The importance of path dependency can be seen by showing that the choice of China's leadership to gradually liberalize markets is due in a large part to its earlier actions. Specifically, once China had successfully implemented property rights reform and restructured its farms (as well as adjusting prices to reduce the implicit tax on farmers), it is clear the policy actions needed to continue the reform by liberalizing markets became less imperative. The diminished need to continue the agricultural reforms can almost certainly be traced to the fact that the early pricing reforms and HRS helped the reformers to meet their initial objectives. The HRS reforms increased agricultural productivity which led to higher farm incomes and food output. The agricultural pricing reforms also contributed to higher farm incomes and output. From the point of view of the leaders, the performance of the agricultural sector helped leaders achieve their goals by fuelling China's first surge in economic growth and reducing the concerns about national food security. The legitimacy that they sought as leaders of a government that could raise the standard of living of its people was at least temporarily satisfied.
Given this, there was no immediate necessity to launch into an entirely new set of reforms that would necessitate spending additional political capital as well as exposing the leaders to a new set of risks that reforms inevitably create. Most likely there were still those that recognized that the reliance on government input supply channels and state procurement agencies at set prices was imposing efficiency costs on the economy. Indeed, one of the first set of government-designed experiments in the mid- to late 1980s was to set up a market reform experiment in Henan province to determine how the market could be allowed to play a more important role in the procurement of farm output (Sicular 1995). But, at the time in the early 1980s, planners had erased, at least temporarily, the worst of the inefficiencies created by nearly thirty years of government policy. Not only had HRS policies improved incentives, the planning commission had implemented price reform by adjusting the mix of domestic output and input prices to levels that were more favourable to farmers and also improved incentives for rising input use and output expansion. Hence, with the urgency for additional reforms dampened for both the top leaders (since their goals were met) and farmers (since their incomes and control over the means of production had both improved), there was less policy pressure from the top and the grassroots.
If the gradual pace of reform taken by China is indeed due to the initial success of the price reform and decollectivization, then the fundamental determinants of market liberalization are essentially the same as those that are associated with decollectivization. As discussed in the previous section, wealth, initial technology, and decentralization created the environment within which decollectivization could succeed. According to our logic, then, the same factors—wealth, initial technology, and decentralization—are likewise the underlying causes of the gradual pace of market liberalization in China.
Wealth, or more accurately China's poverty, may also have directly contributed to the decision to delay market liberalization. Although the potential disruption effects due to market liberalization were relatively low (given the nature of China's farming systems), ex ante the leaders did not know how much disruption would be caused by complete market liberalization. In the early 1980s, China was still a net importer of food, had only small foreign exchange reserves, and had little means to make up food shortfalls through imports. The nation's per capita calorie level was still low. In short, China was living on the edge of a precarious food balance; it was mostly feeding itself, but barely. Hence, when considering whether or not to proceed with a reform that possibly (though maybe not even probably) could disrupt the nation's food supply, it is easy to see how the calculus induced leaders to proceed only gradually.
Besides, the decentralized nature of China's economy gave it a choice not only when to reform, but how. In addition to the indirect effects of decentralization on the pace of market liberalization in China, decentralization also affected the way that China reformed its markets. Because regions were relatively self-sufficient, China's grain system was built around thirty separate provincial grain bureau systems that each ran around 100 county-level grain bureaux. Each county grain bureau had its own network of ten to twenty township grain stations. Hence, in total there were more than 50,000 different units involved in the grain business. While vertically integrated into a nationwide hierarchy, the grain bureau in each individual jurisdiction also reported to the local government and part of their effort (as well as part of their funding) was spent in meeting the food goals of the local economy. Essentially what this means is that while each grain bureau sub-agency did retain ties to the grain bureaux in the level of government above them, they also had a certain degree of independence. An almost identical system existed in parallel with the grain bureau for distributing fertilizer.
As a consequence, when China's national leaders finally began to slowly relax the restrictions on inter-regional trade of grain and fertilizer they did not need to build a competitive market system out of nothing. Instead, grain and fertilizer marketing reform was actually started by partially commercializing the state-owned grain stations and fertilizer input supply corporate branches. In return for performing certain state policy functions (such as continuing to collect the state-imposed delivery quota or deliver ration-priced fertilizer), managers of the grain stations and input supply branches were allowed to engage in trading as long as it did not interfere with their policy duties. They were also allowed to keep part or all of their trading profits. Hence, as described by McMillan (1997), China liberalized grain markets using an approach that was used in other sectors of the economy: competition by entry. In this case, however, the competition was among quasi-commercialized grain bureau managers and the entry occurred because there were thousands of units all of which were provided with an incentive to trade. During most times, there were also few restrictions imposed by policy on who could trade where.
Fertilizer market reform: a case study of China's gradual approach
The effectiveness of such a system in giving control to China's leaders over the pace of reform is seen in the case of reform in the fertilizer sector (Stone 1988; Ye and Rozelle 1994; Rozelle 1996). In search of more efficient inter-regional allocations of chemical fertilizers, leaders partially commercialized the local branches of China's Agricultural Inputs Corporation (AIC) in the mid-1980s. Almost immediately, inter-regional trade sprang up to a level that had never before been experienced (albeit still relatively small from the point of view of a mature market economy), driven by managers that had an incentive to arbitrage price differences between fertilizer surplus regions and those in relative deficit.
The new fertilizer marketing channels, however, were still relatively new, and although the newly liberalized traders helped ease regional shortages, they did not eliminate them. In fact, they could not for two reasons. First, the marketing networks were still immature, having just started. Many transactions still depended on old relationships and not the forces of supply and demand through competitive wholesale markets. In addition, the nation was still in aggregate deficit; that is, aggregate fertilizer supply was insufficient to meet aggregate demand. Moreover, the aggregate deficit not only existed when output prices were relatively low in 1985 and 1986, but was even more evident as the demand for fertilizer rose with the rise of grain prices in the late 1980s.
It was the tensions caused by rising demand for fertilizer and a marketing system that was not ready to handle the pressures that ended up leading to a suspension of the first attempt at fertilizer reform. As the prices for grain began to rise sharply in late 1987, the demand for fertilizer across regions became increasingly intense. The media was filled with reports of hoarding, fertilizer hijacking, and price gouging. By early 1988, it was becoming clear to leaders that a system relying solely on the nascent fertilizer markets was not going to be able smoothly to handle the rising pressures. In response, China's government took immediate action by temporarily suspending the rights of AIC officials to commercially trade fertilizer and reverted back to the planned allocations. As during the time before the reforms, localities would depend mostly on production from their own local plants (which were built during the Mao self-sufficiency era) supplemented (often only minimally) by shipments supplied under a nationally planned inter-regional transfer matrix.
The actions of the leaders revealed their preferences and demonstrated that they had a choice in the pace of liberalizing markets. Despite the inefficiencies associated with the plan, at the very least local leaders and producers could make their production plans under a degree of certainty, even if the quantity of fertilizer was insufficient. Apparently, China's leaders believed the costs of allocative inefficiencies by not having market forces equilibrating prices across regions (and relying on planned fertilizer allocations) were less than the costs that would have been created by the uncertainty of access to fertilizer associated with imperfectly developed markets.
After the aggregate supply of fertilizer rose in the early 1990s, due to increased production capacity and imports, fertilizer markets were liberalized once again, this time with almost no market disruptions. Clearly, the gradual nature of China's fertilizer reforms benefited from the decentralized nature of China's economic and political system and the fact that there was no immediate imperative to reform. If it did not work the first time, a second attempt at reform could be started at some point in the future when conditions were more favourable.
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