The Political Economy of China's Declining Growth



Thomas G. Rawski

University of Pittsburgh

Pittsburgh PA 15260 USA





China's long economic boom, now entering its third decade, is a major event in world economic history. During the past twenty years, China has achieved immense growth in every dimension of material well-being. Never before have so many emerged from deep poverty so rapidly. The impact of China's stunning growth is clearly visible in a wide array of world markets ranging from garments and toys to grain, steel, stocks, and bonds.

Comparison with other transition economies underscores the magnitude of China's economic accomplishments. Per capita incomes in nations of the former Soviet Union and its East European satellites have certainly not grown, and may well have declined during the past two decades. In China, by contrast, yearbook figures show that average real incomes rose by over 130 percent between 1978 and 1989, then doubled again during 1989-1997. Whatever the deficiencies of the data, the contrast is beyond dispute: the most laggard Chinese regions have outperformed the most dynamic regions of the former Soviet Union and its ex-socialist neighbors by an immense margin.

China's long boom, although widely remarked, is not well understood. Why did explosive growth occur in China - rather than in India or Egypt? Why in the 1980s - rather than the 1970s or 1990s? We have barely begun to address these issues. If we think back to the literature on Great Britain's eighteenth-century industrial revolution, we find researchers championing four areas as the principal cause of long-term growth:

-- entrepreneurial culture (Macfarlane 1978)

-- sweeping changes in technology and information (Landes 1970)

-- development of market-leaning institutions (North 1981)

-- revolution in diet and energy (Fogel 1994)

I hypothesize that each of these factors exerted strong influence over China's economy from the start of reforms in the late 1970s. This perspective, if validated by future research, will remove much of the mystery surrounding the origins of China's completely unexpected emergence as the world's most dynamic economy.

China's transition from planning toward a market system has many surprising features. The Communist regime remains intact. Reform has meant a gradual erosion of state economic control rather than a quick retreat from planning. Reform began with no clear objectives other than a determination to improve performance. Even the slogan "crossing the river by stepping on stones" (mo shitou guohe) presents a false image of a specific target - the other side of the river - where none existed. The goal of creating a "socialist market economy with Chinese characteristics" is itself an outcome of the reform process that emerged well into the second decade of transition.

China's success is particularly discomfiting to economic zealots who insist that a policy mix centered on private property, deregulation of prices and markets, and open trade holds the universal key to reform success. The dissonance inherent in China's unexpected combination of stunning success and flawed institutions was one important spark for intense debate about the merit of rapid and gradual reform. In retrospect, this debate appears largely otiose. Modest historical reflection could have anticipated what everyone now understands: creation of a market system, with its myriad institutional linkages, cannot progress rapidly. After all, did not R.H. Tawney apply the term "transition" to gradual changes in the "complex structure of habits, knowledge, and beliefs" that accompanied the secularization of business in early modern Europe (1926, p. 17)?

China's long boom may be nearing its end. The pace of reported growth is declining, and actual growth may fall short of official claims. Information about declining profits, growing unemployment, idle capacity, unrepayable debt, falling prices, and stagnant demand do not fit comfortably with the picture of robust growth portrayed in official statistics.

Why is China's economy slowing? Students of Tawney will not be surprised to observe that reform is not complete. Even after two decades of massive socio-economic change, China's economic landscape offers a mix of immense transformation and limited change. My own work has focused on transformation (Jefferson and Rawski 1994a, 1994b; Rawski 1995). Lance Gore (1999) provides cogent evidence of limited change. He notes that state enterprise leaders are still appointed by agencies of the Communist Party, and that enterprise managers continue to report to government officials. But we know that the thinking of party and state leaders has changed remarkably, so Gore's evidence of structural continuity is not sufficient. We need evidence that focuses on outcomes rather than structures. This is the motivation for the following analysis of China's declining growth performance, which will show how unreformed structures threaten China's economic momentum.

Reported GDP growth, as noted above, is declining. Furthermore, the most recent figures (for 1998 and 1999) may be overstated as China's State Statistics Bureau (SSB) struggles to cope with an upsurge of false reporting that began in the second half of 1998. Provincial GDP reports for 1998 indicate national growth of more than 9 percent (Chart 1).(1) The SSB scaled this back to 7.8 percent. The magnitude of the reporting problem emerges from Chinese commentaries, some recalling the catastrophic famine of the late 1950s, caused in part by rampant falsification of harvest data. The following observation forthrightly attacks the 1998 campaign to achieve 8% GDP growth:

Whenever the leaders insist on accelerated growth or when accelerated growth becomes the content of evaluation, the wind of overstatement flourishes . . . . Some of the targets that come down from the higher levels are objectively impossible to reach, but since the leaders demand high speed, then the operating departments split up the responsibilities, and, in order to ensure the achievement of the result specified by the upper levels, the lower levels apply more pressure with the result that the indicators become seriously divorced from reality (Gan and Li 1998).



A wealth of material, including low growth rates for energy output, a reduction in freight haulage, declining employment and wage bills in the formal sector (Survey 1999), and press reports of falling incomes and stagnant markets, suggests that actual growth in 1998 did not attain the reported figure of 7.8 percent. Figures showing that, despite extensive price discounting early in the year, airline passengers and passenger kilometers rose only 2.2 and 3.4 percent seem notably inconsistent with 7.8 percent growth (Survey 1999, p. 120).

[Insert Chart 1 about here]

Whatever the precise figures, why have growth rates declined? Why is China's boom fading? It is tempting to blame the slowdown on the Asian financial crash of 1997. By hobbling China's export expansion and stalling the growth of incoming foreign investment, the Asian crash certainly exerted a negative impact on Chinese growth, particularly in the pace-setting coastal regions. It is my contention, however, that careful analysis can trace the origins of China's slowdown to internal forces that predate the Asian crash. The dynamics of slowing growth emerge from obscure, but revealing statistics.

I begin with information on the seasonal changes in GDP, reproduced in Chart 2, which shows quarterly figures for nominal GDP from 1995-Q1 to 1998-Q3 along with projections through 1999.(2) These data show a consistent pattern. Output rises sharply in the fourth quarter and declines precipitously in the first quarter. There is modest expansion in the second quarter and little change in the third quarter. These observations are typical, not unusual. Projections for 1998/99 show the same features, which also appear in data for 1980-95 (not shown).

[Insert Chart 2 about here]

Chart 3, which shows the percent change in nominal GDP from quarter to quarter, underlines the regularity and scale of seasonal fluctuations. In every case, first-quarter output trails the result from the previous quarter by at least 35 percent. The celebration of Spring Festival, during which many (but not all) sectors are idle for up to two weeks, accounts for only part of this decline. And, following modest recoveries in the second and third quarters, output in the final three months rises in each case by at least 35 percent.

[Insert Chart 3 about here]

These data show that the world's most dynamic economy regularly shrinks during 3 months of each year and stagnates for another quarter, with all the growth occurring in the second and fourth quarters.(3) The enormous seasonal fluctuations dwarf comparable variations in market systems. In the United States, for example, quarterly GDP fluctuations between 1875 and 1995 are limited to plus or minus nine percent (Economist 1995).

In reality, these data are not mysterious. The seasonal profile is typical of a socialist economy driven by planned investment. The socialist calendar is punctuated with regular bouts of storming or shock work (tuji), "the spurt of activity before the end of each planning period. . . in an attempt to achieve 100 percent fulfillment, with a subsequent period of slack until the next target date approaches" (Brown and Neuberger 1994, p. 370). Indeed, disaggregation of the GDP figures (not shown) reveals that huge fluctuations in investment drive the seasonal patterns displayed in Charts 2 and 3.

These observations raise the possibility that limited reform of investment, which accounts for roughly two-fifths of Chinese aggregate expenditure, may lie at the root of China's growing economic difficulties. This possibility is well-understood by Chinese economists:

Many basic components of a 'pure' market economy are still in their incipient stage in China, although market-oriented reform started two decades ago. Government-guided investment mechanisms, a State-controlled banking system and dominant State-owned enterprises. . . still run in a framework molded primarily on the previous planned economy. (Li Jianlin 1999, p. 4, with emphasis added).



Anyone who visits China or reads Chinese publications encounters frequent reference to capital scarcity, e.g. "Generally capital remains in short supply" (Shen Kunrong 1998) or "capital shortages still exist" (Dong Fureng 1999). Elementary economics teaches that if capital (or anything else) is scarce, profits will be high for the lucky few who gain access to the scarce resource. But profit rates in China have fallen almost continuously for the past two decades. The tribulations of state enterprises are all too familiar. But we also observe steep declines in the profits of rural collective industries, where after-tax profit rates plunged from above 20 percent of total capital during 1978-82 to less than 10 percent in nearly every year from 1987 (Kwong 1987, p. 496; Yearbook, various issues). The unexpected combination of scarce capital and falling profit rates signals the presence of serious defects in China's capital allocation mechanism.

Chinese investment spending may generate weak financial outcomes, but what about product flows? Here again, we encounter unmistakable evidence of difficulty, this time from information about rates of capacity utilization. In 1995, the utilization rate for China's steel refining capacity, which then amounted to 169 million annual tons, was only 56 percent (Chen Jiagui 1997). Even though output never came close to 1995 capacity, new investment pushed refining capacity to 190 million tons, nearly double the expected 1999 output of 104 million tons (Steel 1999). In the glass industry, a 1995 report indicated that "float glass production lines which have started construction or preparatory work number 73" and that "the combined annual output capacity of the 73 lines far surpasses actual demand and will cause a surplus on the market." Even so, the same report quoted a government official who stated that "the country plans to build some float glass projects with foreign investment in the central and western regions to seek a balanced distribution of float glass projects" (Zhang Yu'an 1995). Four years later, the government belatedly decided to block new projects and close down existing float glass plants (Yu Ren 1999).

This history of excessive investment recurs in sector after sector. China's 1995 industrial census revealed that the average utilization rate for equipment in 111 product lines was 66 percent, with half of the figures falling under 55 percent.(4) Since then, utilization rates have fallen further. In 1996, information for 1,000 product lines showed 600 with utilization rates under 60 percent. A 1999 report, presumably referring to conditions in 1998, stated that "at present, nationwide utilization rates are below 60% for half of all industrial products" (Chen and Qi 1999, p. 16). Data for Guangdong, one of China's most dynamic provinces, show that: "of 320 types of production equipment [apparently for 1998]. . . 52% have utilization rates below four tenths, and 22 types have utilization below two tenths. . ." (Li Chao 1999, p. 45). Recent reports describe overcapacity across a broad range of industries, including steel, glass, cement, chemicals, motor vehicles, fertilizer, electricity, textiles, garments, appliances, paper, coal, and oil refining. Evidence that industrial investment projects often fail to produce commodities as well as profits provides further proof that China's economy is riddled with massive waste of capital.

Why, after two decades of market-leaning economic reform, do vast quantities of investment funds continue to pour into ill-considered projects? Chinese analysts and external observers point to a number of institutional factors. The most plausible explanation is the continued dominance of government administrators in investment decisions. We have already seen that officials do not hesitate to initiate industrial projects intended to "seek a balanced distribution" despite ample warning of excess capacity. Other non-economic motives are regularly brought to bear. Beijing welcomed "the completion of five new office projects in celebration of the 50th anniversary of the founding of the People's Republic of China" even though a surplus of office space, with 30.2 percent of available space vacant at the end of 1998, meant that "they are unlikely to be sold or rented out in the short term" (Xu Dashan 1999). Preservation of employment or regional balance offers additional rationales for investments.

While there is no shortage of explanations for the prevalence of poor investment decisions, including soft budget constraints, pressure on banks to provide non-commercial loans to state enterprises, and simple graft, the continuing role of government, with its wide array of non-profit objectives, seems to dominate on the institutional side. As one Chinese economist puts it:

It is widely recognized that the root cause for the low efficiency of China's economy lies in overly duplicated industrial structures and overflowing similar products. . . . Behind the duplicated industrial mix is a diseased investment decision-making mechanism.  Most investment projects are funded not based on an investors' pursuit of profit maximization, but on administrative power. (Li Jianlin 1998, with emphasis added).



There is also some basic economics involved in the consistent pattern of poor investment decisions. Chart 4, which plots the five-year moving average of real interest rates facing Chinese enterprises. Surprisingly, complaints of "scarce capital" coincide with a long interlude of negative real rates lasting from 1985 to 1994.(5) Negative real rates encourage excess investment and complicate the efforts of China's banks to reorient their bloated and under-qualified work force toward commercial analysis of loan applications.

[Insert Chart 4 about here]

The history of many nations, including all the major industrial market economies, shows that strong and dynamic economies have the capacity to grow and prosper while absorbing large amounts of waste. But as the volume and proportion of wasted resources increases, the costs inflicted on the viable segment of the economy mount, creating pressures that can slow or reverse forward progress. This is now happening in China, where protracted waste of investment funds has inflicted frightening financial pressures upon governments, who are the main owners of capital, and upon their clients: publicly-owned state and collective enterprises, state-owned banks, and public sector employees.

These pressures take the form of financial losses, dwindling profits, slow revenue growth, and accumulation of unrepayable debt. The most dramatic consequence is xiagang, best translated as "furlough" or "on-the-job layoff." In 1998 alone, 12 million workers were laid off, of whom only half were re-employed; formal employment in the urban sector dropped by 23 million or 16 percent, with more to come as downsizing continues and enterprises begin to sever ties with furloughed personnel who still remain on the employment rolls (Shen and Bing 1999; Survey 1999, p. 35).

The expansion of xiagang or furloughs for redundant personnel has contributed to, but did not cause a collapse in job creation which dates from 1996, long before the Asian financial crash. This sudden faltering of the demand for labor provides a logical explanation for increasingly frantic official efforts to prop up China's aggregate growth. No government can stand idly by as job creation plunges into negative territory.

The abrupt drop in job creation emerges from Table 1, which contains figures for labor absorption in various segments of formal employment calculated as percentages of increments to the national labor force. The residual of labor force increments that are not matched by increases in formal employment is assigned to the "informal sector," which includes self-employed farmers and unemployed persons as well as casual workers. Table 1 provides a clear overview of changes in China's national labor market. There are three distinct periods:

i) During the 1980s, formal employment absorbed half of the labor force increment, with new positions in TVE firms and in urban formal employment each equivalent to roughly one-fourth of the labor force increment.

ii) During the first half of the 1990s, expansion of formal employment jumped far ahead of labor force growth.

iii) Conditions changed abruptly after 1995. Although success in stifling inflation encouraged claims that China's policymakers had piloted the economy to a "soft landing," labor market outcomes tell a very different story. The annual increment to formal employment plunged from 13.7 million in 1994/95 to 8.6 and 1.4 million in 1995/96 and 1996/97, and then into negative territory in 1998.

[Insert Table 1 about here]

Table 1 also highlights the surprising emergence of private business as a major source of formal employment growth. China's formal private sector remains small, accounting for 2.6 percent of formal employment in 1990 and 8.6 percent in 1997. Its impact on employment growth, however, is far larger. The figures show that new formal employment in officially-registered domestic private enterprises (including "individual" enterprises with fewer than eight employees and "private" firms with eight or more workers) accounted for 37.6 percent of incremental formal employment at the national level during the years 1990-97. If we limit the comparison to new urban formal employment, the share of the domestic private sector rises to an astonishing 55.7 percent. The data show that China's domestic private enterprises added more workers during 1995/97 than the combined total for state, collective, and TVE firms, a finding that will surely apply to 1998 and 1999 as well. With some private enterprises "reluctant to register. . . for [fear of]. . . being taxed" (Zhu Qiwen 1998) and others disguised as urban or rural collectives, these figures surely understate the contribution of domestic private undertakings to Chinese job creation in the 1990s.

China's long boom actually consists of a series of sectoral or regional investment surges in farming, rural industry, coastal export zones, foreign-linked manufacturing, and construction of housing and infrastructure. One reason for falling growth is the absence of a leading sector. As China enters the new millennium, there is little prospect for an investment boom centered on agriculture, manufacturing, exports, housing, or foreign investment. The Keynesian policy initiative of 1998/99, which sought to use government-financed infrastructure projects to stimulate the economy, appears to have fallen considerably short of its objective, and in any case, was at best a temporary stopgap. As one economist explains:

The main engine pushing China's current economic growth is public expenditures. To transform this momentum into sustainable economic growth, the govt should make further economic re-adjustments. Unless growth of the non-State sector is boosted, heavy investment in the State sector alone will not lead to the country's economic recovery (Zhang Ping 1999).



The surprising emergence of private business as the main source of new employment raises the question of whether a concerted effort to roll back the barriers obstructing development of private business might form the core of a new policy strategy aimed at curtailing long-standing waste of investment funds and promoting a resumption of high-speed growth. A policy centered on private business growth is not inconsistent with China's long-term reform strategy, which sees the private sector as a significant component of China's "socialist market economy." This provides a distinct advantage over current pump-priming efforts, which have the unfortunate effect of partially reversing important reform initiatives, especially in banking and finance.

Such a policy could build on a growing recognition of the actual and potential contribution of private business to the national economy. Changing attitudes are most clearly visible at the local level, especially in China's southern provinces. The Vice-Governor of Zhejiang, for example, has announced that "private companies will be treated as equal to their State-owned counterparts and enjoy the same policies" (Zhang Yan 1998). Zhejiang's government plans to "upgrade the importance of the private economy and 'propel the local economy to a new stage'" (Zhou Weirong 1998). Guangdong officials seem comfortable with genuinely independent private entrepreneurs who reject informal contact with government agencies (interview, May 1998). The national government has supported this new approach with a constitutional amendment recognizing the role of private business, as well as measures that increase private firms' access to export opportunities and bank loans (Shen Yefan 1999; Wang Ying 1999).

The difficulties, however, remain formidable. Prejudice against private business is deeply entrenched in many official agencies. In Shaanxi, for example, "efforts to promote local private enterprise" consist of policies under which "local officials are being asked to refrain from discriminating against private enterprises. . . as has been done in the past, and to try harder to provide better service to them" (Ma Lie 1997). Supporters of private business often feel compelled to use coded language. Thus economists speak of the need to encourage "medium and small" businesses. A proposed law to protect private business is discussed under the opaque heading "solely-invested enterprises law"; proponents complain that while the measure "is meant to be an encouraging law. . . there are too many articles on punishments" (Yu Yi 1999). Banks are encouraged to support private firms, but loan officers hesitate to do so (Shen Bin 1999), apparently because they regard failed loans to private firms as more dangerous to their career prospects than non-commercial lending to the public sector. Officials see no irony in announcing that "The State is determined to stop all unnecessary administrative fees and fines imposed upon foreign enterprises" while denying the same protection to Chinese firms (Su Dan 1999).

Under these circumstances, a big push to remove the limits to private business development must include sustained personal involvement from top leaders at all levels. Such efforts have been conspicuously absent, particularly among China's national political elite who, unlike many provincial and local leaders, show little taste for openly promoting private business.



China's long boom is an important event in world economic history that has delivered immense benefits to China's citizenry. We know that accelerated growth cannot continue forever. It seems quite possible that the accumulated costs of massive investment mis-allocation have drained the momentum of Chinese growth. It is essential to emphasize that long-term reform continues through a combination of official action and market response even as policy-makers scramble to concoct remedies for fading growth and surging unemployment. Some recent reforms, such as the reorganization of China's central bank and continuing efforts to improve the quality and uniformity of enterprise accounts, directly address issues linked to the systematic mismanagement of investment funds emphasized in the present analysis.

A sustained effort to overcome longstanding difficulties in the allocation of investment funds necessarily involves large-scale reductions in the supply of funds to the worst offenders - government agencies and unprofitable state enterprises. This poses a sharp conflict between short- and long-term economic objectives that the 8 percent growth drive of 1998, with its emphasis on hastily contrived public-sector infrastructure projects, has only served to intensity. In the current environment of deflation and near-stagnation, government cannot possibly curtail funding to traditional beneficiaries of the largely unreformed investment planning system in the absence of a dynamic source of new investment demand. Private enterprise stands out as the only feasible source of such demand. Accordingly, I conclude that China's short-term prospects for resumption of rapid growth are closely linked to the speed with which reform efforts can dismantle the formidable obstacles facing potential private business investment.





Table 1

China: Sectoral Contributions to Labor Absorption, 1980-1997





1980/90 1990/94 1994/95 1995/96 1996/97
Labor Force Increment

(millions)

215.5 32.9 7.5 9 7.5
Absorption (Percent)
Formal Sector 49 141 143 63 -34
State 11 26 7 -2 -27
Collective 5 -8 -17 -14 -19
Other 1 18 17 8 20
Private 3 27 64 32 45
TVE 29 84 112 72 -1
Xiagang 0 -6 -40 -33 -53
Informal* Sector 51 -41 -43 37 134



Source: Calculated from Survey 1998, p. 32 and Rawski 1999, Tables 1 and 2.



Xiagang figures: 2 million for 1994, 3 million for 1995 and 1996, 4 million for 1997 [Measures 1999, gives a figure for 1997 and a cumulative total of 8 million at year-end 1996].



*Residual, including self-employed farmers and unemployed workers. Note that xiagang workers remain associated with their units and are therefore included in the employment totals.





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NOTES

1. Provincial and national data: Xu Binglan, "Statisticians Seek Reliability," China Daily Business Weekly 2-15-99, p. 1. Sectoral data from Survey 1999, p. 104 and 120. GDP weights based on 1997 provincial GDP figures from Yearbook 1998, p. 63.

2. Data for Chart 2 are from PBOC 1997; Zhu Yunfa et al, 1997, p. 4; Zhang Yanqun, 1998, p. 80, and Zhu Yunfa and Zhang Yanqun, p. 139.

3. This explains the Chinese practice of comparing partial year output totals with the same period during the previous rather than with the prior month or quarter. This approach avoid the question of why, for example, output in the first quarter of 1999 was projected to be nearly 40 percent below the figure for the final quarter of 1998.

4. Source: calculated from Yearbook 1997, pp. 454-455.

5. Chart 4 is based on the author' electronic file realrter.xls; the chief source is Lardy 1998, p. 108.