incentive,” therefore, had actually become a way to prevent productivity from falling, rather than to improve it.

    The social contract ties political stability to the state’s capacity to deliver welfare. Since the state sector has been unable to provide the welfare alone, the high economic cost of maintaining the social contract has to be covered by other resources. The ability of the regime to finance the social contract is a precondition for the maintenance of the social contract. Whether the social contract can be maintained in the long term depends on the balance between the available resources and the resources the social contract consumes.

    The first and the easiest source of funds is the state budget. Before reform, the government carried out most investment in the planned economy, financed by transferring state enterprise revenues to the state budget. The government therefore directly controlled about one third of the Gross National Product (GNP). Reform has reduced the share of the state budget of GNP by decreasing the transferred revenues from state enterprises and leaving those enterprises to deliver welfare provisions.

    Another possible source of funds is the banking system. All banks are state-owned and centrally controlled by the party-state as a machine to collect savings and distribute financial resources. Individuals can only put their savings into the state banks, but usually cannot borrow from the banks for their own businesses. The banks operate on instructions from the government and make loans primarily to the state sector. As all bank directors are appointed by the Communist Party, the banking system is actually an extension of the state, and the banks function as a “second state budget”. In considering the state’s financial capacity, one should never ignore the state capacity built on the banking system. The financial resources from the banking system are greater than that of the state budget.

    Before 1988, the government relied mainly on the state budget to cover the expenses of the social contract. Economic reform changed this as more financial control was given to enterprises. The state reduced its expenditures in line with reductions in its revenues. The state’s share of national income steadily declined from 35% in 1978 to 20% in 1988. Since then the state budget has been unable to finance the social contract and the government has had to find an alternative way to cover the welfare expenditures of the social contract.

    Since financial liberalization was excluded from the reform effort and the banking system remained a government monopoly, it was quite easy for the government to make the switch from budgetary resources to banking resources to finance the social contract. As the household share of national income increased from 10 to 15 percent in the 1980s, the ratio of household saving to national income jumped from 4% in 1978 to 15% in 1990. The government is able to use those bank savings to fund the state sector.

    Performance of the state sector has experienced little improvement since reform started, but state enterprises, fulfilling the social contract, have increased wages, bonuses and welfare provisions, even when the enterprises could not afford these expenditures. As a result, operating costs of the state industries have soared while profit declined from 15 percent in 1985 to 2 percent in 1993 and have remained low. This sector employs 45 million people, but half of its enterprises have been money losers since 1995. As these enterprises made little or no money but had to provide more wages and welfare to “buy” political compliance, they became increasingly dependent on bank loans. The state banking system was thus under constant pressure from the state enterprises backed by the government to provide a steady stream of credit. The state sector now gets 79 percent of national financial resources, while the percent of its output in GNP fell to 43 in 1994.

    Financing higher wages and welfare benefits through borrowing, many managers of the state sector recognized that their priority was to make their employees happy rather than to make or keep their enterprises profitable. As loans were necessary to maintain the social contract, many managers had no plans for paying back these loans. Some of the poorest state enterprises were even unable to pay the interest and the loans became “donations” from the state banks. The government used personal savings for political purposes, and the state banking system was required to play a role like a “cashier” for the government and the state sector. Thus, the social contract reinforced the “soft budget constraint,” a well-known feature of a socialist system defined by Janos Kornai.

    It has resulted into two consequences after using the state banking system as the financial resources of the social contract. First, the huge loans the state sector owed have become a heavy debt burden that led many state enterprises to bankruptcy. Formerly, the state sector had very few external liabilities; in 1979, for instance, the sector only owed banks a sum equal to 26 percent of their book value (depreciated fixed capital plus the value of all inventories). This ratio doubled during the period from 1980 to 1989, and rose to 83 percent by 1994. The rapidly increasing equity rate indicates that if debts are subtracted from gross assets, the total net assets of the sector shrank during the reform period, and the heavy external liabilities have resulted in risks of more bankruptcies.

    Second, as two thirds of the state enterprises were struggling to survive and could not repay the loans, by 1994, about 60 percent of bank loans had turned out to be bad or dead loans. In a market economy, once a bank is found to have such a high dead loan rate, the bank is considered bankrupt. According to international standards, technically the Chinese banking system is already bankrupt, but, as the only banking system in China and protected by the government, the state banking system will not be closed but may be shaken by possible financial crisis. To support the social contract, the banking system has almost depleted its financial resources. In this situation the state sector can no longer depend upon the banking system to obtain financial resources.

    While political stability is a significant outcome of the social contract, the contract has created several economic problems. For example, as the decentralization gave local governments incentives to build more new factories, it reinforced the typical socialist “investment thirst,” and led to a waste of funds. Over-investment can be found in almost every industry, and many new factories built in the past decade have been unprofitable since the day they opened. This is why China’s industrial structural distortion has worsened.

    Another example is the growing urban-rural income gap, which has had an unexpected negative impact on the state sector. Since 1986 most financial resources have been put into the state sector concentrated in the cities. And the urban-rural income gap, after a temporary reduction from 1979 to 1985, grew again after 1986. The difference is now even larger than in the pre-reform era, though the government promises almost every year to reverse it. While low rural purchasing power reduces the potential rural demand for the low quality products of the state sector, the fast growing urban consumption level stimulates demand for imported goods and reduces the demand for goods from the state sector. The state sector has received most of the country’s financial resources, but has seen diminished domestic demand for its products as well, and therefore hurt itself.

    Maintenance of the social contract is expensive. The financial resources from the state budget and banking system were available only in the early decades of the reform period. While the government continuously raised urban living standards, as promised by performance legitimacy, the high costs of the social contract have resulted in an imbalance between the available resources and the required resources. Once the resources from the state budget and banking system have been exhausted, maintenance of the welfare-oriented social contract will become more difficult economically, and then, the “feeding and cooperation” relationship may have to be altered.

    Will the “Honeymoon” between State and Society End?

    The social contract has sustained political stability and a partial economic reform for almost two decades. To maintain the social contract, available financial resources have almost been exhausted, and further economic reform now appears to be inevitable. Any further economic reform will have to break the social contract, and, in turn, may damage cooperation between the urban population and the regime and undermine political stability. Solving the puzzle will be very difficult for the third generation of communist leadership. Very probably, the “honeymoon” between the urban society and the regime under the social contract may come to an end, to be replaced by rising social tensions. Under pressure of possible social tension, it is uncertain whether the government will be able to continue economic reform of the state sector and to maintain political stability as well.

    Since the beginning of the urban economic reform program, reform of the SOEs has fallen far behind other reforms such as price reform and liberalization, and little progress has been made in improving the efficiency of the state sector. Some Chinese economists have appealed to the government for a thorough reform of the state sector and also have warned many times of the danger of the exhausting the financial resources, but their voices have been ignored while decision making was restrained by the social contract. It was only when the dead loans of the state banks exceeded the security line of the banking system in 1995 and a looming financial crisis threatened economic and political stability that the government finally took action to protect the banking system from collapse. To reduce loans for wages and welfare expenditures of those nearly bankrupted SOEs, the government quietly changed its employment policy and allowed the SOEs to lay-off some redundant workers. Recent statistics indicate that from 1995 to 1997 about twelve million employees were laid off, about seven million of whom are now still unemployed.

    A consensus was reached in the 15th Party Congress held that in order to save the banking system from bankruptcy, the state sector must be reconstructed by laying off more workers and closing those SOEs which are losing money. If this reform is implemented, there will be at least twenty four million employees laid off in the next few years, and about one-fourth state employees may lose their jobs at almost same time. The government is acutally aware of the political risks of this program. But it must exclude a large portion of the population from the social contract in order to reduce that cost of the contract and thus save the banking system and stabilize the rule of the communist party.

    According to an estimate by a former deputy director of the State Commission on Restructuring Economic Systems, to carry out the program, the government needs at least 2,000 billion yuan to repay part of the bad loans to the banks. And it needs another 730 billion yuan to build a safety net for unemployed people, whereas only about 40 to 50 billion yuan each year is available. Without sufficient financial resources, the “shock therapy” may cause more severe social consequences than have occurred in the former Soviet bloc.

    Politically, the reconstruction program implies that the government intends to rescue the banking system at the cost of breaking the social contract. While this will reduce the risk of economic instability, it may undermine political stability. If the “feeding and cooperation” relationship ceases to work, the state-society relationship will be destabilized, and the performance legitimacy the regime relies upon will be shaken.

    At the end of the 1970s, the bankrupt orthodox ideology and personality cult of Mao had seriously damaged the traditional legitimacy and authority of the communist regime. People’s loyalty to the regime was gradually transferred in a pragmatic direction, i.e., to expectations that the regime could solve various economic and social problems. The regime gradually changed its social control method, from political and ideological mobilization to a loosened political control with material incentives. Since then, both the state and urban society have experienced a “honeymoon” period in their interaction. Both parties thought that the social contract satisfied their own interests and preferred to maintain it. Such a “honeymoon”, however, is conditional; it depends on the degree of realization of popular expectations and the promises the regime has made. Once the state is unable to meet society’s rising expectations, the social contract is broken and the “honeymoon” will be over.

    During the “honeymoon,” people were encouraged to turn their concern to the improvements in their living standards and they became sensitive to changes regarding their new or vested interests. As soon as people find themselves worse off due to economic reform, extensive social dissatisfaction may appear. The reconstruction program of the SOEs will withdraw most welfare provisions from millions of employees and leave them unemployed without economic or political compensation. Although the program is justified by the rationality of economic efficiency, SOE employees will find that they are required to make sacrifices. In such a situation, the regime can no longer expect political compliance of these people, and must find an alternative for the social contract to maintain political stability and regain people’s cooperation.

    It could be argued that under threat of repression and strict control, the Chinese people are atomized and depoliticized, and are socially and economically dependent on and manipulated by the state or work units. Therefore, they are unable to organize effective collective action in behalf of their own interests and are not a party in the bargaining with the government. So far, workers’ protests against pay-cuts and possible unemployment have been small-scale and not a social movement, though some strikes and collective bargaining occurred in 1989. What makes the state nervous is the structured homogeneity of individuals’ opinions, which means that a spark might produce an extensive societal response. The state responds neither to public opinion nor organized interest groups, but to a spontaneous societal reaction, which is often initiated by those in an unfavorable situation in the reform. Under Deng, almost every time the leaders confronted significant social costs or negative political responses to reform policies, they retreated.

    Society under an authoritarian regime lacks organized bargaining power, and has no independent leadership; however, discontent shaped by the structured dependence upon the state sector may produce massive unorganized collective action, even without an organized power emerging. State employees enjoying the socialist welfare system share the same opinion, in opposing reductions in welfare benefits or reforming the socialist employment system. On other matters, such as wage system reform, workers in the public sector, party officials and intellectuals may have different opinions, but relatively homogenous ideas exist within each group. Individual dissatisfactions can be transformed into institutionalized homogenous public disaffection.

    Expression of the popular disaffection has four stages. First, complaints begin in private among relatives, friends, and others, but not with superiors. Second, as more and more express the same sense of dissatisfaction, they dare to talk about it in public places and criticism of the government easily arouses a sympathetic response in the populace, so that the dissatisfaction spreads rapidly. Third, if the regime fails to solve problems, social discontent may accumulate, and people may begin work slowdowns as a way of protesting. Fourth, when people’s dissatisfaction is ignored by the government for a long time, they may doubt the regime’s capability and there will be a “crisis of confidence” in the regime, party and system. People may keep their distance from authority and refuse to obey orders from the regime, and finally may withdraw their loyalty to the regime if there is a chance to do so. Anger may rise, leading to public protests. This may take the form of non-political, unorganized collective action, such as panic purchasing, withdrawal of bank deposits, and even demonstrations for economic purposes.

    To be sure, the regime will find it difficult to deal with the disaffection. First, institutional barriers to the transmission of pubic opinion make it hard to discover and respond to social disaffection in its early stages. Once information about social disaffection reaches the central government, disaffection will already have spread. Second, having relied on the social contract for two decades, the regime has become almost unable to control social disaffection by the old instruments such as Maoist ideology or extensive political persecution. When official propaganda convinces fewer people and political mobilization no longer works, the government actually lacks its instruments to deal with dissatisfaction effectively. Third, the regime cannot simply employ despotic power to repress social discontent. Seeking legitimacy, the government can hardly reject the economic demands of the populace or respond with political persecution. Severe political persecution may also seriously damage the reform efforts.

    Throughout the reform era, decision-makers at various levels often have been motivated to make economic concessions. In addition to the reasons already cited, social unrest can be used as a weapon to attack those in decision-making positions in the power struggle within the party. Worrying about people’s passive withdrawal of support may also interfere with economic performance and, in turn, produce more social dissatisfaction, Chinese politicians usually try to evade responsibility for any social unrest or economic instability, and compromise economically with those most disaffected people.

    Today’s leaders are weaker than Deng and need more societal support to carry out their policies. The critical financial situation, however, forces them to carry out a radical reconstruction program of the state sector, though they lack the necessary financial resources and political instruments. More likely, they dare not break the social contract completely, but reduce only the range of welfare provisions and decrease the number of people the social contract protects. Even so, the social foundation of the Communist Party will rapidly shrink and social conflict intensify. Under social pressure the regime may vacilate in implementing the reconstruction program and economic growth may gradually slow down. Yet hesitation in the reform program can only make the financial situation worse and lead to more tension, which may, in turn, call for political reform.

    The social contract has helped the communist regime keep itself away from the pressure of democracy but will ultimately undermine the rule of the regime. Radical reform can save China from a threatening collapse of the banking system, but cannot help the regime retain its power. The looming financial crisis probably signifies a turning point on the road to reform. The gradual and peaceful reform process under the social contract may come to an end, and a swifter and more profound transition may occur, propelled not only by the goodwill of policy designers, but also the pressure of the conflicts in the current political and economic system.

    Notes:
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    1. Andrew J. Nathan, “Even Our Caution must be Hedged,” Journal of Democracy 9 (January 1998): 62-63.
    2. Jose Maria Maravall, “The Myth of the Authoritarian Advantage,” in Economic Reform and Democracy, eds., Larry Diamond and Marc F. Plattner (Baltimore: The Johns Hopkins University Press, 1995), pp. 13-14.
    3. Victor Nee and David Stark, “Toward an Institutional Analysis of State Socialism,” in Remaking the Economic Institutions of Socialism: China and Eastern Europe, eds., Nee and Stark (Stanford: Stanford University Press, 1989), pp.1-31.
    4. Janine Ludlam, “Reform and the Redefinition of the Social Contract under Gorbachev,” World Politics 43 (January 1991): 284-312; Linda J. Cook, The Soviet Social Contract and Why It Failed: Welfare Policy and Workers’ Politics from Brezhnev to Yeltsin (Cambridge, MA: Harvard University Press, 1993).
    5. Andrew Walder, Communist Neo-Traditionalism: Work and Authority in Chinese Industry (Berkeley: University of California Press, 1986); Kenneth Liberthal, Governing China: From Revolution Through Reform (New York: W. W. Norton & Co., Inc., 1995).
    6. Central Committee of Chinese Communist Party, “Zhonggong zhongyang guanyu jingji tizhi gaige de jueding” (“Decision of the Central Committee of Chinese Communist Party on Reform of Economic System”) Renmin ribao (People’s Daily), October 21, 1984.
    7. Janos Kornai, Economics of Shortage (Amsterdam: North-Holland Press, 1980).
    8. Samuel P. Huntington, The Third Wave: Democratization in the Late Twentieth Century (Norman, OK: University of Oklahoma Press, 1991), pp.50-51.
    9. Stephen White, “Economic Performance and Communist Legitimacy,” World Politics 38 (April 1986): 462-82.
    10. Ludiam, “Reform and the Redefinition of the Social Contract under Gorbachev,” pp. 284-312.
    11. This information is drawn from an interview the author did with a former official of City Government of Shanghai in 1997.
    12. Walder, Communist Neo-Traditionalism, p. 224.
    13. Janos Kornai, “Transformational Recession: A General Phenomenon Examined through the Example of Hungary’s Development,” Economic Appliquee XLVI (1993, No.2): 181-227.
    14. Barry Naughton, Growing out of the Plan: Chinese Economic Reform, 1978 – 1993 (New York: Cambridge University Press, 1995), pp. 104-5.
    15. Walder, Communist New-Traditionalism, pp. 237-40.
    16. Naughton, Growing out of the Plan, p. 31.
    17. Cheng Xiaonong, “Gaige zhong guomin jingji shouru liucheng de bianhua” (“Changes in Distribution of National Income in the Process of Reform”) Zhongguo: Fazhan yu gaige (China: Development and Reform) 8 (August 1987): 17-24; “Gaige zhong de hongguan jingji: Guomin shouru de fenpei yu shiyong” (“The Macroeconomic in the Process of Reform: Distribution and Use of National Income”) Jingji Yanjiu (Economic Research) 8 (August, 1987): 16-28.
    18. Xiaonong Cheng, “Distribution of National Income during Economic Reform,” Working Paper (San Francisco: 1990 Institute, June 1991); Naughton, Growing out of the Plan, p. 85.
    19. Cheng, (fn.17 & 18).
    20. Cheng Xiaonong, “Weichi wending yu shenhua gaige: Zhongguo mianlin de jueze” (“Transition versus Stability: China’s Dilemma”) Dangdai Zhongguo yanjiu (Modern China Studies), 1 & 2 (March 1995): 95.
    21. Wenwen Niu, “Jianshao guoyou qiye de kuisun: jinhou de jianju renwu” (“Reduce Losses of the State Sector: A Tough Task in the Next Years”) Jingji Ribao (Economic Daily), December 11, 1997.
    22. Naughton, Growing out of the Plan, p. 205.
    23. Cheng Xiaonong, “Fanrong cong he er lai?–Zhongguo jingji xianzhuang he qushi de fenxi” (“The Puzzle of China’s Economic Prosperity: Problems and Perspectives”) Dangdai zhongguo yanjiu (Modern China Studies) 3 (October, 1996): 31-6.
    24. Kornai, Economics of Shortage.
    25. Cheng, (fn.20), p. 97; Gao Shangquan, “Guoyou qiye de zhidu chuangxin he fazhan ziben shichang” (“Institutional Innovation of State Enterprises and Development of Capital Market”) Jingji cankao bao (Economic Information Daily), September 30, 1997.
    26. bid.
    27. Cheng, (fn.23), p.51.
    28. Survey Department of Household Income, State Bureau of Statistics, “Woguo cheng xiang shouru chaju wenti yanjiu” (“On Urban-Rural Income Gap in China”) Jingji Yanji (Economic Research) 12 (December, 1994).
    29. Zhongguo gaige bao (China Reform News), January 21, 1998.
    30. Gao Shangquan (fn.25).
    31. ibid.
    32. Xueguang Zhou, “Unorganized Interests and Collective Action in Communist China,” American Sociological Review 58 (February 1993): 54-73.

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