April 1999 This paper intends to properly account for China's two decades of market transition by examining its institutional foundations. The journey of transition is analyzed as a two-stage process. In the first stage (1978-93), the system was reformed to unleash the standard forces of incentives, hard budget constraints, and competition, but the underlying institutional forms and mechanisms are far from conventional: reforming government through regional decentralization; entry and expansion of nonstate (mostly local government) enterprises; financial stability through "financial dualism;" and a dual-track approach to market liberalization. In the second stage, China aimed to build a rule-based market system incorporating international best practice institutions but proceeded in its own way. Major progress was made in the first five years (1994-98) on the unification of exchange rates and convertability of the current account; the overhaul of the tax and fiscal systems; reorganization of the central bank; downsizing of the government bureaucracy; and privatization and restructuring of state-owned enterprises. To complete its transition to markets, China still faces serious challenges, especially in transforming its financial system and state-owned enterprises and in establishing the rule of law. The paper concludes by reflecting on the economics of reform and institutional change from the Chinese experience. The main lesson learned is that considerable growth is possible with sensible but not perfect institutions, and that some unconventional "transitional institutions" can be more effective than the best practice institutions for a period of time because of the second-best principle. Specific lessons include: incentives, hard budget constraints, and competition should apply not only to firms but also to governments; reforms can be implemented without creating many or big losers; and successful reforms require appropriate, but not necessarily optimal, sequencing.
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