Decentralization, agency costs, and the new economic constitution of China

Abstract

This article examines the evolution of the rules that govern central-local government relations in the Chinese political economy. Although the federalism that accompanied China's market reforms has substantially facilitated economic growth, it has also created powerful incentives for local authorities to abuse their powers, significantly increasing the agency costs to the central government of maintaining political stability and creating a national market. This article analyzes the institutional design of the nascent Anti-Monopoly Law (AML), known to officials and academics as China's new ''Economic Constitution''. It demonstrates that the major purpose of the AML is to break up the so-called ''administrative monopolies'', or bureaucratic fiefdoms over local economies. In contrast to existing academic treatment, it will study the AML in the framework of competition for influence over economic policy between rent-seeking central and local actors. It argues that the AML, despite its stated purposes, is indeed designed to reduce the policy-making powers of the regions to the comparative advantage of the central government. The AML can thus be modeled as a new constitutional contract that the center wishes to enter into with the localities in order to repeal the existing rules of decentralization. It will be further shown that the AML, reflecting the allocation of power in the Chinese state, prioritizes the political imperatives of recentralization over the facilitation of competitive markets.

An equilibrium path for institutional change in China

“…responsible for running the country's 31 provincial-level units, which are home to an average of 42 million people per unit (Ip and Law, 2011). However, institutional change has acquired so much momentum that it cannot be stopped; China will have to continue along this path.…”

“…Local governments now deliver a wide range of services, including education and health care, through state-owned enterprises that they control (Li, 2011). Inevitably, a form of fiscal federalism has emerged in China, and the country’s written constitution, which mandates a unitary, centralized state, no longer resembles the de facto constitution (Ip and Law, 2011). The emerging federalist political structure allowed liberalization of local regulations based on the belief by central government reformers that local governments best understood their local conditions and were thus best suited to create institutions that would support the emerging market economy (Montinola et al., 1995; Qian and Weingast, 1997).…”

“…The central government’s political patronage became less important than the efficiency of the local economy in furnishing revenues for local governments, and the overall influence of central government ministries in economic regulation declined drastically (Weingast, 1995). Indeed, local officials often ignore central government policy recommendations in areas such as planning of economic growth and resource management, especially since most tasks imposed by the central government are either underfunded or not funded at all (Ip and Law, 2011). Unfortunately, one consequence of this approach is that the quality of Chinese institutions varies significantly among the provinces, leading to large variations in economic growth and political processes (Ji et al., 2014; Li, 2011).…”

“…The federalism that has accompanied China’s market reforms greatly facilitated economic growth, but also created an opportunity and incentives for local authorities to abuse their powers. This has significantly increased the costs of maintaining political stability and encouraging the development of a national market (Heinemann and Tanz, 2008; Ip and Law, 2011). Additional challenges include increased social inequality, many environmental crises, the risk of political instability (Knight, 2013), a rising crime rate and rising unemployment, and widespread corruption (Dong and Torgler, 2013; Wang and You, 2012).…”

“…Because ideological constraints from the Mao era were a major obstacle to growth of the private sector (Lin, 2002), the success of adopting new approaches based on proof of their success rather than ideological considerations consolidated Deng's political power and removed many obstacles to economic reform, leading to transformation of the socialist ''command and control'' economy into a more market-oriented capitalist economy. This paradox has been referred to as a ''socialist market economy with Chinese characteristics'' (Zhang et al, 2008;Ip and Law, 2011).…”