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turned out to be considerably smaller than expected or even nonexistent altogether, while costs were huge or exceeded expectations. It is easy to assume that an incremental reform step would be “Pareto positive” or efficiency-enhancing. What is not sufficiently recognized, however, is that each incremental reform step is a carefully negotiated policy move and embodies compromises that permit continuation of economic inefficiency. Under the right circumstances, partial reforms may produce more efficiency gains. But because residual inefficiencies are politically protected, it is equally likely that the costs of maintaining such residual inefficiencies may be high or even exceed any efficiency gains from partial reforms.

The best example is perhaps China’s introduction of the so-called contract system in the 1980s in reforming its SOEs. Based on the model of the rural household responsibility system, this measure was initially thought to be capable of giving SOE managers new incentives to improve the performance of their firms with specific targets and more managerial autonomy—without touching the sensitive ownership issue. But the net result of this measure was asset-stripping and long-term deterioration. Insiders in SOEs improved short-term performance to maximize their pay at the cost of deteriorating balance sheets and asset quality. The reform was unceremoniously abandoned in the early 1990s.118

How Marketized Is the Chinese Economy?

The degree to which market forces determine economic activities in a transition economy is an important measure of the success of reform, regardless of the mode of transition. In assessing the achievements of China’s gradualist approach, a crucial yardstick is the degree of marketization of the economy. Unfortunately, marketization is, at most, a subjective measurement. Estimates reached by Chinese scholars show that, at an aggregate level, the marketization of China’s economy in the late 1990s was about 50 percent, implying that the transition was perhaps only half-complete.119 There are enormous variations across regions and sectors, however. According to an official report, the level of marketization is higher for commodities and lower for factor inputs. The financial sector is the least marketized. Coastal areas in the east are more marketized than the western regions.120 In this section, we will use a variety of economic indicators to assess the degree of marketization in China twenty-five years after the introduction of gradualist economic reform.

SOEs’ Share of Economic Output and Employment

To the extent that direct ownership of firms allows the state to control or influence economic activities, the share of economic output from SOEs should be an important measure of marketization. The higher this share, the lower the degree of marketization, and vice versa. By this measurement, the Chinese economy can be said to have been significantly marketized. Official figures indicate, for example, that SOEs (including firms controlled by the state through majority holding) accounted for 44 percent of the gross industrial output in 2001, a decline of 20 percent from 1983.121 Employment in SOEs has experienced a drop of similar magnitude. In 1985, employees in SOEs accounted for 68 percent of the industrial labor force; by 2001, the figure was down to 48 percent.122 Taken together, however, these aggregate data suggest that, despite dramatic progress in marketization, the state retains an important presence in China’s most important economic sectors. In particular, the state has maintained its monopoly or near-monopoly in several key sectors, such as telecom, banking, energy, power generation, civil aviation, and rail transportation. The control over these important sectors allows the government to have an ability to influence economic activities—and distort the market—that is perhaps far greater than its share of total economic output would indicate.

The State’s Influence in Commodities and Factor Markets

Most economists agree that China’s commodities markets have been