How to harden the `budget constraint' faced by state-owned enterprises is a key current policy issue for formerly planned economies in transition. In Discussion Paper No. 1013, Yingyi Qian and Research Fellow Gérard Roland develop a model which examines the link between regional decentralization and the budget constraint in the case of China.

The majority of enterprises in China are controlled by local governments at the provincial, city, county, township and village levels. The authors show that the effect of competition among local governments depends on the allocation of fiscal and monetary authority and control rights over enterprises between the central and local governments. Fiscal competition among local governments under (foreign) capital mobility may be effective in hardening enterprises' budget constraints. Fiscal competition can thus be viewed as a commitment device. The costs, however, are distortions in the shape of excess infrastructure investment, the so-called `development zone fever'. Decentralization of monetary authority is found to lead to a softening of local governments' budget constraints, as well as those of enterprises. Fiscal decentralization combined with monetary centralization (that is, fiscal federalism) is the preferred mix, not only for hardening the budget constraint, but also for the objective of achieving monetary restraint.

The paper also examines how conditions in labour and product markets under regional decentralization affect enterprises' soft budget constraints, as well as showing that the fewer the number of enterprises under one jurisdiction, the weaker the ability of local governments to use cross subsidization for income smoothing, and consequently the harder the budget constraints of enterprises.

Regional Decentralization and the Soft Budget Constraint: The Case of China
Yingyi Qian and Gérard Roland

Discussion Paper No. 1013, September 1994 (IM)