Introduction

International experience suggests that the effect of globalization on economic growth, poverty and income distribution can vary significantly among countries, and that its impact depends crucially on national policies. Liberalization of trade and investment since the 1990s has brought high economic growth to China, and China has continued to lift people out of poverty. Inequalities, however, have deepened as the distribution of income and opportunities has shifted in favor of urban areas and coastal regions, leaving rural areas and less developed regions farther behind. Among workers, those with skills have seen their incomes grow much faster than others.  

This report assesses the possible patterns of inequality in China in the future, and outlines policy options that could help accomplish China's objective of growth with equity. Growth and inequality projections suggest that, if recent trends in widening rural-urban inequality and the disparate growth of per capita incomes across provinces continue, income inequality would rise sharply, bringing the Gini coefficient up to 47.4 by 2020 (compared to 43.7 in 1999), with essentially equal contributions to national inequality from the rural-urban and inter-provincial disparities.

For sustaining growth, the report emphasizes the freer flow of resources and goods and services in the economy, to be achieved by domestic market integration and flexibility. The report suggests that the cost of market fragmentation and rigidities is high, and highlights measures to reduce local protectionism, facilitate migration, and commercialize the banking sector.

To optimize the results of domestic market integration and promote growth with equity, the report proposes a package of policy actions that would promote new job opportunities, especially in the less developed regions, and raise returns on farm labor and land. Among these, the report highlights investing in people, promoting the diffusion of technology, facilitating urban agglomeration, expanding services and enhancing farmers' prospects.

Finally, the report tackles the social, economic and fiscal risks that may threaten future growth and distributional performance. In particular, it suggests extending different types of formal social security in both urban and rural areas, for fixing the inter-government fiscal system in order to facilitate the provision of public services, and for managing fiscal risk beyond the government budget and officially recognized debt.

Poverty and Inequality in a Historical Perspective

Large-scale poverty reduction has been one of China's greatest accomplishments during the post-1979 reform period. Amidst enormous structural transformations, which included shifts from central planning to markets, from agriculture to manufacturing and services, and from a closed to a globally-integrated economy, government reforms facilitated the lifting of about 400 million people out of poverty at the $1 a day expenditure level. Early reforms, particularly the establishment of household responsibility system and of township and village enterprises, accompanied by sharp increases in agricultural procurement prices, supported agricultural productivity and allowed farmers to exit from agriculture to pursue better paid off-farm jobs. Rural incomes increased rapidly and, during 1978-1984, the rural-urban income ratio rose from less than 40 percent to 55 percent.

Further reforms benefited the poor less effectively. Furthermore, undertaking such reforms without resolving other domestic market distortions contributed to widening inequalities across China. Price liberalization and trade expansion during 1985-1992 mainly boosted productivity in the industrial sector, and thus disproportionately elevated urban incomes (bringing the rural-urban divide back to its pre-1979 level). As foreign direct investment took off in the early 1990s, bringing technology and export competitiveness to China's coastal regions, the inland and western regions, disadvantaged by low agglomeration, scarce skills and expensive transport, fell behind. But, under increasing pressure from imports and changing demand patterns, township and village enterprises lost momentum. As a result, new off-farm job opportunities in the rural areas dried up and migration into urban occupations was not enough to reduce the number of farmers per cultivated land sufficiently to raise returns from farming. Although aided temporarily by increases in government procurement prices during 1994-96, farmers have seen their incomes lag further behind. The existing obstacles to human development and labor mobility have added to the economic and social cost of economic restructuring in both urban and rural areas.

China's quarter-century record of dynamism offers great promise for the future. Continued economic growth is likely to raise household incomes across the entire income distribution if energetic policy action complements economic forces. Such policy action could concentrate on three themes: Promoting domestic market integration and flexibility, improving conditions for growth in the less developed regions and localities, and addressing the risks to future growth and distributional performance in China.

Domestic Market Integration and Flexibility

The pace of overall economic growth in China will depend on the development of China's vast domestic market. By 2007, China's post-WTO accession share of the world exports may rise to about 7 percent (from 4.4 percent in 2001), but more than 70 percent of China's output will still be intended for the domestic market. Size, resulting from a population of 1.3 billion people and from a doubling of income every 9 years or so, is China's most significant source of competitive advantage and a magnet for domestic and foreign investment.

A flexible and integrated domestic market is vital for broadening the basis of China's competitiveness and growth, and for structural adjustment in the Chinese economy. A flexible and integrated market for goods and services, along with flexible entry and exit of firms, allows more productive firms to expand and exploit economies of scale, facilitates diffusion of technology, and stimulates productivity improvements that enhance competitiveness of firms across the national economy. China's labor market, for example, has already seen that mobility across enterprises, sectors and geographical areas facilitates economic restructuring, mitigates its economic and social cost, and helps reduce rural-urban and regional inequalities. As productivity levels in agriculture lag behind industries and services, moving labor from farm to non-farm jobs is vital for future growth. Since most productive non-farm jobs are presently created in agglomerated rather than remote rural areas, the current movement of labor from farm to non-farm jobs is associated with rural-urban migration. As for China's banking system, with annual financial savings running at about 20 percent of GDP, it has an enormous capacity to support growth. Unobstructed by geographical, political, sectoral or administrative boundaries, China's financial market could contribute to sustained growth by promoting efficient resource allocation across the economy.

Currently in China, many forms of local protectionism and market rigidities inhibit dynamic improvements that could promote national competitiveness and growth with equity. Local protectionism continues to be present in both coastal and interior provinces, greater in provinces where local governments undertake more budget spending relative to GDP and where unemployment rates are higher. It is prevalent in industries that are more labor intensive and that make a larger fiscal contribution to the local government budget, in high profit-margin manufacturing goods and raw materials in short supply. Labor markets across China are fragmented, showing wide wage dispersion across localities and across enterprise ownership categories. The financial market provides relatively inexpensive capital to state-owned enterprises but tends to turn away non-state firms. Moreover, the financial market is fragmented across localities and sectors, and the profitability of that the efficiency of financial investment is lower than it would be in a commercially-motivated and commercially-oriented financial sector.

Market rigidities and fragmentation tend to result from broader structural and institutional problems. Among local governments, protectionist incentives sometimes emerge from overlaps among the functions of local governments and enterprises, from close personnel connections between the local government and local enterprises, and sometimes also from the nature of the local development targets used by the central government. The ability of local governments to erect protectionist barriers mainly relates to the high level of autonomy that local governments are given in terms of market regulation and competition policy, and to the influence they are able to exert on the judicial system. In the labor market, the main direct obstacle to migration, the hukou (household registration) system, has been slowly easing. Less direct obstacles, including weak execution of land use rights in rural areas, shortage of low-income housing in urban areas, and a deep segmentation of the social security system, remain to be addressed. Fragmentation of the financial market mainly arises from direct and indirect government control over interest rates and resource allocation. As government has influence on personnel and operating decisions of state commercial banks, incentives to favor government-owned and government-associated credit applicants are strong. At the local level, lending and investment decisions of banks tend to be affected by local government priorities, usually to support the existing local enterprises.

Effort to promote domestic market integration and flexibility could include the following policy measures:

· Review the role of local governments, particularly their functions vis-à-vis local enterprises, financial institutions, and courts, and in the areas of market regulation and competition policy.  In addition, consider innovative measures to make local governments accountable for their influence on the market. Complementing the legal context of China's WTO commitments, such measures could include local governance surveys collecting feedback from market agents.

· Consider further institutional changes to facilitate labor mobility, building on the measures introduced since 2001 to reduce constraints on migration. Labor mobility across and within urban areas would benefit from centralizing the financing and provision of social security to the provincial level and from extending social security to the urban non-state sector, including both local residents and migrants. Conditions for rural-urban migration would improve with continuing reforms in land use rights to offer farmers a formal mechanism to sublease or quit their land plots with adequate compensation. Most importantly, perhaps, overall labor mobility would benefit from policies to promote the development of low-income housing in urban areas and urban peripheries, which would particularly benefit from the development of the urban land market.

· Continue commercialization of the banking sector. Resource allocation through the banking system would improve with further reforms of bank governance structure, accounting and information systems and associated internal control and auditing regimes within the banks. To be effective, bank commercialization may require a greater role for the private sector in bank ownership and operation, more flexibility in interest rates, and improvements in corporate governance, accounting and information disclosure in the enterprise sector.

Improving Conditions for Equitable Growth

Policies to reduce inequality are compatible with the objective of promoting economic growth. Chinese economic strategy, specifically since the 9th Five-Year Plan (1996-2000), has stressed balanced patterns of growth focused on rapid development of the lagging geographical regions of the country, with emphasis given to selected provinces in the interior and western parts of the country. With the appearance of rural distress during the 9th Plan period, renewed attention is being given to developing specific policies and programs to narrow the rural-urban gap. In framing such strategies, it is important to recognize that there are bound to be leading and lagging sectors and regions in a rapidly-growing economy, whatever its size and complexity. Differences in China result from differing endowments, geographical factors, and the effects of policies. The key issue going forward is to design a set of strategies that would generate the requisite rates of economic growth while reducing, rather than widening, inequalities.

Achieving a better distribution of incomes and opportunities - the essence of a xiaokang society - depends crucially on the creation of productive jobs, especially in the lagging regions and on rates of return to farm regions, and on returns to farm labor. With globalization, jobs can be sustained only in competitive areas of economic activity. Increased competition arising from the domestic market integration will not necessarily hurt lagging regions, which are at an earlier stage of industry and services sector development than others. Instead, the ability to source cheaper inputs from anywhere in China enhances the competitiveness of finished goods production in the lagging regions, boosting employment and growth. Without appropriate policy actions, however, such regions may suffer from the fact that competitiveness is becoming increasingly based on technology, human capital, and business services. In rural areas, an increase in returns on farm labor depends mainly on reducing the currently high farmer-per-land ratio. This has been happening with the move of labor out of agriculture. In addition, although with somewhat less dramatic effect, the consolidation of land and promoting environmental sustainability and market infrastructure will enhance returns to land and to farm-related activity.

A policy package to promote conditions for equitable growth could focus on five areas: investing in people, promoting the diffusion of technology, facilitating urban agglomeration, expanding services, and enhancing farmers' prospects. Such a package would broaden the agenda of the Tenth 5-Year Plan and help implement guidance provided by the 16th Party Congress of the Chinese Communist Party in November 2002. In these ways, therefore, the recommended policies represent continuity with the general thrust of China's national economic policy, perhaps with greater emphasis on equity than has been articulated in recent policy documents.

Human Capital Development

Investment in health, education and other social services is crucial for achieving rapid, efficient, equitable and sustainable development in a competitive environment. Improved health contributes to learning and job productivity. Better public health is correlated with greater investors as well as consumers confidence. For basic education, the importance in China today lies in the need not only to raise the level of technological inputs in farm and off-farm rural economic activity, but also to enable inhabitants of rural areas to pursue economic opportunities in an increasingly urbanizing and globalizing environment. In this respect, better health and basic education are core building blocks for a xiaokang society. Furthermore, knowledge and higher-level skills have become critical to achieving technology-led growth, increasingly the basis of sustainable economic development. The importance of secondary and tertiary education and life-long learning has risen as the relative demand for skills has grown, partly a result of rapid introduction of new technologies in China's industries. Faster growth in skilled labor in the context of free migration is likely to assist in reducing inequalities as well as in boosting national welfare.

Human capital development across China, however, faces two main challenges. First, education attainment and health indicators are significantly lower in poor localities. Second, although a large proportion of public funds for education is allocated at the tertiary level, the supply of tertiary education and life-long learning falls short of demand.

· Enhancing human capital development in poor localities would require equalizing the allocation of public funds on basic education and health across localities, introducing special programs to achieve national minimum standards, such as the nine-year compulsory education and basic immunization, and strengthening qualitative and outcome-oriented targets in the delivery of social services.

· In tertiary education and training, private sector provision is likely to expand if the role of government changes from being the main provider of formal education to that of the architect and facilitator of an entire life-long learning system. The implementation of the 2002 Law on Promoting Private Education in China should remove any remaining discriminatory policies and integrate private schools into the formal system. To design and facilitate the entire system of formal education and life-long learning, the government could set up a transparent set of accreditations and certifications, establish standards, regulations and methods of ongoing monitoring and quality assurance, and establish a mechanism to share information on the demand and remuneration for different types of education and skills, and on the quality and performance of different educational providers. Local governments could also assist in facilitating an active role of employers and investors in the life-long learning system.

· Equity in access to education would be well served by a system of stipends and student loans. At the primary and secondary level, child-schooling stipend to the poorest families across China could be effective in reducing drop-outs and enhancing overall school attainment. For tertiary education, the preferred option may be student loans.

Technology Diffusion

Technology is an increasingly important driver of growth in China. Although integrating with the global economy, China is yet to significantly exploit market opportunities in middle- and high-tech products and services. As gaps in efficiency are large, the potential gains from catching up are significant. This suggests that relatively greater emphasis on technology and productivity, rather than merely higher capital investment, should be focused upon as the driver of future growth. Moreover, even sustained competitiveness in low-tech product markets requires new technologies, especially producer services such as marketing and financial management. This is true also for the development of China's lagging regions. Although most jobs created in the lagging regions are likely to target low skilled labor, post-WTO accession competitiveness in the domestic and global markets will require a continuous upgrading of products, the absorption of newer technologies by firms, and the ability of the workforce to utilize such technologies as productively as in competitor firms. So far, however, most of the technology-led growth in China has concentrated in a relatively small geographical area of coastal cities. Broader technology diffusion has been held back by local protectionism, by localized shortages of skilled labor, and by weaknesses in the current technology-oriented policies.

· The existing technology dissemination schemes need at least minimal financial support from their sponsoring agencies to thrive without deviating from their core tasks. Their core tasks need to be defined more sharply, especially with regard to sharing information about production technologies and management approaches emerging across sectors, and providing technical assistance to small and medium-sized enterprises. In agriculture, technology diffusion would benefit from streamlining the existing extension system and complementing it with more efficient information sharing devices.

· To alleviate the problem of local shortages in skilled labor, as part of the agenda to develop, attract and retain skills in lagging regions, local governments may organize training and research centers in partnership with firms, and facilitate closer links between local firms and universities and other schools.

· Overall, technology diffusion would benefit from competition policies that encourage competitive pricing, facilitate entry by new firms, and pressure producers to innovate and improve their productivity.

Development of Producer and Consumer Services

The expansion of services, their improved efficiency, and closer interaction between services and manufacturing can potentially make a significant contribution to China's future growth. Liberalization and opening to foreign entry in logistics and telecommunications will provide more economic opportunities across China, and is likely to promote more equitable growth. Furthermore, the services sector is the likely pillar for future job creation in China. On average, every year during 1990-2002, the services sector generated 7.6 million jobs, compared to 1.6 million jobs created in industry and 1.7 million exits from agriculture. In the provinces included in the Western Region Development Strategy of the Government, the contribution of services to job creation was about 1.3 million a year, while employment in industries actually shrank (by 2 million in total). The 1990-2001 job creation in these provinces, however, was not sufficient to support effective transfer of labor out of farming, and agriculture provided at least 4 million new jobs. Services sector development suffers mainly from restrictions on services production and delivery.

· The services sector and its contribution to job creation in the lagging regions are likely to grow with continuing reforms of the role of the government. Instead of serving as a provider, the government is increasingly becoming regulator - by implementing relevant standards, leveling the playing field for enterprises of all types, and enhancing the local investment climate. This process needs to be accelerated.

· In financial services, international experience suggests that subsidized lending interventions are generally far less successful than self-sustainable outreach schemes. In China, progressive interest-rate liberalization would make microfinance, finance to small enterprises and financial services in underserved localities commercially viable. Availability of financial services to non-state firms will also depend on the development of accounting, auditing, legal and other business services, and on regulations and market infrastructure to improve information reliability and disclosure across the economy.

Urbanization

Agglomeration of people and resources contributes to economies of scale and economic efficiency. Given the economic advantages of agglomeration, most new productive jobs in services and manufacturing are likely to emerge in urban areas and urban peripheries. In the past 20 years, the majority of new non-farm jobs has been created in medium and small size cities, with the highest rate being in urban peripheries. Although the greatest benefits of agglomeration are seen when small and medium-sized cities expand, urbanization policy delivers best results if it encourages the development for all types of cities, rather than suppressing the growth of larger cities while promoting small and medium-sized cities and towns. The process of agglomeration is effective, and its economic and social benefits sustained, if it occurs in harmony with the restructuring needs of the economy.

· The benefits of agglomeration in China would expand with establishing sound markets for industrial land development and a favorable environment for low-income housing development. Commercial motives would encourage the desired pattern of land development and use, if complemented by stronger regulatory and supportive government policies.

· The overall results of urbanization also depend on government policies to promote urban peripheries and the quality of urban life. Relocating from city centers, industries are likely to favor urban peripheries, which have the best potential for a synchronized development of new economic activities and housing. In this respect, local governments may need to play a more active role in the residential land market in urban peripheries to facilitate the needed supply of low-income housing. International experience suggests that this role may involve the provision of basic physical and social infrastructure and public services in locations that are near the points of economic activity and suitable for low-income housing. Public services, such as suitable public transport network, locally available basic schooling and environmental protection, would play a vital role in supporting the development of sound and integrated centers of economic activity and quality life.

Farmers' Prospects

Raising income growth rates in poor rural areas will depend on the creation of off-farm jobs, but also on the performance of agriculture. In poorer provinces, rural enterprises are more scarce, rural households draw a higher share of their income from agriculture, agricultural output per farmer is lower, and the gap in rural-urban rates of growth is more prominent. Provinces that contain most of the rural poor appear to suffer from the combined effect of high dependence on agriculture, small land plots and low production inputs per unit of land. Within provinces, dependence on agriculture comes with remoteness. As the average land plot used for farming in China is currently too small to allow for significant improvements in agricultural productivity, the reduction in the farmer-land ratio (by moving labor out of agriculture), accompanied by land consolidation, is the single most important factor to boost farmers' incomes. Farmers, however, continue to face challenges in executing their land use rights as well as in dealing with environmental and food safety issues and in accessing market information and marketing services.

· There is need for effective enforcement of farmers' land rights and of environmental laws and regulations at the local level. A formal enforcement mechanism could be set up to facilitate the sublease and transfer of land contracts, and the use agricultural land as collateral in credit transactions. Such a mechanism may be needed to effectively implement measures approved by the 2003 National People's Congress, including the proposed penalties on local officials who interfere with land rights. The effectiveness of environmental policies and laws can be supported by greater implementation authority of the State Environmental Protection Agency.

· In addition, farmers would benefit from greater assistance in accessing markets. The government has already announced plans to increase investment, set up market information system, promote standardization of agricultural products, and use China's WTO membership to further open foreign agricultural markets to China's products. Guidance on the priorities for the involvement of local governments in improving farmers' market access would best come from their constituencies, from the actual and potential users of services and from private businesses.

Addressing the Risks to Future Growth and Distributional Performance in China

China faces several risks in promoting growth with equity. Among these, the following deserve particular consideration. First, gaps in social security may erode risk-taking in an increasingly market-oriented society and could undermine social cohesion and public support for further reforms. Second, the delivery of public services is inadequate in poor localities and coul d constrain future economic growth. Third, macroeconomic risks facing the government could escalate, raising uncertainty and exacerbating fiscal pressures.

Providing Social Security

Most of China's poor and vulnerable fall through the gaps in existing social security schemes. As the spread of markets and globalization intensify structural changes and increase uncertainties as well as opportunities, social security is gaining importance. Possible reforms could focus on the following policy actions.

· Extend social security to the labor force in the urban non-state sector, including both local residents and migrants. This is important on equity grounds since most new jobs have been generated in the urban non-state sector. Most vital is the expansion of urban basic health insurance.

· Centralize the financing and provision of social security and protection to the provincial level. Provinces are better equipped than cities to pool risk and, with rules for the transfer of rights between provinces, make benefits portable, thus complementing the ongoing labor market reforms.

· Establish comprehensive income maintenance and basic insurance schemes in rural areas. Since poor households and individuals are distributed over the whole of rural China, the government may wish to consider an assistance scheme that would target poor people, rather than only poor geographical areas. Insurance against the financial costs of medical care to address catastrophic illness and injury is particularly urgent, building on recent pilot schemes. Most countries at China's income level provide such insurance, ideally along with immunization and other basic preventive care, in the context of tax-funded universal basic health care with a strictly defined minimum benefit package. Eventually, these schemes may become a good basis for the needed removal of the existing rural-urban segmentation in China's social security system.

Financing the Delivery of Public Services

The present inter-government finance system is not ensuring adequate delivery of public services in many localities across China. The central problem in inter-government finance and public service delivery is the large gap between expenditure and revenue assignments at the local level. Expenditure responsibilities at the local levels are much greater than found in other countries. The delivery and financing of most core public services, including education, health care, social security and infrastructure are assigned to local governments. During the last decade in China, per-capita revenues and expenditures of local governments have varied greatly across provinces. Similarly large disparities have been present within provinces. China is also unusual in not having a transfer system that provides for the expenditure needs of local governments. The current system of intergovernmental transfers, in spite of the large volume of flows (financing 46 and 48 percent of local expenditures in 2001 and 2002) is poorly designed to support the financing of vital social services such as rural education and rural public health. Pushing down expenditure responsibilities to lower levels without providing adequate financial support has produced large and growing fiscal disparities that reinforce income disparities across regions. This is just the opposite of the expected role of government - that of alleviating income inequalities and protecting the poor and vulnerable groups. The outcomes are regressive, where governments in poor regions are providing fewer and lower quality services and passing along a higher proportion of the costs to their constituents.

· Ensuring adequate public service delivery across China may not be feasible without a comprehensive reform of the inter-government finance system. Such a reform would address expenditure and revenue assignments to all levels of government in an integrated way, rather than separately as in recent public finance reforms packages, and coordinate inter-government fiscal transfers accordingly.

· Further reforms in the assignment of government revenues can provide the central government with the resources to fund greater equalization transfers. Separately from reforms to boost the government's overall tax capacity, reforms in the tax sharing system can plausibly boost resources available for transfers as well as they can directly reduce the disparity in local government revenues. In this respect, the amounts allocated on tax rebates could be further reduced and the sharing of value added tax revenues could be further centralized. In promoting fiscal equity across local governments, complementary measures on the revenue side could include a limited discretion offered to local governments in setting local tax rates, possibly as part of the property tax, personal income tax or excise tax.

· Some centralization of the responsibilities for financing and delivery may enhance public service delivery. Moving the responsibility for the financing and provision of selected services from the village, township or county level to a higher level of government may benefit efficiency and administrative capacity as well as equity. The changes in expenditure and revenue assignments should realign responsibilities with financial and institutional capacity at each level of government.

· Furthermore, greater autonomy of local governments, along with greater accountability, could enhance allocative and operational efficiency in their expenditures. To promote the alignment of incentives of local governments with the objective of growth with equity, the central government may want to correspondingly revise the targets and indicators used to evaluate local government performance. Governments at each level could make their decision making process more open and transparent and strengthen monitoring and audit functions. Greater autonomy on the revenue and expenditure sides, complemented by provisions to raise local government accountability, can be attractive to local governments, possibly making the whole reform package somewhat more politically acceptable.

Maintaining Macroeconomic Stability

International financial markets are signaling a renewed risk to China's macroeconomic stability. The perception of macroeconomic risk in China can be plausibly explained by the vulnerability of China's domestic financial sector and by the hidden obligations facing the government. Weaknesses in the financial sector arise mainly from non-performing loans in the banking system, and the potential need for fiscal intervention. This constitutes the core of the perceived government fiscal risks, along with implicit liabilities arising from the pension system and obligations facing local governments. Under favorable conditions, the total burden of government "hidden" obligations currently outstanding appears manageable. Less favorable macroeconomic conditions, however, could generate painful fiscal pressures. Most importantly, continuing accumulation of government obligations poses a major fiscal risk. Therefore, policy actions in this respect are vital.

· In the banking system, an injection of new capital accompanied by structural and regulatory reforms may be needed. The experience of other countries suggests that recapitalization is particularly effective if at least partly financed from private sources, through strategic investors, and accompanied by the transfer and development of new technologies and skills, and if underlying structural problems in enterprises are resolved. Reductions in the rate of non-performing loans on new lending and productivity improvements from reductions in operating cost are likely to come with greater commercial orientation in the financial institutions and with improved regulatory and supervisory systems. Attracting private capital into the financial sector would mean that more risks are assumed by those market participants willing and able to bear them, rather than by the government.

· There is need to stabilize the current level of government obligations. Internationally, a combination of parametric changes (for example, raising the retirement age and lowering the benefits payable under the pay-as-you go schemes) have proven to be an effective way of reducing financing gaps. To limit fiscal risks arising from local government activities, a country-wide fiscal risk monitoring system could be established. International experience offers several good models for establishing local government fiscal risk monitoring systems at the central or subnational level.

· On the whole, the government will be able to reduce its vulnerability by establishing a comprehensive system to monitor all major sources of fiscal risk. Careful fiscal management across the entire portfolio of government direct and contingent, explicit and implicit, liabilities will ensure that future government deficits and debts remain at prudent levels and fiscal resources adequately support future needs for public services. As discussed in this report, a strong combination of progressive policy, private initiative and public finance is required to achieve the growth and equity objectives of a xiaokang society.

Focusing on the Priorities

China can achieve growth with equity if it follows correct policy priorities. The tasks of promoting domestic market integration and flexibility, improving conditions for equitable growth and addressing the main risks facing China imply some common policy priorities. These are centered around adequate delivery of core public services and indirect involvement of the government in the economy, and mainly include:

· a comprehensive inter-government finance reform that would allow for adequate provision of basic education, health and social security, and reduce the incentives of local governments to be engaged in local protectionism

· proper market regulation and competition policy, implemented uniformly across China, which would reduce the capacity of local governments to be engaged in local protectionism, facilitate technology diffusion, and support the development of the services sector

· effective commercialization of the banking sector, supported by continued reforms in the enterprise sector, which would reduce financial sector vulnerability and government fiscal risk and facilitate efficient allocation of capital

· the development of urban land market and urban infrastructure to support low-income housing near points of economic activity in urban areas and urban peripheries, which would facilitate both migration and urban agglomeration

· effective law enforcement that would allow farmers to better utilize their land use rights in the context of migration and land consolidation, offer farmers adequate environmental protection, and support greater autonomy and accountability of local governments.
 
Given various competing interests typically facing government and given the complexities of structural and institutional reforms, these priorities may, at times, be difficult to implement. Although beneficial for the majority of China's population and for China's national competitiveness in a globalized economy, each of the policy priorities listed above is likely to be resisted by some interest groups, and there will be many trade-offs that will have to be weighed. For example, reforms of the banking system will likely affect the flow of credit in a way that is good for the long-term but may have adverse employment consequences in the short-term. Reforms in inter-governmental finance, pensions, the composition of public services, and macro-economic risk mitigation are specific areas where the costs and benefits to different groups will vary significantly. Moreover, policy-induced changes will occur within the broader context of major structural changes that are underway already, partly to accommodate the forces of globalization. It will be a task of enormous political will and strategy to navigate among sources of resistance and to mitigate the sharpest edges without undermining the objective of China's growth with equity.

(China.org.cn September 9, 2003)