Further Details from Joint Symposium Chaired by Xi

Zhou Qiren on "System Cost" within the Chinese Economy

Hey everyone, Let’s shift our focus back to Chinese economic reform today. On May.23, Chinese President Xi Jinping chaired an economic symposium in Jinan, Shandong Province. This symposium includes nine representatives from foreign companies, private sectors, economists, and state-owned enterprises. Topics include developing venture capital investment, upgrades of traditional industries, improving the corporate governance of private enterprises, and optimizing the business environment for foreign enterprises.

After several days, details from this symposium gradually came out. According to People’s Daily, Executive Vice President of Bosch China, David Xu (Xu Daquan), put forward suggestions for optimizing the business environment for foreign enterprises. Xi replied

"We are committed to creating an environment of fair competition and will not squeeze out foreign-funded enterprises from the Chinese market. The door of our opening-up will open wider and wider."

Zhang Bin, Deputy Director of the Institute of World Economics and Politics (IWEP) at the Chinese Academy of Social Sciences, talked about optimizing the layout of regional productivity and preventing "involution-style" homogeneous competition. Xi replied

"The meaning of new-quality productive forces can be further explored in depth. Is new-quality productive forces equivalent to emerging industries? The transformation and upgrading of traditional industries can also develop new-quality productive forces. We should not only focus on the 'new three items.'(referring New energy vehicles, lithium batteries, and photovoltaic products) We should not have a sudden upsurge, a sudden rise, and a sudden dispersal. We must adapt measures to local conditions, as each has its own merits.

Economist Zhou Qiren, a Professor at the National School of Development, Peking University, joined the symposium as a renowned expert on Chinese economic reform. His research focuses on property rights system reform and the relationships between system cost and the Chinese economy.

The concept of "System Cost" extends the idea of "Transaction Cost" and emphasizes the cost of non-market transaction behaviors, such as government regulation, tax, and corruption. Zhou believes that the key to Chinese economic growth is to reduce system costs through reforms.

In one of his articles published in 2017 by China Economic Quarterly, Zhou develops his analysis using the core concept of system cost, defining it as all resources consumed in the establishment, operation, and change of the system. He argues that China's economy grew rapidly between 1978 and 2008, benefiting from the reform and opening up that lowered the previously high system costs, thus playing a comparative advantage in globalization. This, he states, is the foundation of China's economic success.

However, during the growth process, China's taxes, fees, and other statutory payments, rent-seeking, corruption, and extravagant spending have risen too quickly, leading to new pressures on China when dealing with changes in the global competitive landscape. Zhou believes that China needs to significantly reduce system costs through structural reforms to achieve sustainable growth. Although the article was published in 2017, it remains helpful for those seeking to understand Zhou's perspective on the relationship between system cost and the Chinese economy.

I have attached a chapter of his work introducing “institutional friction,” which is a crucial part of system cost generated during the reform. In this chapter, he introduced three cases of such friction, showing how the interests of various departments can hinder the reform.

Unquantifiable Institutional Friction

There are still some system costs that are difficult to be reflected by statistics. Observations indicate that in economic activities, the property rights delineation, contract disputes, new product development, market access, changes in scope of government monopoly, administrative litigation, and civil case trials all involve additional costs other than direct production costs. Although such broad transaction costs or system cost as defined in this paper also take place in mature market economies, these nonproduction-related costs are rather unique in a transitional economy like China and forms its own system. Based on several cases that the author has studied in recent years, this section will briefly discuss the nature of such costs.

The first case involved government monopoly over the telecommunications sector. The backgroundwas in the late 1990s when the rise of Internet provided a newopportunity for voice communications. Different from traditional telecommunications, the Internet-based voice communication (namely IP phone) does not need to exclusively occupy the expensive communication cable, but transfers massive voice packets with the same line, and thus can revolutionarily reduce communication charge. At the end of 1997, a private enterprise operated by CHEN Brothers in Mawei District, Fuzhou City, began to apply IP telephone to commercial activities and became very popular in the market. At that time, international calls were very expensive, ranging from 18 to 32 yuan per minute, but the IP phone provided by CHEN brothers only cost 6–9 yuan per minute. Naturally, their business was booming.

However, they were reported by the local telecommunications bureau to the police as engaging in “illegal business operations”, and the district public security bureau sealed up their business venue, confiscated their equipment and limited their personal freedom. Later, they were released on bail pending trial after their family paid 50,000 yuan. The brothers filed an administrative litigation in the District Court and later appealed to the Fuzhou Intermediate People’s Court. The President of Fuzhou Intermediate People’s Court, Judge XU Yongdong, considered the case involved new technology, and asked the parties to provide expert witnesses to debate in court about the technical differences between IP telephone and traditional telecommunications. After the trial, Fuzhou Intermediate People’s Court held that IP telephone did not fall within the scope of traditional telecommunications but belonged to a new business open to the private sector according to a State Council documents. On January 20, 1999, the Fuzhou Intermediate People’s Court revoked the ruling of the Mawei District Court and ordered a retrial.

Unfortunately, this well-founded 7,000-plus-word verdict was not duly respected. On January 21, 1999, the next day after the Fuzhou Intermediate People’s Court issued the ruling, a division director of the Ministry of Industry and InformationTechnology (MIIT) declared publicly to the media that “the claim that ‘IP telephone is not under the monopoly of telecommunication operation’ is groundless.” His basis is a “Notice” issued by MIIT, which stipulated that the “computer information network business” adopts the license system and “should temporarily not open telecom services such as telephone and fax.” The director claimed that since the Notice clearly stipulates that the business “should temporarily not open to telecom services”, then if someone uses IP telephone to operate long-distance telecommunications business, it is an illegal operation.” He also disclosed the main ways to deal with such illegal activity as IP telephone: “If the scale is small, the administrative department will generally confiscate the illegal income and impose fines; if the scale reaches the threshold for crime, the case will be transferred to the judicial organ and dealt with as an illegal business operation according to Article 225 of Criminal Law. The relevant departments have investigated and handled many such cases in Guangdong and Shanghai, and some have been transferred to the judicial authorities.” So it is clear, in the opinion of this director, a notice from his own administrative department is far more authoritative than the ruling of the Fuzhou Intermediate People’s Court and the quoted State Council Circular, and it is beyond question and requires no judicial discussion. Under such a “legal” atmosphere, the final verdict of the CHEN brothers’ case went nowhere and became unknown to the public.

The second case is the express delivery business by private sector that touched the cheese of the postal sector.With booming commercial activities, the demand for express delivery, such as for commercial documents, samples, and later prosperous e-commerce parcels, increases rapidly. In the 1990s, the Little Red Cap Express emerged in the private sector, and the top five international logistics companies such as FedEx also entered China market. However, they started and all faced this new problem: are non-postal service entities allowed to operate the express delivery? The postal department’s answer was definitely negative, because the Postal Law of the People’s Republic of China, adopted in the 1980s, clearly stated that themail delivery business is operated by state monopoly. The new question is, can the old regulation automatically cover new businesses that did not exist when the old regulations were drafted? The position of the former Ministry of Posts and Telecommunications was that in order to protect citizens’ freedom of communication, the business has to be exclusive to the postal service. Therefore, the focus of the dispute was shifted to whether the emerging express commercial package delivery fell into the category of the “mail”.

The conflict of interest made it necessary to be particular about the wording. So, what is “mail”? The Rules for the Implementation of the Postal Law of the People’s Republic of China formulated in 1990 (hereinafter referred as Rules) points out, “mail includes letters and postcards or other articles”, and “letters refers to message carrier in the form of sealed envelopes”. By this definition, Twenty-Four Histories, Das Capital, Encyclopedia Britannica are all letters if they are sealed in envelopes.

And additionally, what is “other articles with characteristics of a mail”? According to the Rules, they are “those carriers which transmit information by using such forms as symbols, images, or sounds”. Considering possible different interpretations by different Chinese people for frequently used terms, the Rules specifically announced that the “specific content of the exclusive postal operation is subject to the interpretation by the Ministry of Posts and Telecommunications”.

Even the after effects of the 911 terrorist attack in the United States added an episode to the extension of the monopoly of China’s postal service. On November 15, 2001, to prevent the already reported anthrax virus in the US from spreading to China, the General Office of the State Council issued an urgent notice, requiring to “strengthen themanagement of postal services such as letters and printedmaterials to prevent anthrax spreading”. On December 20, 2001, several competent authorities, including the State PostBureau, jointly notified all enterprises that “need to handle the delivery of inbound and outbound letters and articles with the characters of letters”, “should, within 60 days upon the issuance of this notice, go to the provincial postal department to handle the entrustment procedures.” On February 4, 2002, the State PostBureau issued a notice to the provincial postal department, the approval authority for entrustment applications, stating that “the scope of the postal entrustment is limited to the sending or delivery of inbound and outbound mails or articles with characters of letters with a weight of over 500 grams per item, or with the per-item charge above the state prescribed standard for express mail (of the same weight, to the same country/region). The nutshell of this seldom-seen awkward and lengthy sentence is that any mail with the weight of not exceeding 500 grams and the rate cheaper than the state postal bureau are not allowed to be entrusted (or delivered by private businesses). What is even more incredible is that the notice also made it clear that “the scope of the entrustment specified in the preceding paragraph does not include letters with the personal address of citizens and official documents of the party, government, military and other organs at or above the county level.”! The author then commented that these unreasonable and inappropriate administrative controls only aim to protect the obsolete privileges of the postal department and have nothing to do with anthrax prevention.

The third case is a strange story taking place in Dongguan. As a major coastal manufacturing city in the Pearl River Delta, the majority of the permanent population do not have the registered local permanent residence (called “Hukou” in Chinese), which resulted in severe short supply of local services. So lots of private enterprises came in, and their business included opening pharmacies. InMarch 2002, The Interim Regulations for the Establishment of Retail Pharmacies (hereinafter referred to as Regulations) announced the opening-up of the Guangdong’s drug retail market. Investors from elsewhere swarmed into Dongguan with great enthusiasm. However, they soon found themselves running into an administrative wall that caused them bleeding. Starting from June 2001, the Dongguan Food and Drug Administration (FDA) began to implement a Regulation stipulating that any new pharmacy needs to be at least 500 ms from the nearest approved pharmacy by straight distance. Although the Regulation was abolished due to the intervention from the media and provincial leaders, this 500 meter hard requirement was implemented for a whole year. During this period, many investors spent lots of money on buying or renting store spaces, renovation, procurement, and labor costs, yet they could not open the store without the license simply because there was another pharmacy or drug counter within 500 meters, or there was a latecomer with connections. It is said that the officials of the local FDA drove a car to “accurately measure” the distance themselves. Even if it was only a few meters shy of 500 meters, the new store would not be approved. In fact, it is quite tricky to open stores in the market. There is no guarantee that you will not lose money even if you are the only store within a 10,000-meter radius. Likewise, you will not necessarily suffer a loss even if there are three stores within 50 meters. It should be the business of investors instead of the government to care about store layout; the job of the latter is to prevent fake drugs and fraud by supervision.

The above-mentioned cases seem to be trivial in China’s fast-growing economy. However, only by deep diving can we clearly see the economic nature of the institutional friction encountered by China’s economy. It is clear that in addition to direct production costs or direct service costs, economical operation has to pay for other expenses. The confiscated equipment, the bailmoney, the spending on the lawsuit and mental anguish in the CHEN brothers case, and the efforts to get lawful approval for express delivery and the pharmacy retail business, all belong to system costs which is studied by this paper. These “extra” costs can be prohibitive enough to prevent many business activities from happening at all.

Do not assume that as time goes on, these system costs that hinder innovation, investment, and employment will automatically decrease since these cases occurred at the beginning of the new century. Observations show that after China’s economy freed itself from the previous round of deflation and regained a strong momentum at the beginning of the 21st century, “macro-control” preceded the deployment of the reform of “breaking administrative monopoly” and resulted in numerous unwarranted controls and administrative approvals. And this was why in 2012, the new administration once again emphasized on “decentralization and profit transfer” to ease the downward pressure on the economy. The new administration announced that it would clean up and abolish hundreds or maybe thousands of administrative approvals, most of which are not the legacy of the planned era but added to the economic operation one by one during the rapid growth period since the start of the new century. An iconic event may serve as an indirect evidence for the exorbitant system cost. China’s telecom industry, which was supposed to open up as early as in the 1990s, is open only to a couple of central SOEs. Although some improvements have been made to the subscription fee and service quality, the whole sector is still widely criticized such that the Premier had to personally order it to increase the speed and reduce the charges for broadband. However, the announcement from the higher level did not get automatically implemented since it involved the power and interests of departments.