Deng Xiaoping will be remembered mostly for leading a remarkably successful economic reform program which has greatly improved the material welfare of the majority of the Chinese people. In the aftermath of Deng's demise, people around the world are wondering whether the new Chinese leaders will be able to sustain the country's rapid economic growth.

    To answer this most important question, one needs to understand what made Deng's approach to economic reform successful, and what Deng's legacy for China's future economic decision-making will be.


    Two Key Elements of Deng's Reform Program

    Simply stated, we believe that two elements were fundamental to the success of Deng's economic reform program: "incentive compatibility" and leadership authority. "Incentive compatibility" refers to the degree to which a policy provides benefits to agents, in order to induce them to take desired actions. Deng initiated and implemented reform programs in such a way that the majority of the population, including those who seemed to be potential losers, benefited from and were therefore supportive of the reform. Supposedly, the major losers in any reforms that aim to create a market economic system are the incumbent bureaucrats who personify the old central planning institutions. Resistance from these bureaucrats is why reforms have been so difficult in Eastern Europe and Russia. In China, however, the reforms co-opted the bureaucrats, by allowing them to sponsor semi-private businesses with entrepreneurs and to obtain, thereby, a last chance to turn their remaining bureaucratic power into personal economic benefit. The Chinese military, through the same mechanism, has also benefited from and supported Deng's economic program. This mechanism of incentive compatibility has frequently been accompanied by corruption, which has provoked popular discontent and can be seen as a price of Deng's reform program.

    In addition, Deng's patriarchal status and personal authority, due to his revolutionary credentials and his "three-down, three-up" legend (three times, he was brought down by cruel internal fights in the Communist Party; each time he bounced back triumphantly, and regained political power), made his economic programs much easier to implement. Many times during China's 18 years of reform, Deng had to resort to his personal authority in order to jump-start and push forward the otherwise dying process of reform. In this regard, Deng operated in a way similar to the late Chairman Mao. After all, China is still a country with a more than 2000-year history of "rule by the ruler" rather than rule by law. The critical difference between the two rulers was that Mao used his authority to mobilize the Red Guards and destabilize the system, while Deng appealed to reform-minded local government officials and entrepreneurs alike in order to win support for reform.


    Challenges Facing Deng's Successors

    Now that Deng is history, maintaining the elements that accounted for the success of his economic reforms will be a major challenge for his successors. By invoking incentive compatibility, Deng got off to a quick start in the reform process and avoided major obstacles. But incentive compatibility is difficult to maintain, since reform has evolved to a stage where tough decisions have to be made and losers will have to be singled out. Specifically, the scope of the government has to be reduced; property rights have to be clarified and bureaucratic involvement in business has to diminish; many state enterprises have to be restructured or liquidated and workers have to be laid off; the military eventually has to specialize in its own profession and retreat from involvement in business. All of these steps are essential to the successful completion of China's economic reform. But, in each case, there will be losers who cannot be compensated fully.

    At the same time, Deng's successors do not carry personal authority and political status remotely comparable to Deng's. Indeed, few Chinese leaders in the future can hope to emulate Deng in this regard. The new leaders will not be able to resort to political authority when they need to thwart substantial objections to reform and economic policies.


    Two Favorable Conditions for New Leaders

    Does this mean that after Deng, the Chinese economy and the reform process will lose dynamism, as some have predicted? We believe that the answer is no. The reason is that two favorable conditions are emerging in China, and they are likely to replace the two key elements in the success of Deng's reform program.

    Thanks to Deng's successful reform strategy, the fundamentals of the Chinese economy are much more favorable for reform now than they were 18 years ago, and the momentum of economic growth is well in place. China's post-Deng leaders can count on this momentum to push the reform process, even if the conditions of incentive compatibility no longer hold. Already today, China is the world's third largest economy in terms of purchasing power parity. The country's savings rate has been around 40 percent of GDP, which is higher than that of all major economies in the world besides Singapore (where saving behavior is distorted by government control). China also enjoys more foreign direct investment inflow than any other country in the world except the United States. As a result, China's foreign currency reserves are more than U.S. $100 billion, the second highest in the world. Most important, the fundamental economic structure has changed, so that over 70 percent of the GDP is produced by the non-state sector, consisting of private or semi-private enterprises, including foreign joint ventures. Market institutions, including modern corporations, although rudimentary, are emerging. These favorable conditions will help mitigate the pain of reform: high household savings help facilitate housing reform and the privatization process in the state sector; huge foreign exchange reserves help further liberalization of foreign exchange control; the large size of the non-state sector helps to absorb unemployed workers; and the emerging market institutions provide policy-makers with more leverage and instruments of macroeconomic management.

    In addition, lacking absolute political authority, the post-Deng leaders have begun to build up their credibility in economic policy-making. China has been undergoing a transition in the basis of political authority, from ideology to leadership competence. A case in point is the remarkable success of the macroeconomic austerity program over the last three years: inflation has been brought down from its peak of nearly 30 percent in 1994 to 3.3 percent in January 1997, while economic growth has been maintained at a level of close to 10 percent. The Chinese economy has made a soft landing for the first time during its eighteen years of reform, and it is now in its best shape since the mid-1980s. Interestingly, this achievement came in the twilight days of Deng, who typically supported policies of accelerated growth. And this experience has certainly enhanced the credibility of China's economic policy-makers.


    Implications for the Post-Deng Economy

    These fundamental changes in China's economic and political conditions will have important implications for the post-Deng Chinese economy. First, the post-Deng leaders are likely to capitalize on their recent success in macroeconomic stabilization by using it to build their own leadership credibility, if not authority. One important implication of this hypothesis is that those economic policy-makers who are responsible for the success of the austerity program will be promoted to key positions in the government. Such personnel changes at the top level should help boost the credibility of the new leadership.

    Second, the post-Deng economic policy-makers are likely to continue implementing conservative monetary and fiscal policies, in order to sustain macroeconomic stability, which is essential for preserving the credibility and political control of the new leadership. With a growing non-state sector, huge domestic savings, and enormous foreign exchange reserves, this job should be less challenging than it has been in the past.

    Third, the post-Deng leaders will probably push economic reforms on a selective and prudent basis, hoping that the bitter pill of reform can be sweetened by economic growth. To minimize political risk, they may well concentrate on those reforms that are immediately beneficial for overall economic growth. At the top of the agenda are reforms of state-owned enterprises and the banking sector, which have long been delayed; further delay means enormous waste of the country's huge savings and slower growth. Another priority is further opening up of the economy to the outside world, including converting Chinese business practices to international norms and pushing for membership in the World Trade Organization (WTO). Such opening would give a big boost to growth with controllable short-run costs, given the existing economic structure in China. Finally, an important issue is housing market reform, since the next round of growth may well be fueled by booming housing demands and the current housing system is clearly in the way. Overall, the post-Deng leaders are expected to make intensive efforts in a few carefully selected reform areas, instead of spreading their political capital over a broad range of reforms.

    David Li is assistant professor in the Department of Economics and a research associate at the Center for Chinese Studies and the Center for Russian and East European Studies; Shan Li is executive director at Goldman Sachs (Asia) L.L.C., Hong Kong.