Enterprises And The Two-Track System

At the opposite end of the hierarchy from the central government, enterprises are the building blocks of the industrial economy. A few basic principles have guided enterprise reforms from the beginning. Reformers held that enterprises should cease to be administrative subdivisions of the government bureaucracy and should instead become economic entities making independent decisions based on price and profitability. Enterprises would become "relatively autonomous commodity producers," responsible for their own profits and losses, and economic—rather than administrative—means would be used to accomplish economic objectives. Most reformers envisage a continuing activist role for government, but that role is carried out through the manipulation of "economic levers," such as interest rates and prices.^[19] Evidently, such principles require a reduction in direct government interference with enterprise decision making and imply a limited and indirect role for government that requires substantial sophistication.

These principles are too broad to serve as a specific blueprint for the reform process. The concrete strategy that has dominated the Chinese reform process has been that of allowing a gradual expansion of markets

outside the confines of the planned economy. The planned economy survives, but its size has been held roughly constant, while the regular growth of the economy has steadily swelled the proportion of economic activity carried on outside the plan through the market or marketlike exchanges. The leadership hoped that this evolutionary process would result in the gradual marketization of the economy, while the maintenance of a planned sector would anchor the system during the period when leaders were learning to use "economic levers" and indirect market regulation. This reform strategy has often been referred to as a "two-track" system combining both traditional planning and market operations. One of the essential features of this strategy—and one that gives the Chinese system its great novelty—has been that the two-track system is applied not only to the economy as a whole but also to each individual enterprise. Thus, nearly every state-owned factory operates with a portion of its output planned by government and a portion produced according to market demand.

At its best, the two-track-system strategy of reform held the promise of introducing market forces into the state-run industrial system at a rapid pace. Rather than waiting years for a comprehensive rationalization of prices and taxes, enterprises would be confronted with the opportunity of operating in the marketplace immediately. The command economy would persist, but its scope would be strictly limited. As a result, the monomorphism that made all decision making subject to the command relationship would be broken, since enterprise decisions about the growing portion of the economy would be made on the basis of profitability considerations determined by market prices. At the same time, the growth of a market sector would shatter the monolithic state economy; state-run enterprises operating out-of-plan would compete with collective and private enterprises, and markets would provide information and competitive pressures that could be used to reshape the state economy. Alternately stated, if plan targets were frozen, enterprises would face market prices on the margin, and the enterprise's plan would serve as a lump-sum tax, having no effect on current operations. The administrative economy would thus be gradually dissolved by market forces, and the bargaining economy progressively replaced by the objective rule of the market.

In this framework it is essential that the planned "track" be frozen. If the size of the planned economy is not fixed, then enterprise decision making cannot be fully freed to depend on the market. If the enterprise expects that its market-oriented behavior will have repercussions on the level of planned targets or inputs, it will inevitably take those repercussions into account in its decision making. As a result, advocates of the two-track system have tended to oppose using the old command-

economy structure to solve problems, even to the extent of opposing price reforms within the administrative economy. This position has been bolstered by a perception of the bureaucratic economy as a clumsy and unresponsive system, evident in a recent article by advocates of the two-track system:

The debate over whether it is better to adjust planned prices or to simply decontrol stems from different assessments of the ability of the government. Those who advocate price adjustment believe strongly in the ability of the government to control the price reform process ... [while we believe that] there is a serious contradiction between highly centralized price adjustment and the decentralized structure of interest groups. The central government will never be able to calculate the impact of each individual price change as accurately as the localities and ... enterprises, and the ultimate burden of price adjustment will inevitably be shifted onto the state treasury.^[20]

In other words, advocates of the two-track system felt that the flows of information in the command economy were too crude and distorted to be useful in a rationalization of economic relations. A bureaucracy with weak information-gathering capabilities and correspondingly limited management abilities had no choice but to rely on the expansion of markets outside the system to realize its ideals of reformed enterprise behavior. The strategy of freezing a clumsy bureaucracy—rather than trying to rationalize it—implied that the financial and authority relations linking enterprises to their superiors would persist, though, one would hope, in fossilized form.

Unfortunately, this strategy has not yet been adequate to make the enterprise-reform principles into reality. It has been impossible, first of all, to freeze the planned "track" of the economy. The overall size of the command economy (the scale of central-government production and allocation plans) has indeed stayed relatively constant, declining steadily as a proportion of total economic activity as the economy grows. Yet from the perspective of an individual enterprise, plans are anything but stable. Some enterprises experience shrinking plans and are uncertain about the speed of shrinking. Other enterprises discover that their plan is increasing, and they may welcome this when it promises access to cheap inputs. For example, when the foreign joint-venture automobile companies, such as Beijing Jeep and Guangzhou Peugeot, ran into problems with raw-material supplies, the government provided them a special benefit: incorporation into the plan. The overall constancy of the plan thus conceals considerable variation in plan targets at the enterprise level.

Moreover, in the traditional command economy, input supplies are subordinate to the production plan, so that only the level of the production plan itself is important. However, in China, as bureaucratic capabilities declined during the Cultural Revolution, and as the system became less regularized during the reform process, there began to be substantial discrepancies between production plans and the allocation of inputs. Enterprises today cannot necessarily get the full quota of inputs required to fulfill their compulsory plan. Thus, even for a given production plan, enterprises face differential supplies of low-price inputs, and ultimately supply depends upon the nature of enterprise relations with their superiors. Here, paradoxically, the deterioration of bureaucratic capabilities makes it harder to freeze the bureaucratic portion of the economy, because the bureaucratic system is incapable of generating a single parameter to represent the level at which the plan should be fixed. Only enterprises that have obtained administrative recognition of their priority status can hope to receive a full complement of subsidized inputs.^[21] The individual enterprise cannot regard the plan as being fixed in any meaningful sense. A persuasive case to a superior might always make a difference; "plan bargaining" persists in the two-track system.

Outside the plan, the environment in which enterprises operate is still not a pure market environment. Indeed, in general, enterprises do not sell their outside-plan output at market-clearing prices. In most cases, outside-plan output is sold at a higher price than planned output, but the price is kept low enough that shortages continue to arise and the enterprise must decide to whom to deliver its products.^[22] This is a very curious phenomenon that requires explanation: Why do enterprises not exploit their apparent ability to charge higher prices? There seem to be three mutually reinforcing causes of this type of enterprise behavior. First is the government effort to restrain price increases in the inflationary environment that has prevailed since 1984. The old bureaucratic networks persist and are used to pressure enterprises to refrain from raising prices; in this sense, the failure to charge market-clearing prices is simply a result of the failure to free the enterprise from the old authority relations. Such pressures vary greatly from region to region and from sector to sector, depending upon the bureaucracy and type of good involved—producers of certain consumer goods are subject to more

pressure, as are factories in "conservative" provinces with active price-control efforts.

The second factor is that enterprises find it in their own interest not to charge high, market-clearing prices for their output. When enterprises sell their output at the highest possible price, they receive all the benefit from the sale in overt, monetary form: high profits. Profits are highly visible, and they are highly taxed. As a result, although the enterprise may reap greater paper profits from such a sale, it may find itself with little real benefit after delivering taxes and other revenues to its superiors. When the enterprise chooses to sell its output at a lower price, it forgoes some money income but receives something else in return. Most commonly, it receives access to other goods at a concessionary price. If these are consumption goods, the enterprise benefits directly: the goods can be sold to the enterprise's workers without any overt subsidization and without restrictions. It appears to be a pure market transaction and is thus subject to no taxes and no quantitative limits. (If the enterprise had taken the income in money form and then distributed it to its workers, that distribution would have been subject to limitations on bonuses.) Furthermore, the enterprise creates a hedge against future supply and price uncertainties by creating a long-term cooperative relationship with another enterprise. Current income forgone is "saved" by accumulating capital in the form of guanxi (connections). By building up guanxi the enterprise obtains greater flexibility and security: guanxi can be used to shift income from one period to another, or to guarantee supplies of materials when the need is critical. For the enterprise to forgo guanxi for some short-run financial advantage would be shortsighted indeed.

Finally, the benefits received by forgoing enterprise profits can accrue to individuals, particularly managerial and sales personnel. This can take the form of a slightly lavish dinner and a carton of cigarettes, or it can involve major bribery. The danger of corruption is, of course, endemic to a two-track system, because of the existence of more than one price for any given commodity. Overt bribery and illicit sale of in-plan goods, however, can be extremely dangerous and seem to be relatively infrequent. A far more common pattern is the creation of long chains of buyers and sellers, each of whom raises the price of a good by, say, 10 percent, just enough to cover "handling charges." The individual privileged enough to be one of the links in this chain earns a moderate cash reward and acquires the gratitude of the individual who is the next link. No unambiguously illegal activity has taken place, and everyone involved has profited, except the original enterprise. Only at the end of this long chain does the good sell for something like a true market price.

For these three reasons, enterprises and their superiors collaborate in

complex exchanges at other than market prices. On occasion, an enterprise may dispose of goods at market prices when it has no "connection" with the purchaser, and logically even the longest chain of buyers and sellers has a final link, so market prices exist. But it is extremely difficult to determine what those prices are, and difficult to object when transactions take place at other prices. Thus, there is a kind of "exchange bargaining" that goes on between enterprises and also affects enterprise relations with their superiors. Enterprise managers try to maximize a complex mixture of sales revenues and outside-sales benefits, and this leads them into elaborate bargaining arrangements.

When all the enterprise's supplies have been purchased, and all the output has been sold at various prices, the enterprise's ultimate profit is still far from determined. The final bargain that must be struck is that which determines the financial relations that link enterprises to their superiors. These have remained unregularized and subject to a bewildering array of inconsistent provisions. In part, this is due to the failure to successfully implement new fiscal systems, such as the "tax for profit" system and the consequent prevalence of the "contracting" (chengbao ) system. Under the contracting system, enterprise financial obligations to superiors are determined as part of a multiyear contract negotiated between the two sides. Such a system is designed to provide high-powered incentives to enterprises by allowing them to retain a high percentage of their incremental revenues. At the same time, the contracting system indicates the inherent difficulty of the two-track system: the multiyear contract is an attempt to "freeze" the financial tribute the enterprise pays annually to its superiors. The fact that such a freeze has to be specified in a negotiated contract between the enterprise and its superior simply demonstrates that the planned track of the economy was not frozen to begin with. Quite the contrary, the financial relations between enterprises and superiors have been subject to constant, virtually annual, changes between 1978 and 1988. Unavoidably, each time financial provisions are altered, every aspect of the enterprise's economic health, behavior, and relations with its superiors enters into the process of adjustment. The striking of a deal dividing up enterprise revenues, which Kornai has described in Hungary and labeled "redistributional bargaining,"^[23] is prevalent in China as well.

Redistributional bargaining in China is peculiarly unconstrained because of the absence of clear fiscal and financial regulations. Almost any parameter can be altered through negotiation between superiors and subordinates. For example, there is uncertainty as to whether bank loans

should be repaid before or after taxes, so the authority to repay before taxes thus becomes a benefit that superiors grant enterprises. Actually, the discretion available to superiors is virtually unbounded; at one plant visited in 1988 the superiors had decided that the enterprise was having legitimate difficulties in fulfilling its profit-remittance contract because it had such a large volume of loans to repay. The superiors simply allowed the enterprise to count 50 percent of the loans it repaid as remitted profits for the purpose of calculating the revenue split, so that the enterprise succeeded in fulfilling its contract. In this case, the contract fulfillment was entirely imaginary. Taxes are slightly more difficult to alter, since the central government has repeatedly insisted that taxes, particularly those on cigarettes and liquor, should not be forgiven. Nevertheless, tax forgiveness is very significant. In Jiangsu in 1986 local authorities forgave taxes equal to a remarkable 12 percent of total budgetary revenue.^[24] Every financial parameter is subject to negotiation and thus subject to constant change.

An additional aspect of redistributional bargaining links it to my earlier discussion of the central government and its investment plan. I noted above that, before reform, enterprises retained some funds for investment purposes, but that the central government collected no data on this investment and had no way of controlling it. Local governments and enterprises, in collaboration, were thus completely autonomous users of these funds. In the current period, enterprises control substantially more funds, but the central government no longer closes its eyes to their use. Instead, the government by the mid-1980s had promulgated a plan for enterprise-level investment in technical transformation. This plan, which includes projects for about half of all large enterprises, classifies enterprises and projects according to level of priority and establishes technologies and processes that are to be introduced.^[25] This is not a detailed central investment plan, like the priority capital-construction program described above. However, it is the basis for central-government involvement in redistributional bargaining. Enterprises with authorized and high-priority investments are supposed to retain more profit and have easier access to bank loans than other enterprises. Thus, the central government uses this planning exercise to reach down the administrative hierarchy and shape the bargain between the enterprise and its direct superior in ways that reflect central-government priorities. Clearly, enterprises can benefit by appealing to patrons at the central level.

The enterprise is thus enmeshed in a complex bargaining relationship with its superiors. Plan bargaining, exchange bargaining, and redistributional bargaining are all taking place simultaneously; in fact, along with the face-to-face personal relationships involved, they are woven into a single inextricable chain of bargains—repeatedly struck and constantly reopened—between enterprises and their superiors. No wonder, since both enterprises and superiors face a vast realm of indeterminacy, in which everything—price, plan, supply, tax, credit—is subject to change and negotiation. All these parameters can be altered by the enterprise's superior, and only an extraordinarily bold, or extraordinarily foolish, enterprise manager would choose to operate "on the market" as if the wishes of his superior did not matter. Conversely, only an exceptionally obtuse manager would ignore the opportunity to improve his lot and protect himself against adverse outcomes that is possible by the appeal to his superiors. The astute enterprise manager will always keep open the channels to his superiors that permit him to reopen the bargaining relation at any time.

What is true at the enterprise level is also true one step higher in the bureaucratic hierarchy. Local government officials must always be aware of the possibilities involved in currying favor with their superiors. Indeed, since there is no final blueprint for reforms, localities must be given the freedom to experiment and must be supported in this experimentation process. Localities learn very quickly that it is in their interest to have some kind of reform pilot project.^[26] Localities receive special benefits to operate pilot projects, and if one is deemed successful, local officials will undoubtedly receive a career boost. As a result, reform "experiments" proliferate; at the end of 1986 there were seventy-two cities that were "comprehensive-reform pilot cities," sixteen "medium-size city administrative-reform pilots," twenty-seven banking-reform pilots, thirteen producers-goods-marketing pilots, fourteen housing-reform pilots, plus labor-reform pilots, coastal development zones, and so forth.^[27] In each of these "experimental cities" local authorities could hope to obtain benefits and preferential treatment from the central government by extending benefits and preferential treatment to their subordinate enterprises. Thus, just as local governments were squeezed by the central government in the investment-allocation process, so do they squeeze themselves into the system-reform process. The reform process, and the real distribution of benefits within the state sector, evolve from this constant contention and interplay of interests.