China’s Incomplete Contracts

HONG KONG – This year’s Nobel Prize in Economic Sciences went to Harvard’s Oliver Hart and MIT’s Bengt Holmström for their pioneering work on the economics of property rights and contracts. At a time when China is attempting the difficult transition from a system of incomplete contracts to a strong property-rights regime, the real-world importance of these contributions could not be clearer.

No contract can specify every eventuality. So contracts must, instead, spell out the allocation of “control” rights – who can make decisions in which circumstances. For a centrally planned economy attempting to allocate more authority to the market, such contracts are invaluable – at least at first.

This has not been lost on Chinese reformers. From the mid-1980s to the early 1990s, they introduced both the “rural household responsibility system” and the “enterprise contract responsibility system” for state-owned enterprises (SOEs). Those systems essentially delegated more decision-making rights, as well as certain profits, to farmers and workers, so that they had a stronger incentive to work more efficiently within state-owned communes and firms.

A similar approach was adopted in China’s 1994 fiscal reform to handle tax-sharing between the central and local governments, with control rights relating to land and local economic development delegated to local officials, particularly at the municipal and county levels. This helped to advance development, though it also created space for local officials to take advantage of fringe benefits – a practice that later morphed into outright corruption.

More recently, the incomplete contract approach has also been used in the area of shadow banking. Regulators allowed innovations in incomplete contract-based financial intermediations, such as trust companies and Internet-based platforms, while maintaining tight control over the formal banking sector.

By defining partial rights to both decision-making and benefits, China’s leaders gave stakeholders incentives to compete efficiently with their peers, without giving up full authority. In that sense, these incomplete contracts laid the foundation for market-oriented competition in China, before it was possible – owing to institutional and ideological barriers – to achieve clearly defined private property rights.

But while the incomplete-contract approach was necessary during the transition to a market economy, it is not a long-term solution. More clearly defined and securely protected property rights, underpinned by an effective legal and judicial framework, are still needed. In fact, the loopholes in the incomplete contracts are undermining progress.

One of the lingering issues of the rural household responsibility system, for example, was unclear property rights relating to farm land, which is still legally owned collectively by local farmers, even though land-use rights were contracted to the individual households for 30 years. Without privatization, the farmers could not sell their land at market value for urban development, creating space for abuse and corruption, as well as social instability, particularly because urban and rural land values widened substantially during China’s high-growth period.

Likewise, the enterprise contract system failed to move the SOEs to sustained profitability. Unlike farmers, who did not borrow at all, SOEs borrowed heavily from state-owned banks. When they generated profits, the proceeds were shared with managers and employees. But when they generated losses – for example, in the 1990s – the banks were left with huge amounts of non-performing loans.

China’s government under Premier Zhu Rongji attempted to resolve the debt problem by putting the SOEs’ bad loans into four state-owned asset-management companies, and most of the small and medium-size loss-making SOEs were privatized. The remaining large state-owned banks and enterprises then became profitable, thanks largely to their monopolistic positions, which allowed them to be listed on the Hong Kong, Shanghai, and Shenzhen stock exchanges. In the ensuing years, they made critical contributions to China’s massive public infrastructure.

But the SOEs have also been the source of serious problems. They use both financial and human capital far less efficiently than their private-sector counterparts, and they have become key sources of both corruption and distortions in energy and natural-resource prices. Moreover, their stock-market dominance has hindered the healthy development of China’s capital market; they not only crowd out scarce resources for equity capital, but also complicate the normal operation of the market for mergers and acquisitions.

Nowadays, it is very difficult to undertake market-oriented changes in corporate ownership and control for the listed SOEs. Yet such changes are critical to improve governance and competitiveness, especially in the service, knowledge, and innovation-driven sectors that will underpin future economic growth.

To be sure, President Xi Jinping has taken some steps to rein in the state sector. Since 2012, his government has engaged in a massive anti-corruption drive, aimed at controlling the inefficiencies and abuses that have arisen from a lack of appropriate checks on delegated authority. But it has not been enough to root out corruption fully, and problems with pollution, overcapacity, and debt remain, which can be addressed only through a major supply-side structural-reform program.

In short, China’s incomplete contracts need to be completed. The key is judicial reform and the development of an orderly and institutionalized process for resolving property-rights and contractual disputes. Stronger bankruptcy laws, for example, would enable Chinese banks and state authorities to enforce credit discipline, pushing weak or failed borrowers out of the system.

China’s continued progress toward high-income status requires it to develop a strong and comprehensive property-rights system based on more complete contracts. Its leaders should look to the work of Hart and Holmström for guidance.