THE WILLIAM DAVIDSON INSTITUTE AT THE UNIVERSITY OF MICHIGAN BUSINESS SCHOOL Dual Track Liberalization With and Without Losers By Jiahua Che and Giovanni Facchini William Davidson Institute Working Paper Number 669 March 2004 Dual track liberalization With and without losers Jiahua Che University of Illinois and William Davidson Institute Giovanni Facchini University of Illinois March 10 2004 Abstract The success of the Chinese economic reforms has been linked by many observers to the implementation of a dual track liberalization mechanism This approach relying upon the continued enforcement of existing contracts and the simultaneous creation of a free market sector represents a powerful mechanism in economic reform If not anticipated it implements an outcome that is both Pareto improving and e ciency enhancing as compared to the status quo When the reform is instead anticipated intertemporal arbitrage arises potentially undermining these properties Only when the original policy involves both price setting and quantity restrictions can anticipated dual track liberalization maintain its attractiveness While these conditions correspond well to the circumstances faced by transition economies our analysis invites some caution as for the further applicability of the Chinese approach to economic reform JEL classification P2 F1 Keywords Dual Track Liberalization Intertemporal Arbitrage Pareto Improving Reforms China Email che uiuc edu facchini uiuc edu Both authors can be contacted at the following address Department of Economics University of Illinois at Urbana Champaign 484 Wohlers Hall MC 706 1206 S Sixth Street Champaign IL 61820 We would like to thank Dan Bernhardt Hadi Esfahani Earl Grinols Eli Katz Jan Svejnar Bart Taub Cecilia Testa Thierry Verdier Weiyin Zhang Li An Zhou and seminar participants at the ERWIT CEPR meeting in Bern the Midwest International Economics Meetings in Pittsburgh SAET VI conference in Rhodes Beijing University the University of Illinois and University of Leipzig for useful comments 1 1 Introduction In a little more than twenty years China has evolved from a poor centrally planned economy into a vibrant emerging market Its per capita GDP has more than quadrupled and over two hundred million Chinese citizens have been lifted out of poverty Which lessons can be learned from this very remarkable reform experience To what extent is the successful Chinese path replicable elsewhere In this paper we focus our attention on what is widely considered a major catalyst in the Chinese transition process the dual track approach to economic reform In a dynamic setting we study its properties and highlight some of the limits to its applicability In doing so we hope to provide some guidance for policy makers which are in the process of implementing a market liberalization To understand the merits of the dual track mechanism notice that the widespread failure to adopt socially bene cial economic reforms can often be explained by the distributional e ects of the new policy More speci cally the existence of a powerful group of ex ante identi able losers represents a formidable obstacle to economic liberalization 1 Explicitly compensating the victims of the reform might well be then the only way to guarantee widespread support Unfortunately it is di cult to identify both in practice and in theory a mechanism that can achieve these results without requiring the government to have a detailed knowledge of the fundamentals of the economy In two recent papers Lau Qian and Roland 1997 2000 have shown how the simple dual track mechanism implemented in the Chinese economic reform served both the purpose of achieving a Pareto improvement as well as that of attaining an e cient resource allocation The dual track approach allows two regimes to coexist after a reform has been introduced First it requires the government to enforce the contractual agreements in place prior to the reform so that transactions can continue to be executed at the original prices Second it 1 Fernandez and Rodrik 1991 and Alesina and Drazen 1991 suggest possible explanations of the delay in implementing reforms while Dewatripont and Roland 1992a 1992b 1995 discuss mechanisms that can be used to overcome the resistance to the introduction of a reform 1 allows a new liberalized sector to emerge in which exchanges take place in a deregulated market The enforceability of preexisting contractual agreements ensures that none will be worse o while the possibility to engage in arbitrage activities as Lau Qian and Roland 2000 intriguingly demonstrate can help the economy to attain the rst best allocation of resources Limiting the government role to guarantee the enforcement of already existing contracts dual track liberalization represents a very promising approach to successfully implement an e ciency enhancing reform that does not involve the creation of victims Indeed this approach has been widely regarded as a major catalyst for China s remarkable economic performance in recent decades Li 1999 Given its theoretical appeal and its proven record of success it is natural to ask whether this mechanism can be successfully applied to other economies involved in the liberalization process Under what circumstances is dual track liberalization more likely to achieve the consensus needed for the implementation of a reform Are there situations in which the use of such a mechanism should not be recommended to a policy maker To address these issues we extend the analysis of Lau Qian and Roland 2000 in several directions First while they considered only the liberalization of transactions that were originally carried out between the private sector and the government in this paper we generalize the pre reform environment to include exchanges carried out between private parties with the possibility of a government intervention In particular since the transition process involves the opening up to the market system both domestically and internationally we extend the analysis of Lau Qian and Roland 1997 and 2000 by considering also the e ects of removing distortions to international trade In doing so we are able to study the e ectiveness of the dual track approach to liberalize a regulated market economy and not just a centrally planned one Secondly we recognize that political support for a reform needs to be built even before its implementation In other words the design of a reform has to take into account that policies aimed at
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