Part I. Creating a New Role of the State in the New Era

　　POLICY BRIEF 1:Rural Fiscal Policy and a New Strategy for Investment

　　Rural Fiscal Problems and Policy Reforms

　　The conduct of rural public finance is arguably China's biggest problem. The fiscal system, as designed, is out of date, generates inadequate revenues, poorly redistributes collected revenues and does not provide enough public goods. There are problems both on the revenue and expenditure sides and on the way public goods and services are financed.

　　We applaud the spirit of the recent tax reform measures. The reduction of taxes and fees on rural people is welcome. The recent reduction and planned future elimination of the Agricultural Tax also sends a strong signal that the government is serious about shifting its priorities and is becoming more supportive of the rural economy.

　　However, in the context of China's broader rural fiscal environment, economists do not believe that the recent Tax for Fee Reforms can solve rural China's fiscal problems. Tax for Fee is an attempt to reduce the tax burden of farmers in a system that is already characterized by insufficient revenue generation and public service spending at all levels. Studies have shown that savings to farm households are minimal, and when collections fall, public services fall. Fiscal resources in poor areas are already insufficient to meet investment requirements. Over 70% of counties and townships are in chronic deficit. While there are many adverse consequences of indiscriminant fee collection, the root cause may be the system's own design. Increased pressure on counties and townships to generate revenues to meet the system's unfunded mandates leads to excessive fee collection. The problem is most severe in China's poorest areas. The tax system, which remains heavily industry-based, can distort investment incentives and induce local governments to promote industrial development even in areas without a comparative advantage in manufacturing. These elements of the tax system have been shown by China's own economists to slow development. The 1994 tax reform increased the tax collection power of the central government to allow more equitable redistribution. However, while more revenues have flowed into central coffers (reducing local revenues), little has been shifted to poor areas, and the new tax policy continues to favor relatively affluent areas, exacerbating rather than alleviating the rural fiscal crisis.

　　Our main point is that rural fiscal reform needs to go beyond Tax for Fee Reform and consider the way expenditures are managed. The first step needs to be a review of the public goods and services that are needed in rural China. Realistic goals and priorities should be established for their provision. Each level of government needs to be handed clear responsibilities for the provision of a subset of public goods. The resources needed to provide public goods also need to be clearly defined. Leaders need to insure that sufficient resources are available to support the expenditures needed to meet their mandates. In the process, expenditures also need to be reorganized. Many tasks can be relegated to non-state entities. Many countries in the world have used alternative institutional arrangements to deliver key rural public goods without the direct involvement of the government. For example, a county school board with responsibility for running school services would not need to rely on cadres in the government, but instead would establish an office in each township staffed with personnel appointed by the board. The financial flows would be entirely within the system. Although there would have to be some coordination with government, most educational duties would be inside the school system. There would be less opportunity for mixing staff and funds. Similar changes could be made in the health and agricultural extension systems. In doing so, the size of government could be better determined and local governments could be downsized.

　　Impacts Assessment

　　Provision of Rural Social Services

　　Persistent fiscal gaps, or shortfalls between required expenditures and fiscal capacity, have several adverse effects. One is that many rural governments are unable to provide the level and quality of social services mandated by national policy.

　　Investments. Deferred investment is an immediate victim of fiscal shortfall. As officials struggle to meet wages and other immediate needs from diminishing revenues, these needs are displacing development-oriented investments. Even if budgetary officials are directed to allocate funds to fixed investment, the funds are often diverted or borrowed, and, if not returned, the investment is not just delayed but permanently deferred.

　　Rural Education. Calls from the national government to bolster rural education only recently began to be matched by earmarked allocations. National officials have set high educational goals and an education expenditure target of 4 per cent of GDP to be met by 2000, up from 2.66 percent in 1994. Although spending has risen, the goal still has not been met. Imploring local governments to increase education funding more rapidly than the growth in financial revenue has gone largely unheeded, and meeting this target appears improbable. Insufficient fiscal revenues have undermined the quality of education as measured by a number of human capital indicators. For example, a State Statistical Bureau survey shows that 30 million Chinese students have never been to school or have dropped out, 4 million drop out of school each year because they cannot afford the cost, and only 64 percent of rural students complete primary education without repeating a year.

　　However, when funds do arrive, the outcome is dramatic. Visits to selected poor areas in recent years have found that education expenditure in the form of earmarked transfers has risen. By no means universal, but in some of the areas where tuition fees have fallen and teacher quantity and quality has risen, education rates rise rapidly. In fact, when compared to most countries in the world, China's primary education rates are not bad. Most educational rates are 100% in rich areas and over 90% in poor areas. Of course, in areas where not all children go to school, the incidence of drop out is not evenly distributed. Non-han girls in poor areas have schooling records far inferior to other groups.

　　The more problematic area has been in trying to promote universal middle school education. Middle school educational fees are high. Many parents who want to fund their children's education can not. In addition, there is a demand problem in some areas, especially those with poor quality of education and few outside employment opportunities, as parents cast doubt on the return they can get for their educational dollars (even though nationwide the returns to education in both rural, migrant and urban labor markets have risen rapidly). While the government should move towards a system of free education, at the very least a needs-based system that provides scholarships for the poor needs to be implemented so China can boast that any one in the country that wants to go to school can!

　　Rural Health. Ministry of Public Health goals call for 8 percent of rural budgets to be spent on health care. National officials have mandated improved facilities, expanded coverage, and minimum training for doctors. Rules describe what is expected of county and township leaders for establishing ideal rural health systems. However, like education, the actual resources allocated to achieve national objectives fall far short of needs. The national government allocates only 2.4 percent of its recurrent budget for health care services, and only 1.2 percent of the capital construction fund. The situation is more severe in poor areas.

　　Extra-budgetary Revenue Sources

　　A second adverse effect of fiscal pressure is the growing reliance on off-budget finance. The ability of local governments to raise revenues varies greatly and determines the quantity and quality of local public services. County and township officials are evaluated on their fulfillment of mandates. This is an important reason for increasing local fee assessments, rising numbers of personnel and rising burdens.

　　To meet the revenue requirements of these expenditure demands, county and township governments attempt to increase revenue from off-budget sources. Without legal taxing authority or ability to borrow, counties and townships have developed off-budget sources, primarily extra-budgetary funds (EBFs) and self-raised funds (SRFs). The Ministry of Finance has reported that, on a national basis, off-budget revenues bring total revenue collection to about 30 percent of GDP.

　　Although the growth of off-budget revenues has eased fiscal pressures for many localities, it has also produced adverse consequences. It has hastened the decline of the formal fiscal system by providing an alternative tax source that is fully retained. It has created a tax system beyond the reach of the formal fiscal system that is ad hoc, nontransparent, and regressive; the lack of legitimacy may be a greater source of rural discontent than the total burden. It also has become more regressive, since poorer areas have fewer firms and less chance of collecting fees from the conversion of land to non agricultural uses. In fact, poorer areas that have tried to replace the revenue of their failed or privatized firms with real estate development have often failed and incurred losses. This has created part of the non productive conversion of agricultural land to non agricultural uses.

　　Perhaps the most egregious consequence of off-budget financing is the tendency of county and township governments to give policy and regulatory agencies control over the assets they regulate or operate (or the resources they are charged with protecting). Officials then encourage agency officials to use these assets to generate income for staff salaries and other expenses. There are many examples of misuse of these resources. Agricultural extension agents turn into pesticide salesmen; grain reserve managers become grain traders; those in charge of protected areas exploit them for their revenues.

　　Policy Recommendations

　　Radical and Bold Experimentation Needed

　　Although fiscal reforms are complicated and will entail fundamental reorganization, their implementation may be China's greatest policy priority. While increased transfers to eliminate unfunded mandates are the key to the solution of the rural fiscal crisis, the reforms also need to completely restructure local government and fundamentally reorganize public finance. Such reforms will be disruptive, but they need to be implemented in a comprehensive way. To minimize the disruption for the nation as a whole, we believe rural fiscal reforms can begin with regional experimentation. New systems of tax assignments are needed. The roles of townships need reevaluation. The relationship between provinces and counties need to be reorganized.

　　Policy Options for Investments

　　Rapid economic growth has not benefited everybody equally, thus worsening income distribution and regional inequality. The Gini coefficient has risen from 0.33 in 1980 to 0.46 in 2000. The income difference between the rural and urban sectors has become increasingly large. The average rural income was 60% of urban income in 1984, but the ratio declined to only 33% in 2002. The income gap between the coastal areas and the western region has also widened dramatically. With poor infrastructure and a shortage of human capital in less developed regions, it will be hard for farmers to switch from grain production to high value-added crops or to non-farm activities. All of these may lead to an even higher concentration of rural poor in these regions if proper government policies are not implemented.

　　There is considerable evidence that China is at a cross roads in agricultural development as the country appears to be moving from taxing to subsidizing agriculture. How to design an agricultural support policy to achieve long-term sustained, equitable and sustainable growth is a hotly debated topic. Based on the evidence from both China and India, we offer the following policy suggestions to achieve the stated national objectives.

　　More public spending in rural sectors. Empirical evidence has shown that investment in rural areas can yield large returns. Therefore, the government should continue its efforts to increase overall investment in rural areas. Rural investment accounted for only 19% of total government expenditures in 1997, but rural residents account for 69% of China's total population. Moreover, almost 50 percent of national GDP was produced by the rural sector (agriculture and rural enterprises) in 1997. The government's rural spending as a percentage of rural GDP is only about 5% compared with 11.6% for the whole economy. China has implemented an urban and industry biased investment policy for the past several decades. As a result, the rural-urban income gap is large and has increased. Any policies that discriminate against the rural sector will aggravate the disparities and should be discontinued.

　　More investment instead of more subsidies. The India case study clearly indicates that initial subsidies on inputs and output may help small farmers. As time passes, however, these subsidies become increasingly large and very difficult to remove. These subsidies including those on fertilizer, irrigation, power, and credit amounted to about 2% of the national GDP, and 8-10% of agricultural GDP in 2000. These subsidies are in direct competition with long term capital investment in roads, rural education, and agricultural research. China has already reached the initial stage of the agricultural transformation even though China did not provide direct subsidies on either inputs or output. China should not follow India's path to subsidize its agriculture. Instead, the government should use its limited public resources for improving human and physical conditions of rural areas to enable farmers to engage in high-value production or migrate to non-farm activities.

　　Correcting regionally-biased government policy. In addition to biased regional investment policy, predatory price policy on natural resources by the government has been the major culprit in worsening regional inequality. Under China's previous centrally planned economy, natural resources such as minerals and forests were owned by the central government. These resources were shipped to East China at low prices, thereby transferring rents to the coastal areas. The Western provinces, although rich in these resources, benefited little from their exploitation. Even worse is the latest reform of these state-owned enterprises, which left millions of laid off workers and degraded environments under the responsibility of local governments. In response, the central government should re-direct its public resources towards the western region where it has been shown the investments have high returns and large poverty reducing effects. This is consistent with the national strategy to develop western China. Investment in agricultural research, education, and rural infrastructure there should be the government's top priority. Among all the options, the most critical is universal and free primary (ideally 9 years) education funded by the central government.

　　Conclusion

　　Policymakers and researchers are debating how to increase farmers' income, and reduce regional inequality and rural poverty. There are several policy options. One option is to increase price and income support for farmers as many OECD countries have done for the last several decades. Another option is to use trade barriers such as tariffs and import quotas to insulate the domestic from international markets. But, these two options will either cause a huge government financial burden or an increase in domestic food prices and consequently high cost for consumers. These options will also lead to large net social welfare losses due to misallocation of resources among economic sectors. Also, before beginning subsidy programs, leaders should be aware of international experience: Once programs are started they are difficult to stop; political support does not come from maintaining financial support to farmers, but only by increasing it. This will inevitably lead to an upward spiral of support with little benefit attached.

　　Another option is to liberalize the agricultural sector immediately without any preconditions. This option will allow scarce resources to be allocated based on the comparative advantage among sectors and between China and international markets. Overall efficiency and net social welfare will be gained. But we argue that liberalization must have conditions. One of the conditions is to increase investments in agricultural research, irrigation, and rural infrastructure. This is necessary for long-term food security and also a critical precondition to improve overall efficiency of agriculture and to increase living standards of the rural population.

　　POLICY BRIEF 2:Grain Marketing and Reserve System

　　Few accomplishments can rival the government's liberalizing of domestic grain markets. China's grain markets today are among the most competitive and integrated in the world. The cost of shipping goods across China has fallen; the cost of shipping maize, rice and soybeans in many parts of China is about equal to the cost of shipping grain down the Mississippi River in the US. Markets also have integrated rapidly; by 2002, prices between almost all pairs of markets across China–even those as distant from one another as Xian and Guangzhou or Heilongjiang and Shanghai–move consistently together. Much of the gain is due to the construction of roads and improved communications. The improvements in China's market also arise from increased competition; since the mid-1990s, thousands of private traders have entered the commodity markets and actively trade. Thousands of wholesale and retail trading companies currently trade into and out of all major metropolitan markets, a fact that makes competition in China's grain markets much more intense than most other developed countries where typically a handful of firms dominate national grain trade (e.g., in the US the market share of the top five grain trading firms is more than 80 percent; in China the market share of the top five trading firms is certainly less than 5 percent).

　　The emergence of domestic agricultural commodity markets is playing a major role in transforming the landscape in rural China. There is a sharp move towards specialization. In the same way that specialized agricultural villages and regions appeared in Japan in the 1920s, 1930s and 1950s and in South Korea and Taiwan in the 1970s and 1980s, specialized villages in every conceivable commodity are appearing in China today. Such specialization facilitates the adoption of new technologies, improvement in product quality, greater access to markets and overall higher incomes. Certainly this shift needs to be encouraged in the future. Based on this, China deserves market status under the WTO.

　　With such well-functioning domestic output markets, it is not surprising that the government is considering implementation of a new set of grain policy reforms. The main target of the reforms is the reversal of the national grain procurement and marketing policy regime that has been built up since 1998. Initiated in 1998, the grain policy, called the Three Policies Agenda (or Sanxiang Zhengce) has cost the national government hundreds of billions yuan. Most economists and policy officials recognize, however, that there has been little positive return. Fiscal expenditures have built nothing and productivity has not been enhanced. Little of the funding has gone to farmers. Instead, the policy built up a large grain inventory and a growing set of bad loans in the Agricultural Development Bank. Although there has been little effect on national markets, grain policies and institutions have slowed down (or halted) the development of efficient private sector storage and behavior that will help markets smooth price fluctuations across seasons and over longer periods of time

　　Recognizing these shortcomings, the State Council ordered a bold new set of reforms in June 2004, called the new Regulations on Grain Circulation Management. The new regulations provide guidelines for the full-liberalization of China's domestic grain markets. The Task Force believes these changes are positive, assuming they are implemented, but additional policy changes are needed to ensure that several major issues are dealt with completely.

　　Major Issues

　　China's Grain System: "Old Debt, Old Grain and Old People". The high level of accumulated debt, perhaps more than any single issue, hampers the state grain sector from moving toward more market-oriented reform. Statistics from various sources indicate the magnitude of losses in grain marketing, including losses resulting from price interventions and deficits from business operations (300 to 600 billion yuan). The losses come from a variety of sources, including misappropriation or illegal diversion of budgetary allocations to other uses and losses from the payment of interest, reserve management and asset depreciation from China's large grain reserves. Most of the expenditures were funded by bank loans. The size of this accumulated debt is such that local governments and grain bureaus could never absorb such a loss.

　　At one point prior to 2003, the quality of China's grain in the state-run grain reserve system was also a major issue. After purchasing enormous quantities of grain in the late 1990s, reserve officials had no option but to hold stocks for many years. Stocks deteriorated in quality. More recently, the low quality of grain in the national stocks has become a less pressing issue.

　　Dealing with the large number of workers in the Grain System is another challenge in implementing new grain marketing reforms, despite progress in the past. Although the state grain system reduced its staff by more than 1 million employees between 1999 and 2002 (mostly by commercializing certain functions), there are still more than 2 million employees. The main area of redundancy is the 1.4 million people that are still engaged in procurement and marketing activities. This part of the grain system is performing functions that are being carried out by hundreds of thousands of private traders. The annual volume of procurement is less than 90 tons of grain per person, which, given the level of budgetary support for the procurement bureau, is grossly inefficient and leads to high losses in China's competitive grain markets.

　　Grain Direct Subsidy. During the past two decades, China stands out as a country that has used little in the way of agricultural subsidies. While many other countries have heavily subsidized their farmers, China has had one of the lowest levels of Aggregate Measure of Support in the world, between 0 and 2 percent of agricultural gross domestic product. Subsidies are not effective tools to promote long-run development. Instead, they are costly and in almost all nations have a tendency of becoming permanent programs. After receiving subsidies for several years, international experience has shown that farmers begin to believe that the government is not helping them, but that they are entitled to the payments and only credit policy makers if subsidies continue to rise, a phenomenon that never stops until the budget gives out. Moreover, phasing out subsidies almost always leads to serious social and political upheaval. Hence, one of the major issues for grain policy is to decide how to move in the future in the area of grain subsidies.

　　National Grain Reserve Issues. China's policy towards its national grain reserve is not well defined and almost certainly is hindering the development of efficient marketing institutions. National grain reserves in China focus excessively on holding large-scale strategic reserves. While one approach is to ensure that there are stocks of food to smooth prices across seasons and years, China's strategy is excessively high cost. The high costs, among other things, are due to the excessive quantity of grain reserves, the inefficient location of stocks (international best practice dictates most reserves be held in production regions, while much of China's stocks are held in consumption regions) and the absence of a clear set of rules and regulations to manage procurement, release and pricing. Because of poor system design, inappropriate management typically fails to smooth short term fluctuations in grain prices and has been shown to make them worse at times. Grain stocks should only be used to smooth short term fluctuations in market supply; they should not be expected to cover long term shortfall. Instead, to ensure long term grain supply, the nation needs to rely on a set of policies that uses financial reserves (instead of grain reserves) with international markets and increases the efficiency of domestic production by allocating funds to productivity-enhancing investments.

　　Understanding the level of China's grain stocks is a major issue. No where in the world is the level of grain reserves regarded as a state secret. Not knowing the level of stocks and the rules governing its release is incompatible with a market-oriented agriculture economy. The Task Force believes that much of the recent rise in grain prices would have been avoided if grain stocks had been managed in a transparent and open manner. The lack of transparency in reserve quantity, throughput and operation misleads producers, consumers and grain traders and thus hinders the prediction of short and long term grain price. As long as the government manages its stocks in this way, it will never get help from the private sector in holding and managing a large share of grain stocks for the nation.

　　Policy Recommendations

　　Grain Market Reforms: Three major sets of policies are critically needed:

　　1). Resolve Old Debt. This is a precondition for grain market reform. The large amount of debt hampers initiation of reform of the grain bureaus. With so much debt, there is little or no incentive for the state grain enterprises under the grain bureau to reform. The Task Force suggests that the government issue a public bond to absorb and eliminate most of the "Old Debt". Currently, China's public debt accounts for less than 20 percent of GDP, which is much less than in OECD member countries (average 74 percent of GDP).

　　2). Reduce redundant staff. Successful reform of the state owned grain system depends on how the overstaffing issue is resolved. We estimate that 60 to 70% of the existing staff needs to be reassigned to make the current state-owned grain trading enterprises competitive. With the potential for social destabilization, this should be implemented carefully through a one-time early retirement payment or some alternative mechanism. The grain enterprise should not be responsible for the welfare of former employees. Grain trading is so competitive that firms must be allowed to compete as if they were private sector firms. The budget to support such a program could come from various sources, including government budgets or auctioning some of the system's assets and subsidiary firms.

　　3). Deepening state owned grain enterprises reform. Once the debt and overstaffing problem is resolved, there is one more policy to implement: complete and unconditional commercialization of state-owned grain trading and marketing enterprises. The experience of China to date is that, if firms are given complete property rights, commercialization leads to more efficient operation, higher employment and higher profits. The break with the state needs to be clear and final. Currently, grain procurement enterprises have control over large volumes of fixed assets, to which they usually do not have official title. Title issues need to be clearly resolved, with little or no residual ties. It is better to give the assets away than to have lingering title issues.

　　Eliminate the "Grain Direct Subsidy" program and reallocate the budget to the provision of rural public services. The Task Force suggests that the government should consider phasing-out the current "Grain Direct Subsidy" program. Instead, the current and future funds that are earmarked for subsidies should be reallocated to support additional investments in rural education, agricultural research and extension, irrigation and other rural infrastructure. The rate of return to a number of investments in the rural economy (see policy brief 1) are high and lead to reduction in poverty. We do not believe fragmented payments of 20-30 yuan per mu given to households will have a large multiplier effect. In fact, unless households believe these payments are permanent, economic logic (the permanent income hypothesis) suggests there will be no return.

　　National Grain Storage/Reserve. Three sets of policy initiatives are needed:

　　1). Clarifying policy objectives for government grain storage/reserve program. This is a major policy measure to ensure food security and to help stabilize the market price and help farmers with production decisions. However, this does not mean that the government must run the reserve system. With appropriate policies, it can entrust much of the actual operation to commercial enterprises through competitive bidding. Although grain reserves can be used to smooth sharp short-term fluctuations in market price when necessary, it is recommended that the band of fluctuation not be set too narrow. Government involvement also must be made clear and done according to simple and well-thought out rules. Price fluctuations are an effective signal to achieve dynamic balance between demand and supply. Seasonal differences in price are necessary for commercial enterprises to maintain "normal" stocks in running their business (and they must have good profit-maximizing incentives to seek profits from storage). Eliminating price differences by managing a buffer stock system with a narrow price band will make commercial enterprises unwilling to keep their own stock.

　　2). Consolidating measures to achieve food security effectively and efficiently. A new plan is needed for a nationally integrated grain reserve. To achieve a particular level of self-sufficiency, a nation-wide unified reserve program incurs much less cost than segmented programs run by each province. In fact, it has been estimated that the national grain reserve system could be less than 80 million metric tons, only a small fraction of current reserves. China's grain output displays the least amount of variability in the world and with a modest-sized reserve, fluctuations of greater than 20 to 30 percent could be eliminated more than 95% of the time. If management of the domestic grain system is coordinated with international trade (which can rely on private and commercialized enterprises), the policy costs for grain reserves could be further reduced (to only 30 million tons) and the level of security enhanced. In contrast, according to estimates by China's economists, to smooth output fluctuations completely in each province (as is mostly done now), the reserves managed by each province would total 346 million tons (with no help from international markets). The criteria to trigger an increase or decrease in grain reserves should be set objectively. Full 100 percent smoothing of annual output fluctuations is too costly and also may distort price signals, leading to continued imbalance in the grain market, and actually reduce food security level.

　　3). Disclosure of the grain reserve quantity, throughput and operation. The reserve requirement, throughput and operating rules need to be transparent. Transparency is absolutely critical. It is conducive to the formulation of price expectations in the short- and long-run which is needed to help make better decisions about grain production, consumption, storage and marketing.

　　POLICY BRIEF 3:Trade Liberalization

　　China has promoted international trade aggressively in the past two decades. At one time in the early 1980s, China was one of the most isolated nations in the world with high rates of protection. Since then, leaders have reduced tariffs, removed licensing requirements, reduced the role of state trading and allowed thousands of enterprises to engage in import and export of most goods. In doing so, China has become a more open place. For example, average tariffs fell from more than 50 percent in 1991 to around 20 percent by the end of the 1990s. During this period, the total value of China's agricultural trade grew by about 6 percent annually and the growth of agricultural exports has exceeded that of imports.

　　Although there are concerns about the impact of an increasingly open economy on some groups of China's producers, there are many reasons to believe that the nation will benefit by carrying out its trade liberalization plan. Workers gain access to employment. Consumers benefit from lower prices. All producers benefit from lower fertilizer prices. If trade liberalization leads to greater exports, farmers can benefit from higher prices.

　　In assessing China's current trade policy, we examined two sets of issues. 1.) What will be the effect of the nation's accession to the WTO and the extent of its participation in future trade liberalization talks. 2.) How will trade affect the poor?

　　China and WTO: Now and in the Future

　　While it is well established that the economy as a whole benefits from accession to the WTO, the case of agriculture is somewhat mixed. Producers of rice, most vegetables and fruits, many livestock and aquatic products and other higher-valued, labor-intensive goods will benefit if trade liberalization leads to higher exports. While producers of barley, soybean and other edible oils were hurt by liberalization during the 1990s, most of the fall in the prices of these commodities had already taken place prior to recent trade reforms, so the agreement will have little effect. Predominantly maize, cotton and wheat farmers will be adversely affected. However, because most farmers are diversified and are able to change product mix when relative prices change, the overall cost will be small. The only groups that are likely to be adversely impacted are a subset of poor, inland farmers.

　　To get the most out of its trade policy, China needs to make complementary policy changes. Chief among these is to allow farmers to have access to the lowest priced and most productive inputs and technologies from inside or outside China. The WTO agreement challenges China's farmers with competition in output markets from producers in the rest of the world. To compete, farmers need to have access to the same low-cost inputs and high-quality technologies. There are many restrictions keeping seeds and other inputs from moving around the country. There also are barriers against the importation of inputs and technologies or investment by foreign technology firms. These should be sharply reduced and eventually eliminated in order to improve the income of farm households. According to international experience the entry of foreign seed and technology firms into the country could lead to both more competition and better transfer of technology.

　　Assessing China's Position toward Future Trade Talks—Two Years After WTO Accession

　　While most of the facts on the accession of WTO are well known, China faces another set of issues in thinking about how they should move forward in the next round of international trade talks. While there is always going to be uncertainty, research by economists inside and outside of China are producing many ideas with broad consensus:

　　• Doha Talks: On the three "pillars" of WTO agriculture negotiations now underway – market access, reducing export subsidies, and reducing domestic supports – China's interests lie in a robust liberalizing outcome to negotiations.

　　• Proponent of reform: China is already bound by commitments that put it ahead of the pack in terms of openness, and neither a collapse of talks nor a modest outcome will put it on a more even footing – only an ambitious reform outcome will do that.

　　• New analytical capacity: China's analytical capabilities in agriculture policymaking have increased significantly in recent years. Although still far behind many nations, including some developing ones, for the first time China has the expertise to make quantitatively derived choices about the best directions for its welfare. Chinese leaders know what is good for them and can pursue it with new confidence as a result.

　　• Comparative advantage: China's agriculture is evolving in the direction of national comparative advantage, in terms of sown area, investment in R&D and exports. China is shifting toward labor-intensive, high-value added production, instead of the land-intensive crops it emphasized in the past and where it has less comparative advantage.

　　• WTO has not been a killer of the rural economy: The net negative impact some expected on China's agriculture has not occurred; China's agriculture is doing well post-WTO.

　　• Foreign market access: China is increasingly concerned about market access problems abroad, as its competitive exporters bump into tariff and non-tariff barriers.

　　• FTAs: In regional free trade agreements (FTAs), China is showing its readiness for early and aggressive agricultural trade liberalization, more so than almost all other developing countries, especially in the Asia Pacific.

　　• Domestic adjustment: Like all economies, China must address concentrated economic pain from structural adjustment at home if it is to push further reform; but China has sufficient WTO-consistent means to do so while remaining a good player internationally.

　　• Alternatives to farm employment: Rural development is benefiting from strong industrial and tertiary services sector growth, gradually reducing the urgency of sustaining millions of farmers through agricultural supports.

　　• Disputes manageable: A number of residual non-WTO compliant practices in China fuel disputes with trading partners; but the list of such problems, while more transparent and reported today, is shrinking relative to the volume of agriculture trade that is trouble-free. If China can continue to improve in managing ongoing trade problems, it could gain in credibility that will allow it to be a positive player in future trade reform efforts.

　　Trade and Poverty

　　In the same way that the forces of development have generated progress and problems, the nation's efforts at pushing ambitious market liberalization policies has had both positive and negative consequences. Although the nation's accession to WTO will help rural residents and improve incomes generally, with competitive markets that extend to most parts of China, the effects of trade liberalization—both those that raise and lower domestic prices—will be transmitted throughout the economy and could hurt subsets of households.

　　Unfortunately, until recently, researchers rarely tried to track closely how different types of households in different regions of China have been affected. Specifically, almost no research has tried to measure the effects of trade liberalization on a commodity by commodity basis. Likewise few have tried to assess the effects of trade policy changes on different types of households in different regions of the country. Without this type of analysis, it is difficult to assess household impacts. However, according to new analysis by the Task Force that does trace trade effects to specific groups of farmers, the subset of all farmers that get hurt from trade liberalization is small. And, it is quite specific. In particular, poor maize, cotton and wheat producing areas in the Central and Western parts of the nation are the ones that have been hurt the most.

　　Several factors are responsible for these adverse effects. First, households in these poor areas—due to lower social capital—are less likely to be diversified into the off farm sector. Thus, while richer households are able to offset the loss from trade liberalization with gains from their participation in the off farm sector, some poorer households are less able to do so (although the rise in migration is making this less of an issue). Second, farmers in poor areas often are growing the crops that are uncompetitive—maize, cotton and wheat. They are less likely to be in sectors in which China has a comparative advantage—e.g., horticulture and aquaculture. Finally, because farmers in poorer areas have less physical and human capital (including less access to credit) than those in richer areas, they often have difficulties in shifting from the agricultural commodities that are hurt by trade liberalization into those that benefit.

　　According to China's own estimates, the annual loss due to WTO to these households (who are the most vulnerable of all households) is small. Research shows that the overall impact on the poorest of the poor averages only about RMB50 per household. A policy that compensates such households by RMB50 per year for the first several years after WTO (e.g., through a policy that eliminated tuition and school fees for households in these areas or paid the premium of rural health policies) would offset the negative consequences. Therefore, given such a small impact on such a small part of China's rural sector, there are no grounds for slowing trade liberalization based on the negative impacts of increased international trade. The negative effects are far outweighed by the positive ones.

　　There are some actions, however, that policy makers can take. For example, they need to try to encourage farmers in poorer, inland areas to shift their production (where appropriate) to more competitive crops. This can be done with well-targeted investments and training programs. Investments should be well-targeted and emphasize productivity enhancing activities. Market information should be provided and farmers should make their own decisions. Officials also may need to take other, non-trade actions to increase the livelihood of farmers in these areas. In many areas, farmers do not have an advantage in any farming activity. In such areas rural education, better communications and other policies that might facilitate their shift into the non farm sector may be the most beneficial policy.

　　Future Directions and Policy Implications

　　This summary of trends in China's agriculture sector after the nation's accession to the WTO does not dispute that China faces massive challenges in the agriculture sector. While overall welfare has improved in all income deciles, important local dislocations exist due to domestic adjustment and opening to foreign competition. China's system of agriculture sector financial support and adjustment is primitive and in need of dramatic improvement. The private and public financial infrastructure to permit capital upgrading and rationalization in the agriculture sector is not in place, thus constraining growth and adjustment. Vested interests, especially in niches still heavily influenced by state entities in production or distribution, cannot be properly contested due to the lack of political liberalization needed to encourage competitive interest group politics.

　　But despite these problems, the direction of change in China's agriculture is manifestly toward reform, structural adjustment and economic rationalization. China is further along toward the end point of that process than generally recognized, and shows a deep, probably irreversible commitment to the process. China can point to demonstrated successes in raising incomes, overall welfare and productivity to justify (to itself) the pain of further adjustment, and has the policy skills to manage (if not minimize) adjustment costs.

　　In manufacturing, China did not need to "make rules" in the international system to enjoy its comparative advantage as a factory to the world; it merely "took rules" and adapted its domestic economy in such a way to profit from them. In agriculture the situation is different. Having gone ahead of the pack in its commitments to join WTO in 2001, it stands more liberal than other countries – especially many developing countries – on the major agriculture policy axes. A collapse of WTO efforts to accelerate liberalization for developed and developing countries – that is, the status quo – will leave China ahead of the pack and fail to address China's interests. A diluted WTO outcome with modest reduction in protection by developed economies (the biggest distorters) and weak new commitments by developing countries would do little more for China than no agreement at all. Only a robust agriculture trade liberalization agreement would allow China to actualize its agricultural comparative advantage in the same way that its manufacturing has benefited.

　　That outcome is not the default case for current WTO talks on agriculture. Privileges secured by developed economies and exceptions to WTO disciplines for many developing economies (exceptions which China has already largely foregone) are likely to be sustained. To avoid that scenario China needs to get actively involved in WTO talks not as a follower or taker of rules, but as a proponent of reform. While new to WTO, China has leverage usable for such an endeavor. China can concede still further liberalization, for example by reducing subsidy ceilings or opening trade in commodities for which it has no advantage (e.g., sugar, dairy, or wool) as a contribution. It can further increase the size of its tariff rate quotas on some of its major commodities (e.g., maize, wheat, and rice). China can remind WTO members eager to sell it Airbuses, BMWs, GE power plants and Toshiba laptops that it has comparative advantage in higher-value added, labor-intensive agriculture, and that this should be taken into account.

　　In short, China needs to be bold during the next round of the trade talks. It is in their interest to play an active role. It needs to press other nations to reduce barriers. It needs to stand with other developing countries to put pressure on developed countries to drop the excessive levels of subsidies that are distorting international trade. In pursuit of their interests and in a leadership role in the talks, they should press for developing countries to open their markets, using their own nation as an example.

　　Problems will occur because of new trade reforms. Some may suffer from increased openness. China needs to take actions to minimize the effects – on both the poor (discussed above) and on the environment (discussed in another brief).

　　POLICY BRIEF 4:Building Partnerships with Farmer Associations

　　In a modern society that is dominated by markets and where most assets and information are in the hands of private individuals and enterprises, the government needs partners to engage in the development process. It is important at this point of its development that China encourage the development of truly independent non-state organizations, including those that will act as information networks, business support group, and technical and marketing systems cooperatives. Cooperatives played major roles during the rapid growth periods in all European and North American nations. In Japan, Korea and Taiwan the rural economy's development was guided by cooperatives and farmer associations (FAs). In a number of developed countries, as the government moves out of extension, FAs are taking over information dissemination and service provision.

　　The Absence of FAs: Legacy of the Past

　　FAs have a relatively low profile in China and little is known about them. In the mid-1990s it was estimated that there were more than 100,000 farmer associations in China. The Ministry of Agriculture claimed that during the 1990s up to 5 percent or more of all farmers belonged to associations. Because the source of these numbers is unclear, those familiar with rural China often cast doubt on the figures. Field workers during the 1990s rarely encountered such associations. Retrospective information from a recent community-level, national representative survey in 2003 confirms that even by as late as 1995, only a small number of villages and a smaller number of farmers participated in FAs.

　　The conditions in rural China have changed markedly in recent years and there is now a rising demand for institutional change. Almost certainly the poor record in establishing FAs during the 1980s and 1990s was due to China's unique legacy of planning, an environment characterized by poorly developed markets and the lack of a legal and institutional support framework. In the past government agencies were responsible for delivering and financing inputs and technology and for procuring and marketing output. Markets and price signals were weak. The demands of those buying agricultural products rarely included quality or value added services. In the old environment there was little need for FAs to aid farmers in accessing technology and inputs or for marketing their products.

　　Since the mid-1990s, the situation has changed. The legacy of planning began fading; markets began to emerge and started to become the dominant source of technology and inputs; the demand for higher quality, safer and fresher food products from farmers has steadily risen. In the new environment, there has been little on-the-ground response outside of a few notable experimental areas. The slow response is not surprising, given the absence of many of the basic conditions that facilitated the emergence of FAs elsewhere in the world.

　　New Urgency, New Efforts

　　China's government began to take steps to promote FAs in recent years. The main factor that changed is the attitude of the government towards FAs. While in the past FAs were viewed with ambivalence or even as a threat, they are now embraced. The beginning of a new phase of FAs is best marked by the revision of the Agricultural Law in 2002. The new version provides the fundamental legal basis for the development of FAs in China. Article 14 of Chapter 2 stipulates that "farmers and farmer production and marketing organizations may establish various kinds of agricultural commodity sector associations, to provide services to members in production, marketing, information, technology and training, to bring into play the functions of coordination and self-control, to submit applications for support in agricultural trade related issues, and to protect the interest of members and the sector." In a document of CPC and the State Council for guiding agricultural and rural work in 2003, the important roles of farmer associations and other cooperative organizations are also recognized. Finally, and perhaps most importantly, in the 2004 No. 1 Document of the CPC and the State Council, the prominent role of FAs has been promulgated as well as more concrete measures designed to promote their development. The document states, "The development of various kinds of agricultural professional cooperative organizations … should be encouraged. The formulation of the law for farmer professional cooperative organizations should be advanced … To accommodate the new development situation of world agricultural trade, the establishment of sector or commodity associations for major export products including poultry, vegetable and fruits should be accelerated."

　　FAs are now growing relatively rapidly, although from a small base. A recent nationwide survey by economists in China=\ confirms the recent surge in FA activity. FAs do exist in China; however, they are still in an early stage of development. From less than 1% in the mid-1990s, it is now estimated that about 7% of villages in China have functioning FAs. Around 2 to 3 percent of China's households participate in some type of FA. Although the level of participation is low, in recent years their emergence is accelerating.

　　The expansion of FAs is not spread evenly across China. FAs appear in greater numbers in richer villages, but surprisingly there are also substantial numbers in poorer areas. Whilst the relative wealth of the area is not correlated with the formation of FAs, the distance from a major economic center is strongly correlated. Where villages are further away from major economic centers, FA activity falls rapidly. This means that if households in more remote areas are going to start FAs, they will require substantially more help than in the past. Finally, most of the associations are in areas where there are more higher-valued crops, such as fruits and vegetables, and other non-cropping activities, such as livestock production.

　　Remaining Constraints

　　There are still shortcomings that are keeping FAs from growth and constraining their spread to new communities. Above all, there are legal constraints. Despite the new laws and higher policy status, today FAs have no legal status. Members are unable to sign contracts as an organization. They cannot take out loans or act as a guarantor. In the vast majority of cases studied by two separate MOA and Peking University research teams, the lack of legal status has been identified as the most limiting constraint to the expansion of FA activity.

　　The other pressing need is to find the right group, agency or institution to act as a catalyst to promote FAs. It is almost universally known that although cooperation and collective action among farmers will lead to rising welfare for the entire group, it often is difficult to overcome group dynamics and to achieve cooperative behavior. In such cases, the input of an outsider (or a champion/ leader from the group) is needed to get the group going and to mentor it, especially in its early years. However, though it is necessary to have a catalytic agent it is difficult to establish the right balance between encouragement and domination. Farmers need to be encouraged and indeed sometimes pushed into such organizations, but to be successful FAs need to be voluntary. In other countries, various agencies have taken responsibility for promoting and managing cooperative movements. In the US, the agricultural university system has a network of cooperative extension agents. In Japan, there is a special ministry-level cooperative commission. In Europe, the cooperative movement is quite mature and local cooperatives are bound together by informal networks of upper-level, pan-national cooperative associations. Currently. in China there is really no single group that has responsibility for promoting and fostering the nation's FA movement.

　　The record in China shows that such a service (government or not) is needed, but that it is difficult to find the right balance. According to a survey by economists, the actions of local governments often dampen the enthusiasm of farmers. In many places the government has put in place regulations for registration and the establishment of charters—when following the rules the FAs become formally established. In other areas, the emergence of less formal FAs have been allowed or encouraged. In many cases, even without being formally established, farmers cooperate in their input purchasing and marketing activities, in organizations that are called functioning FAs. Research shows that there is some overlap between formal and functioning FAs, but most non-functioning ones are actually formal ones. In contrast, most informal FAs function well. This indicates that strict regulations may slow FA growth. It also suggests that fewer rules may not harm the growth of the FA movement.

　　On the other hand, the government clearly has an important influence on the emergence of FAs. Government involvement in promoting FAs within a locality is the single most important factor that explains why FAs exist in some communities, but not in others. Such a finding suggests that China may consider adopting a system like that used in other countries in which government employees are hired with the explicit job to be an advocate for FAs. Such an official would be rewarded for rapid expansion of FAs as long as they developed in a way that is pro-farmer and positively affects rural welfare.

　　Finally, research has found that lack of resources—both financial and information—in the hands of FA leaders constrains their growth. The success of the influential Farmer Association movement in East Asian economies is often attributed to the fact that there was a great deal of motivation for members to participate in and contribute to the leadership of the local Farmer Association. The association had support of the government and was the recipient of investment from budgetary authorities and financial support from the banking system. Many of rural development initiatives worked through its FAs and due to the high level of participation of farmers, even the poorest and most land constrained could benefit.

　　Policy Options

　　Although the impetus to meet and act as a group must originate from the farmers themselves, the government can create an environment in which FAs can thrive. First, leaders need to develop laws and regulations that promote and protect FAs. The legal status of groups needs to be clear. FAs need to have the ability to enter into contracts and take loans. FAs need the authority to be able to act for the members of their group as well as to be subject to well-designed regulations that protect the membership from the leadership, including the way in which the leadership is selected and monitored. There is now a working group that is pushing for a new law by 2006. The law should include clear and unambiguous language giving FAs full legal status. Efforts are needed to ensure that the law is well written in other dimensions and immediately implemented. When it is final, there should be no expense or effort spared in promoting the law and its implementation.

　　Second, the experience of FAs in other countries has shown that even when a favorable legal and regulatory framework exists, an independent catalyst is also often needed to get FAs started, expand and perform better. While China has a number of FA-promoting agencies, these institutions are controlled by the Government. Alternative models should be sought to create catalysts that are first and foremost responsive to the needs of farmers' and FAs. The main role of such an advocacy organization is to facilitate their creation and provide information that allows its members to promote the interests of the association – usually the FAs that survive are those that provide financial gain to farmers as a result of their involvement.

　　Third, new measures should be enacted immediately to provide more technical and financial support to FAs. Technical support from governments is needed for sound development of farmer associations and good functioning of those associations. The technical support can be in the form of: training staff of the associations in establishing an efficient and democratic internal management system; technical services provision by public agricultural extension systems/units to members of farmer associations; marketing information service from governmental organizations. It is also possible to offer financial and economic support. Care, however, is needed to ensure that the incentives for establishing FAs are not so great that fake FAs appear solely to take advantage of the benefits.

　　Fourth, there is a great deal of accumulated experience and knowledge about FAs in many other countries. China should take advantage of this experience and expertise to further its own development and utilization of this valuable tool. Many countries and their FAs are willing to share their knowledge and experience with China.

　　Part II. Investing in Agricultural and Rural Resources

　　POLICY BRIEF 5: Preparing for Migration Off the Farm

　　All modern nations in the world—in Europe, North America and Asia—are urban with robust industrial and service economies. There are no high-income countries in the world that have more than 7% of their populations reliant on agriculture or have more than 10% of their people living in rural areas. None of these nations, however, started out with this structure. At some time in the past they were all similar to China's society in the early 1980s when most of the population was living in rural areas and engaged in farming. From international experience, one of the most defining characteristics of successful development is transformation from rural to urban societies based on industry rather than agriculture. The development of labor markets and access to off-farm jobs is the conduit through which the shift of population from rural-to-urban and agriculture-to-industry occurs.

　　The Miracle of China's Labor Shifts

　　Off-farm work has emerged as the main source of income growth for rural households. By 2003 1/2 of China's rural labor force earned at least part of their income from off farm jobs; more than 85% of households had at least one person working off the farm. Internal migration has become the most common way for rural laborers to get a job off the farm. More than 100 million migrants now reside and work outside of their home villages. More than 75% of 16 to 20 year olds work off the farm in cities far away from their homes. A veritable flood of young and relatively well-educated workers has been flowing towards China's cities and into industrial and service sector jobs in recent years. Self-employment opportunities in the rural economy also have risen rapidly during the past two decades, and the quality of these micro-enterprises has steadily improved. The firms, although household-based and extremely labor intensive, provide employment for more than 80 million rural residents in more than 50 million households.

　　Off Farm Employment and Productivity, Income, Poverty and Inequality

　　The shift of the rural population off the farm into wage earning jobs and self employment has generated large increases in productivity and is responsible for most of the increase in rural incomes since the mid-1980s. Large increases in productivity are generated by moving low productivity workers from farms to more highly productive manufacturing and service sector jobs. For example, during the 20th century, more than 60% of the rise in productivity in the fast-growing Asian economies is attributed to the shift of the labor force from rural to urban. Research shows that about 50% of the rise of productivity in China has come from moving rural workers into off farm jobs.

　　The role of off farm work in raising rural incomes is significant. Between 1980 and 2000, rural household income per capita rose by 4% per year, almost all of it from the off farm sector. The importance of off farm employment is even more significant when viewed from the household's perspective. When households are able to place one more member into an off farm job household income, on average, rises by 56%.

　　Off farm employment is the primary engine of poverty reduction and in recent years has begun to aid in the reduction of rural income inequality. Economic growth and access to off farm employment were by far the greatest sources of poverty reduction during the 1980s and 1990s. The increase in participation of young men and women from poor, rural areas demonstrates the pervasiveness of the penetration of labor markets into poor areas. For example, the participation rates of 16-25 year old men and women from poor areas in wage earning activities rose from about 15% in 1990 to nearly 70% in 2000.

　　Although off farm income was inequality-increasing during the late 1980s and early 1990s; since 1995, as more and more households have found jobs off the farm, wage earning activities, especially the earnings of migrants, have begun to reduce inequality. Access to off farm employment was by far the most important source of the reduction in inequality. In the same way that other East Asian countries, during their periods of rapid development experienced "growth with equity," China's income disparities have moderated almost exclusively due to the rapid rise in more equally distributed wage earning jobs, China's rural Gini coefficient fell between 1995 and 2002 from 0.42 to 0.38.

　　Enabling Factors

　　Rapid economic growth has been responsible for the strong expansion of off farm employment for rural workers. China's continued rural transformation will depend on the demand for labor generated by the industrial and service sectors. Importantly, the sectors that have been key in job creation are mostly in the market-oriented, private sector.

　　As China's economy has developed and the incentives that drive employment and other business decisions have become more focused on profits, labor markets have emerged and have gradually begun to function well. Research supports this assertion, especially work on the off farm-sector's returns to education, the relationship between investment in education and earnings. Returns to education in China rose during the 1990s. For example, the returns to education for those 30 years of age reached more than 10% by 2000; the return to education in the migrant labor force is more than 13%. As these returns have increased, the importance of investing in education for households has risen, since higher wages and access to off farm jobs depend inherently on access to education.

　　While the rising demand for rural workers was the key to increasing off farm employment, a number of other factors also allowed rural residents to find off farm jobs. Despite the persistence of China's household registration system and the artificial barriers that it raised during the planning era, restrictions on movement around China and into cities for rural residents were gradually relaxed throughout the 1980s and 1990s. In the countryside the initial worries about land tenure insecurity proved unfounded and as land rights improved and rental markets emerged, individuals and families have been increasingly willing to leave their rural homes. Rules and regulations for self employment are minimal and the ease of entry into many sectors, such as construction, transportation, trading, retail and small scale manufacturing, have encouraged those with capital and entrepreneurship to become self employed in search of higher returns. Today China's markets for wage-earning workers and for the self-employed are among the fastest growing and competitive of all markets.

　　Remaining Constraints

　　Not enough jobs and poor human capital are the main constraints to future growth of off farm employment. While much progress has been made in the management of China's industrial structure, many policies of the past and present distort the relative demand for labor and capital. For example, an inordinate proportion of loans from the nation's banking system are targeted for capital-intensive industries that provide relatively little employment, while many medium and small enterprises are unable to obtain enough financing. .

　　While the dual urban-rural household registration system does not act directly as a barrier, the lack of basic services for rural migrants is undoubtedly slowing China's transformation. Migrants still face discrimination in entering urban school systems despite recent changes in regulations. Private clinics that are affordable for rural migrants are heavily regulated, frequently to the point to which they are driven underground. Housing policies in the cities have not promoted the emergence of a low-cost housing sector—either for sale or rent. There is little private housing available to migrants—especially in the larger, faster growing municipalities. Health insurance, unemployment insurance and social security are still unavailable to rural workers. Above all, rural China's weak education system—especially in poor areas—and its poorly developed system of skills training pose the largest threats to the long run growth of the economy. Even with the government's recent efforts to improve education, the weakness of rural education is evident in many dimensions. For every 100 yuan spent by the government on an urban primary student, only 20 yuan are spent on rural students. The difference is even greater for middle school.

　　The quality of rural education is poor. There is almost no country in the world in which primary education is not free. Other countries support primary and secondary education because the social return is far above the private return; it just makes economic sense to do so. And while private returns are high and most rural families are willing to invest heavily in the education of their children, the current system often puts a burden on rural households. China's rural households, especially in poor areas, spend up to half of per capita income on elementary school fees and more than per capita income on middle school.

　　In many cases they are unable to afford high school and college, in the rare cases that students are able to gain entry. The main problem, of course, is lack of funding. Part of this problem is structural. In China local governments still bear an unusually large part of the burden for financing primary and secondary school education. In nearly all other modern nations the national government provides basic educational services. With the rise of migration in China local governments will have increasingly less incentive to provide high quality education, since those that get educated will almost certainly leave the local economy.

　　The low level of funding and poor quality of rural education manifests in many ways. Although attendance rates in primary schools have risen in recent years, drop outs, repetition of grades and poor grades still plague many schools, especially those in poor, remote and minority regions. Research has shown that young girls in some areas are especially vulnerable. The greatest discrepancies occur in secondary school. Despite rules on mandatory 9-year education, the drop out rate of rural children is more than 10 to 20 times that of urban children. And, while upper middle school education is becoming nearly universal for students in many cities, it is still unusual for households in many rural areas. Entrance to college is rare and almost unheard of in most villages. Hence, in a society that is endowed with labor, access to those services that enhance human capital and raise the returns to labor are extremely unequal. If not rectified soon, this will almost certainly become a bottleneck for development. Rural health and other social services are equally, if not even more, poor.

　　Policy Options

　　Unfortunately, there are few new policy ideas for reducing barriers to the continued expansion of off farm employment. Most fundamentally increased off farm employment depends on new jobs and enhancing human capital. On the side of demand for labor, rapid economic growth is the only true engine of employment growth, especially in an economy like that of China where labor markets function reasonably well and where many industries are relatively unregulated. Policies that promote labor-intensive manufacturing and service provision are needed and policies to minimize investment into and loans for capital-intensive industries should be based on profitability and not on other criteria. Any measure that eliminates distortions in investment into and lending for state-owned enterprises and capital- intensive firms and into the private sector and labor-intensive firms will be pro-employment.

　　On the supply side, the experience of developing countries around the world, but especially those of Asia, demonstrate that rural education underpins development. China needs to commit itself to providing free primary and lower middle school education. Additional funding to make upper middle school and college education attainable for rural students should be implemented. Needs-based scholarship programs are desperately needed. In short, the gap in funding between rural and urban education should be eliminated and China should make it a goal to allow all children, regardless of their socio-economic status equal access to education. School funding, at least for poor areas, but even more ideally for all of rural China, should come from the national government. The curriculum for rural residents should be flexible, especially at the middle school level, to allow both academic and skills training options. If anything, teacher salaries in rural areas should be raised above those in urban areas to encourage high quality teaching. Equally ambitious efforts should be focused on providing better health services and health insurance. Above all, even more effort should be made to provide education and health services to those in remote, minority regions.

　　New and innovative programs are also needed for those that are still young and mobile but through their basic education program. Adult training programs that give potential migrants the skills that employers demand will improve the nation's productivity. Experiments with adult education in rural source communities and in urban migrant destinations should begin and be given priority funding.

　　In the cities, the policy goal should be to offer those of rural origin equal access to housing, education, health and other services. In the long run, there is no good reason for China to maintain a two tier system of citizenship. Efforts should be made to encourage the construction of low-cost housing that is affordable for rural migrants to buy or rent. The government should consider policies similar to those promoted in other nations. There needs to be rules requiring low cost, affordable housing to be built in some proportion to higher cost development. Preferential, needs-based mortgage programs will promote home ownership by the poor. At the same time, policies to promote, small, inexpensive private clinics are also needed. A variety of education institutions should be allowed. Migrant schools, although informal, should be allowed to help rural residents to bring their children and families with them to the city. The recent changes in rules regarding opening urban elementary and middle schools to migrants should be continued and implementation encouraged. It should be a matter of national policy to promote gradually a legal and social environment that will encourage rural workers to move from the countryside to the city and welcome them when they arrive.

　　POLICY BRIEF 6:Raising Productivity on the Farm: Agricultural Research, Extension and Water Management

　　Agricultural Research

　　China has traditionally had a strong agricultural research system that has generated technologies adopted by millions of farmers to meet the increasing demand for food and fiber in the most populous country in the world. Publicly funded agricultural research and a network of extension agents were the keys to the nation's performance. There is concern, however, that China is not currently investing enough in agricultural research. Agricultural research investment intensity (ARII—agricultural research expenditures divided by agricultural gross domestic product) declined from the mid 1980s to the late 1990s. Although increasing since 2000, total ARII is still only 0.5 percent, less than half of the minimum level of investment recommended by the United Nations. If we examine only government budgetary allocations for agricultural research (that is, if we exclude earnings of the commercial subsidiaries of China's research institutes), the percentage of budgetary ARII is only 0.25 percent, only about one tenth of the average for developed countries (2.37 percent) and about one third of the average intensity for developing nations (0.65 percent).

　　At the same time, substantial changes are underway in the agricultural research system. Research institutes are overstaffed and burdened with the duty to care for retirees and house the staff. Recent changes in the funding mechanisms for research institutes have transferred responsibility for raising funds to the institutes themselves. While these changes have the potential to make some of the research institutes more efficient and more responsive to the demands of the market, not all agricultural research can or should be commercialized. With rising concern about research being needed to address problems of raising yields for conventional varieties (that is, for crops in which the private sector has no interest), poverty reduction and environmental sustainability, the government needs to remain actively involved in funding. Since the benefits from basic research rarely accrue to the party that is engaged in such research, commercial interests will never do the optimal amount of basic research. Most scholars believe the agricultural research system needs to be fundamentally reformed to be able to serve the nation as its modernization proceeds.

　　Extension

　　There is even more concern about China's extension system. The Task Force concludes that it is a great challenge for the agricultural extension system to provide new and appropriate technologies for 240 million small farm households. Unfortunately, during the 1990s, one of the largest and most effective extension systems in the world nearly collapsed. According to a recent survey, of the nation's 1 million extension staffs, only a small fraction is engaged full time in extension work. Many extension stations at the township level exist in name only. Extension agents often pursue agendas that are not in the interests of farmers.

　　While poor training and antiquated equipment and methods are problems, by far the greatest weakness is that the government's budgetary commitment to agricultural extension is inadequate. Since the late 1980s, many local extension stations have not been able to pay their technicians a full salary. Instead, upper level officials encourage their field agents to shift part of their efforts to commercial activities in order to supplement their income. Extension agents are supposed to do business, such as selling pesticides, for part of their time and use the earnings to subsidize their extension work. They cannot effectively serve two masters, but even when agents are willing to perform their extension tasks they do not have access to any resources to do so. A recent survey shows that extension agents spend only a small fraction of their time, if any, doing extension work. More than three fourth local extension stations do not have any extension projects. Finally, there are many reported cases where extension agents are not promoting appropriate technologies, at least in part because of conflicts of interest between their commercial activities and their extension work. In some areas extension agents tried to slow down Bt cotton adoption since it would reduce the demand for agricultural chemicals. Without reforming the extension system, it will remain an overstaffed bureaucracy with unqualified technicians that have little incentive to work on appropriate extension activities.

　　Despite the problems facing China's agricultural research and extension systems, it is more important than ever to build up the institutions that can create and deliver new agricultural technologies. The country is still land short and faces an emerging water crisis. The new pressures of urbanization, changing preferences, rising wages and emerging markets will put a lot of pressure on the research and extension system to create and deliver agricultural innovations that can raise agricultural profitability in the future.

　　Facing the Challenges of Water Management

　　Water shortages pose a serious barrier to growth, are limiting efforts to alleviate poverty, and are becoming a major source of environmental problems. So far, no option has proved very successful in combating the problem of increasing water shortages. Unfortunately, traditional policies either no longer work (e.g., investing in increasing the supply of water—most of the water in northern China is already being used) or do not lead to real water savings (e.g., the promotion of technologies such as sprinklers). Such strategies are unlikely to solve China's water shortages since they do not lead to real water savings. Even with South to North transfer, there will still not be enough water to solve the crisis.

　　With the failure and infeasibility of traditional engineering approaches, there is need to turn to more ambitious water policies. While complicated, we summarize here the steps that the Government must take in order to begin to manage north China's water resources.

　　• First, water savings in irrigated agriculture need to focus on reducing the water consumed per unit of crop production. This requires an integrated approach of improvements in irrigation technology (including water conveyance systems and drainage), agronomic practices, and farm water management.

　　• Second, water management agencies need more authority to implement the difficult allocation measures that are needed.

　　• Third, to achieve true water savings while avoiding inequitable outcomes, a system of water rights for both surface and ground water is needed, with rights extending to individuals that live in specific areas and the total amount of the rights limited to water availability after taking into account the environment and other needs.

　　• Fourth, after water rights are established, China needs to begin the investments and management shifts that will allow for volumetric pricing and regulation of water.

　　• Finally, with the institutions and facilities in place to implement a system of water rights and volumetric charges for water the nation can begin to move toward improved water management.

　　The efforts on the conservation side must be matched on the pollution abatement side in order to stop the mounting, and often irreversible, damage to China's water resources. Water scarcity is more critical when limited water resources become unusable because of water quality deterioration. In sum, it is not going to be easy to make the fundamental shifts, but of all the areas of resource management, getting water policy right may be the most important.

　　Major Issues

　　Reformers of China's agricultural research and extension system face 3 major issues:

　　Antiquated institutional setting:　　

　　

•  Lack of coordination and unproductive duplication: China's agricultural research system is the most highly decentralized system in the world. Over 95 percent of research institutes and more than 85 percent of China's research staff are in provincial and prefecture institutes. There is little coordination between central and sub-national institutions. Without coordination, research programs in many parts of the country are duplicative. While competition among research centers is healthy, redundant duplication wastes resources and leads to few new breakthroughs. A gap between research and extension also has emerged.
•  Overstaffing with unqualified personnel: China's R&D staffing levels are too high. Overstaffing plagues almost all institutes. Most institutes are burdened with many unqualified staff. There are more than 130 thousand approved staff positions. Although many positions are unfilled, there are 70 thousand active research personnel, a level that is 3 times that of either the US or the former Soviet Union. There are more than 1 million extension workers. Only 10 percent of China's extension staff has BS degrees; only 0.1% have MS or Ph.D degrees. There are no systematic on-going training programs for extension agents; the lack of ties between research institutes and agricultural universities makes continuous learning difficult.
•  The drag of retirement: In addition to all other duties, the research and extension system must provide social welfare services for its retired staff. It is estimated that the ratio of working staff to retired staff increased from 4:1 in the 1980s to about 2:1 in the late 1990s. Because core funding has not increased as retirement costs have risen, an increasing share of the research and extension budget is being allocated to retirees.

　　Public and private partnership:　　

　　

•  All public; no private: The creation and extension of China's agricultural technologies are overwhelmingly financed and undertaken by the public sector. While the public research system comprises over 1,600 research institutes, there are no more than a handful of private agricultural research institutes. Investment in R&D also is mostly from the public sector; less than 2% of research expenditures are by the private sector. In contrast, the role of the private sector is rising in many other nations. China's already over-burdened public sector is taking on tasks that are privately funded elsewhere in the world. The presence of the government often suppresses private sector activity.
•  Need for bold reforms: Although China has been trying to reform its agricultural research and extension system, the results of reforms have been mixed. Few of the reforms have reached the goals of creating a modern and efficient agricultural technology sector. In the same way that the bold reforms in other parts of the research system outside of agriculture were executed and succeeded (e.g., those in CAS), wide reaching commercialization of selected institutes and the concentration of greater levels of funding on the best research teams are needed in agriculture. These changes will not be easy; and will not be painless. China must have them to modernize its R&D system.

　　Financing:　　

　　

•  More funding; improved R&D climate: While there has been increasing investment in agricultural research since the late 1990s, China's investment in agricultural research is still low. Insufficient budgets are severely limiting the effectiveness of the agricultural research and extension system and reducing the incentives of the staffs.
•  More funding; higher quality research staff. Insufficient funding is limiting the ability of China's agricultural research and extension system to attract quality staff. In today's world, the system must be able to compete for the best and most creative minds.

　　Policy Recommendations

　　Deepening agricultural research and extension reforms 　　

　　

•  China's leaders should take decisive steps to further its reforms in agricultural R&D. High levels of future funding should be promised to those institutes and academies that take bold moves to upgrade their research capacity and eliminate marginal research staff.
•  China may consider establishing a new series of Regional Agricultural Academies of Sciences by merging several Provincial Agricultural Academies of Sciences that are in the same eco-region. A similar approach can be applied to the merger of prefectural agricultural research institutes into larger ones. National level academies and institutes should be strengthened and there should be clear divisions of responsibilities between them and regional institutes. The national government must take far greater responsibility for funding and coordinating research at the new academies since coordination and joint-funding arrangements are difficult to arrange. Regional research projects funded by the central government, as is done in the US and Canada, are also needed.
•  China needs to completely reform its agricultural extension system. It may even be worth creating an entirely new public extension system; the current system is so weak and ineffectual that reform may be impractical. The reformed system should draw no more than 20 to 30 percent of the most qualified extension technicians from the current system. New personnel with more training are needed. The new staff needs to be well-supported with adequate salaries and program funds. They should not be allowed to engage in commercial activities. Ongoing training needs to be systematized.
•  Modern and effective institutional arrangements should be established in the new agricultural research and extension system. For example, extension programs that are put out for competitive bid may help better match skills to extension needs. Competitive grants in the research program will improve incentives and guide the direction of research. However, not all funding can be by project. Basic salaries and program costs must be met from government budgets.

　　Create better environments for a better relationship between public and private sectors　　

　　

•  China needs to clearly delineate the roles to be played by the public and private sectors in agricultural research and extension. Public research and extension should concentrate on the provision of public goods; other activities should be spun off to the private sector. New and effective institutions are needed to facilitate public-private partnerships. For example, private seed companies should be encouraged.
•  To increase the financing and effectiveness of applied research and extension, the government might consider industry groups such as agricultural industry groups in Australia or the agricultural commodity organizations in the US and Canada. These organizations tax those who could benefit from research – for example the beef industry – and in return the industry has a say in what research and extension are financed.
•  The reforms also should recognize that not all agricultural research institutes and technologies can be commercialized. Research institutes should not be encouraged to go into business. Commercial businesses require competitive and efficient institutional and management systems. Rules and institutions that encourage public institutes to license and sell their technological products to the private sector are needed.

　　Substantially increase its investment in agricultural research and extension　　

　　

•  China needs to substantially increase its investment in agricultural research and extension. Commercializing part of its current agricultural research and extension systems does not imply a reduction in the government's role in financing agricultural research and extension. Agricultural research driven by commercial interests would naturally be directed towards the most commercially viable products and technologies. Once the market-driven research system starts to fund and execute research of certain commercial commodities and activities, the public research system can focus on activities that will lead to poverty reduction and environmental sustainability.
•  The current needs for agricultural research and extension indicate that public funding from the central government should be the primary source of agricultural research and extension in the decade ahead, with continuing aid from provincial and prefecture governments. Difficulties in implementing and enforcing a strong IPR system also imply the importance of the government's continuing support for agricultural research and extension.
•  We recommend that public agricultural research investment should be increased from the current level of less than 0.3% to at least 1% of total agricultural GDP. Although China will still be far behind other countries, it is a goal that is attainable in the short term. Similar levels of public investment in agricultural extension are needed.
•  Remove restrictions on foreign investment in R&D in biotechnology and the seed industry.

　　Improving the Environment for Intellectual Property Rights Enforcement

　　• If the private sector is to play a larger role in conducting and financing agricultural research, intellectual property rights (IPRs) on inventions in the private sector must be strengthened. The main problem of IPRs in China has been enforcement of trademarks, patents, and plant variety protection rather than the laws themselves. The trademark, patent, and plant variety protection laws are similar to laws in developed and more advanced developing countries. One limitation of the laws is that some crops–such as cotton—are still not covered by plant variety protection.

　　• Reduce government subsidies to provincial, prefecture and county seed and input companies so that the subsidies support the provision of public goods.

　　• Ensure that regulations on technology quality, environmental safety, and food safety are science based and are enforced by officials that adequately paid by the government and do not earn money from the regulated industries. For example, seed quality regulations are handled by government seed stations that are also in the seed business.

　　Improving Water Management

　　• Implement several drastically needed policies:

　　o Raising water prices (although higher prices may need to be matched by increased investment);

　　o Promotion of new water saving technologies (ones that will lead to true water savings, such as, reduced-irrigation cultivation practices for wheat). Increases in investment in research and development on water saving technologies is needed; investments in new extension efforts and training also are needed.

　　o Reform management institutions in order to achieve cropping intensity levels and cropping patterns, as well as municipal and industrial use levels that will be sustainable.

　　• CCICED should consider formation of a new Task Force immediately to study this important public policy issue that threatens to limit productivity and economic development in north China and hamper efforts in poverty reduction and environmental sustainability.

　　POLICY BRIEF 7:Encouraging Land Security and Rental Markets for Cultivated Land

　　Secure property rights and well functioning land markets are considered important catalysts for economic growth, as they make investment worthwhile and facilitate transfers of land to the most efficient users. The efforts of the government over the past decade and the new Rural Land Contracting Law, where fully implemented, have solved most of China's land tenure security problems. Poor tenure security seems to have only minor effects on agricultural investment In a recent survey, only 6 of 1200 households in 60 agricultural villages across China reported that they had had a fixed investment taken away from them over the previous 20 years; in 4 of 6 cases, the household received compensation.

　　Security of Land Rights: Issues and Recommendations

　　Land security has benefits beyond promoting investments in agriculture thus it is important that central and sub-national governments continue to make a strong and sustained effort to implement and enforce the new regulations. Land can serve as a mechanism through which farm households can gain access to credit. For example, household access to credit significantly increased in Vietnam when the household received a formal title to its land, since the title was used as collateral to secure the bank loan. Income from renting out land also can add to family income when families are engaged in off farm activities or when they are older. Access to land by rural families has been shown to be a source of employment during times of recession in the city and serves as a form of unemployment insurance.

　　Although China has made progress in promoting land security, many villages still do not provide completely secure tenure. The new Contracting Law tries to promote secure access to land that should promote all of these functions. Surveys by the China National Statistical Bureau, however, has found numerous violations over the past two years and discovered that almost half of local leaders and most farmers do not fully understand the law.

　　Secure tenure also is needed to ensure that households are provided with appropriate compensation when their land is appropriated for development projects. Currently, one of the most egregious violations of the rights of rural households occurs when farmers have their land taken from them and receive only minimal levels of compensation. In the past 5 years, there were still about 25 percent of villages in which no compensation was paid for land that was taken away from them. On average, for those that did receive compensation, the average level of payment amounted to only 12,000 yuan per mu, only a fraction of the land's true value. In most cases the price paid to villagers was far below the value of the land. And, while the original land owner never gets its full value (in fact, internationally the developer usually gets the larger share), the share that has gone to villages in China is only a fraction of what is typical. And, when the share of the compensation that goes to villages is small, the share that goes to farmers is even less. While there are many reasons why this situation occurs (because it is not legal for villages to sell development rights directly to users; land must be sold to the government who resells the land to developers), the lack of clear ownership and land titling make compensation issues less clear.

　　Rental Markets for Cultivated Land

　　In addition to implementing the new contracting law to promote tenure security, additional effort is needed to promote well functioning land rental markets. In an economy with scarce land, off-farm employment is becoming the main source of future income for most farmers. The future of China's development will rely on the growth of off farm income and the movement of the rural population to urban areas. In order to achieve efficiency and equity, households with opportunities off the farm need to be able to rent their land out, and those that are left in the village need to be able to rent land in to be able to raise their incomes from farming. Increases in farming income for those left in rural areas are important for stability as well as for providing the resources that will let them invest in future generations that can continue to push China's modernization.

　　Over the past decade the record on rental markets for cultivated land is clear: while still not completely developed, their emergence is well under way. According to data from national surveys, cultivated land rental markets in China began to emerge in the late 1980s. At that time, however, only 1% of land was rented. By 1995, around 3% of cultivated land was rented. According to China's 2003 national household survey more than 10% percent of households nationwide rented in land. In some provinces, such as Zhejiang, up to 20% of the cultivated land is rented.

　　There are many indications that the growth of cultivated land markets is improving efficiency. Rental markets have been shown to shift land from those that have relatively large quantities of land to those with lower quantities. Across China, land rental occurs more frequently in regions that have high levels of migration. For example, while the average rental rate in China was 10 percent in 2000, it was 15% in China's central provinces (province with high migration rates), such as Hubei and Anhui. When examining household data, it is clear that migrant households are more inclined to rent land out, while households that have few or none of their members off the farm rent land in. Rental markets in China are increasingly moving land away from those who farm with less efficiency to those who are more efficient at farming.

　　Survey data indicate that land rental markets assist in poverty reduction. Households renting in have less than half the level of assets of those that rent out. The households that rent in also have lower endowments of land. And perhaps most importantly, the per capita income of those renting in is significantly lower than those that rent out.

　　Taken together, the importance of rental markets is evident. They promote efficiency. They promote equity. And, since they raise income of those engaged in agriculture, they will lead to higher output. Finally, because rental markets provide land to families in villages that have high rates of migration, they also contribute to poverty reduction.

　　Government Policy and Land

　　Despite the recent improvement in tenure security and the emergence of rental markets, policymakers still have an important role to play. In order to ensure even better security, the central government needs to make repeated efforts to publicize, through various channels, the salient clauses that affect farmer rights. Strong directives through both the government and party hierarchy need to convey the importance of the Rural Contracting Law.

　　New regulations also are needed to protect the rights of farmers when their land is being bought for development. For example, clear property rights and regulations that allow land sales transactions directly between developers/city users and villagers are needed to protect the interests of villagers. Titling will also help.

　　Although rental transactions should occur between households that are seeking to improve their welfare, there is an important role for government in promoting the mobility of land among users. The experience in other countries indicates that formal land registration can lead to increased rental market activity and lay a foundation for banks to begin to use land for collateral for loans. In general, registration gives additional protection to farmers by improving transparency in land transactions. Moreover, if it is administered at a high enough level, farmers across large regions can be provided uniform certificates of registration that will broaden the market and make registration more valuable. For these reasons, a provincial level pilot for Land Use Rights Registration is suggested. It has been shown in other countries that land registration is one of the most productive and useful loan/grant packages (in terms of its impact on raising the productivity of the agricultural economy). It can be done with a minimum burden to the government. Land registration loans are largely self-financing, since registration fees paid by farmers are usually sufficient to pay back the entire amount of the loan. Land titling, however, can only succeed if the land titles are given the utmost authority in a legal sense (that is, the titles give the holder complete control rights over the land).

　　POLICY BRIEF 8: Expanding Finance Options for Rural Development

　　The Place of Finance in Rural Development

　　Availability of credit facilitates development; it is not a determinant of development. Development is an outcome of entrepreneurs, in business and in farming, who exploit opportunities to employ new resources, combine resources with emerging technology to produce new products, or combine resources to build new markets for existing or new goods and services. To make these changes entrepreneurs in business and farming require access to sources of finance. The availability of credit can facilitate such entrepreneurial initiatives.

　　A defining characteristic of successful development is a transition from a rural, agriculture-based economy to a more urban, industry-based economy. The development of labor markets and access to off-farm jobs are means to achieving this transition. Therefore, addressing credit constraints to agricultural development needs to include finance for the creation of off-farm employment in villages and towns as well as finance for on-farm activities. When families move from the countryside to the city, they also need access to financial resources to do so. Given China's enormous challenge of creating hundreds of millions of jobs over the coming years, China is in need of developing a solid rural financial system.

　　For farm households it also is important to recognize immediate, short-term credit needs may well arise from family emergencies or spending expected for important life-cycle events – birth, marriage and death – within a family. In typical small-farm households there often exists a need for credit to meet both the family's consumption and production needs. It is credit sought under the latter that will lead to productive investments with some probability of success. Income transfers obtained from kin, especially to address "surviving economy" needs, are typically not seen as credit, but they are important. In many successful developing countries, there are many sources of rural finance, some formal and others informal.

　　Likewise, the rural financial system also plays in important role in providing rural households a safe place to make deposits. In many rural settings, and for many households even in prosperous areas, there are not necessarily always good projects with high returns. In such cases, farmers value access to a rural credit system that will allow them to invest some of their funds safely at a positive interest rate. A good rural financial system will intermediate such funds from those that have funds but no projects to those with projects that are in need of funds.

　　Limitations of the Current Rural Financial System

　　In China there are three formal rural credit sources: Rural Credit Cooperatives (RCC's), Agricultural Bank of China (ABC), and the Agricultural Development Bank of China (ADBC). As of 2001, loans extended in China were 11,200 billion yuan, of which agricultural loans accounted for 570 billion, or 5%. Loans to township and village enterprises (TVEs) were 640 billion yuan, an additional 6%. Even if loans by ADBC for the procurement of agricultural products are added, the support for agriculture and rural industrial development accounts for only 17% of loans nationwide.

　　The role of ABC in rural finance is declining. Prior to the mid-1980s, 98% of its loan portfolio was located in the countryside. From the mid-1980s to the early 1990s it adjusted the structure of credit, using 60% of its "agricultural" credit to support the purchase of agricultural by products and to develop TVE's. After the mid-1990s, as progress in commercialization reform of the ABC quickened, the allocation of its financial resources was no longer limited to agriculture and the countryside as its support for rural power grids, transport and communications was strengthened. After the 1990s, its institutional network gradually withdrew from the countryside, the rate of growth of agricultural loans eased, the ratio of take up began to fall and business was sought increasingly in cities and with industry. Currently, agricultural loans account for only 10% of ABC's loan portfolio. Research shows that one of the main problems faced by ABC management in making loans in rural areas is loans that are small and interest rates are regulated heavily. Furthermore, many policy measures also make it difficult for rural customers to come up with collateral for loans.

　　With this substantial cut back by ABC in rural finance, the RCC's have become the main source for agricultural loans. Although RCC's are formal financial institutions that directly cover a vast area of the countryside with an extensive network, their provision of loans to small-farm households is limited. Only 25% nationwide have obtained a RCC loan. Further, the proportion of RCC loans for agriculture has declined from 46% in 1990 to 34% in 2000—although in recent years new government programs have increased the flow of funds to rural areas. As major commercial banks, one by one, withdraw from the countryside, dependence solely on the strength of credit available from the RCC's will by no means be adequate to resolve difficulties in obtaining loans by farmers and small-business entrepreneurs in towns and villages. An additional concern is the high proportion of bad debts (estimated at 37%) held by Chinese rural financial institutions. As they lack an equivalent capital base to cover these bad debts, their commercial viability is not assured.

　　Informal credit is widespread in rural areas. The main channel through which farm households borrow is private loans. It is estimated that between 50 and 60% of farm households have obtained informal loans accounting for at least 70% of total funds borrowed. This is commensurate with TVE's that seek high interest financing through popular channels. The existence of informal credit also suggests several other facts about the nature of the rural financial system. First, there is unmet demand by the formal credit system. Second, although being unregulated may enhance access to credit in some cases, if it is possible to allow for informal lenders to become more formal without impeding their ability to lend (or if it is possible to allow the entry of more formal lenders that will service the part of the economy being serviced by the informal sector), the overall rural financial system might be strengthened.

　　It is fair to say that, even though for more than a decade reformers have tried to reform the banking sector in rural China, the nation still faces most of the common problems faced by other developing countries. The rural economy faces poor financial intermediation. There are large flows of funds out of the region. Recent studies show China extracted a total value of about 1,289 billion yuan (in 2000 prices) of capital from the agricultural sector for use in the nation's industrialization between 1980 and 2000. Nearly twice as much, about 2,297 billion yuan, flowed from the rural sector to the urban economy during the same period.

　　Remaining Constraints and Enabling Factors

　　In 1998 the National People's Congress identified financial system reform, including decentralization and commercialization, as one of five priorities. This process is now well underway, although the reach to rural areas, especially in western China, is still limited. Current initiatives include decentralizing RCC's to the provincial level. In addition, the People's Bank of China initiated a program in 2001 to encourage RCC's to develop micro-finance options. There is some evidence of pay-off from this initiative in that RCC loans to small farm households more than doubled during 2002.

　　Another encouraging development is experiments with both unofficial and informal approaches to credit delivery. With administrative supervision from the Ministry of Agriculture, Rural Cooperative Funds have emerged at the township level. As they cannot accept deposits, they facilitate borrowing, by farmers and TVE's, drawing on funds obtained from share capital. Local governments, non-governmental organizations and a number of international donors also are experimenting with various approaches to micro-finance.

　　Nonetheless, significant barriers to financial market reform remain in rural areas:

　　• Interest rates remain regulated, which rations credit and limits access of small borrowers and depositors. Given high administrative costs of maintaining a large portfolio of small loans, the band of interest rates allowed by the People's Bank of China is still too low to permit earnings that provide competitive returns on a rural lending institution's assets and equity. Hence commercial sustainability remains problematic. The regulated interest rates also distort resource allocation, inviting misallocation and rent-seeking, and they reduce incentives to hold savings in a financial form as real interest rates are negative in years where significant inflation occurs. The impact has been limited expansion of financial services to meet demand from emerging entrepreneurs in small businesses and farms.

　　• With limited opportunities to deposit savings in many rural areas, households primarily hold their wealth – an estimated 83% – outside of the banking system. Savings are held in the form of housing, cash, grain, and fixed assets. For pastoralists it is livestock. They view their herds of animals as their "bank." The animals are a form of saving that can be liquidated into cash when needed. They also represent various forms of insurance to meet emergency needs for cash in times of illness, accident, unemployment or death. While rural households will always keep some of their wealth in these real assets even though many are unproductive (e.g., holding grain stocks that exceed one year's consumption), from a national development point of view, there is scope for increasing savings rates.

　　• Subsidized credit has been used extensively as an approach to poverty reduction. As this micro-credit is offered with the intent that the poor households will graduate to an income level where they will be served by existing financial institutions, the programs make no attempt to build institutions and sustainable micro-finance programs. As a result, alternative approaches to delivering rural finance, based on market interest rates, have difficulty competing with this welfare delivery program. The net effect is stunted development of financial services in rural areas, especially in poverty-designated counties.

　　• Formal lending practices typically are based on collateral. Farmers find it difficult to meet these collateral conditions as they do not own their land and markets for land use rights are only beginning to emerge. In Vietnam land use rights titles are used to secure loans; after titling lending to farmers increased sharply. Alternative lending practices need to be considered: informal appraisal of borrowers and investments, access to repeat and larger loans based on repayment performance, and collateral substitutes such as group liability, compulsory savings or some form of guarantee.

　　While all of the above problems pose a challenge to reformers, many observers believe that by far the biggest problems in the rural financial system are in the ownership and lack of competition in the sector. Until managers, boards of directors or other actors are directly responsible for (and are rewarded by) the growth in bank assets, lending will always be more political than economic. Today no one is interested in building healthy portfolios because there is little incentive to do so. Frequently, rules are set up so rigidly that entrepreneurship and creative credit policies are dampened. In addition, without free entry of banks, competition is lacking. Research by China's economists has demonstrated in almost every case where there is competition, the quality of the portfolio and the profitability of the lender rises.

　　Policy Options for Reforming the Existing Financial System

　　Rural financial reforms have not kept pace with growing demands for banking services to facilitate a continued economic transition in rural areas. A fundamental resolution of current outstanding problems of Chinese rural finance cannot be confined to minor repairs and adjustments to the current rural financial system. It is necessary to have the system as a whole in mind and again perform functional reorientation and adjustment of the ABC, the ADBC and the RCC's with an aim of establishing a more complete, vigorous rural financial system.

　　Reforming RCCs

　　First, a solution should be found to common problems in RCC's: unclear proprietary rights, incomplete legal person administration, comparatively low levels of management, and a lack of effective inspirational mechanisms and control of insiders.

　　Current demands put forward by central government in a call for reform of the RCC's include: property right relationships should be clear, the mechanisms of restraint should be reinforced, service functions should be strengthened, there should be appropriate state support and that local governments should be responsible. As a result of the differences between places throughout the country, it would obviously be inappropriate to compel RCC's to reform in line with a centralized model.

　　There are two schools of thought about this reform. One option is to reorganize each RCC branch into a joint-stock company. If business is reasonably good in developed areas it is appropriate to commercialize the running of credit unions in this manner. This structure localizes proprietary rights with autonomous, independent management as its basis. No specialized legislation is required as joint-stock companies form part of the national banking legislation. Existing regulations and laws relevant for joint-stock companies would apply and would govern management and operation of such financial institutions.

　　The second option is to reorganize RCC's with a stratified setup. Drawing lessons from the successful experience with the development of cooperative banking abroad, branches of the RCC can be changed into truly cooperative financial organizations. These cooperative banks would be owned by residents of a community who choose to become members. The intent is a non-profit association that operates as a commercial enterprise without interference from local government officials. Alternatively, current RCC branches within a province can be changed into a grass roots network of the ADBC with policy related loans as their main business. This variation of the second option is mainly suitable for areas where the level of economic development is rather low, with residents who lack the necessary knowledge and skills of risk management and other financial operations.

　　Whichever type of organizational form is adopted, it is necessary that problems of unclear proprietary rights and poor legal person administration be resolved. Only in this way can there be a solution to the problem of governments carrying final, overall responsibility for the bad debts of RCC's.

　　In other words, although the long term solutions are complex and must be done gradually, there is still scope for beginning by focusing on more immediate, less comprehensive reforms. We believe China can and should begin to experiment with issues of how to raise the short run supply of credit locally in order to attempt to increase farmer incomes and promote production activities and that this may help gain experience in solving some of the longer term problems (such as the property rights of banks, the emergence of small and medium private banks, managerial and governance reforms of the state-owned commercial banks.

　　In conducting experiments, we believe China may want to take a regional approach. Because the demand for credit varies among regions, and because the institutional capacity of the banking system is so different in each part of the country, banking officials should be able to conduct experiments in coastal, central and western areas. The most important reforms invariably will happen in the coastal areas, since China's drive to establish a modern banking system must start in the most advanced areas. The overall goals should be to abolish policy constraints and foster competitive rural financial markets. In the near future, private banks should be allowed to emerge in some areas and their effect on the financial system should be assessed carefully.

　　More Flexibility with Interest Rates

　　A second issue that needs to be addressed is the problem of interest rate controls. The negative effects brought about by these controls are not only a distortion to the price of using funds and irrationality in the allocation of financial resources, the level of earnings by commercialized financial institutions in the rural financial market also is affected. Strict enforcement of official interest rate restrictions will prevent the development of micro-finance programs as well as the RCC system. The floating of interest rates on a large scale should be realized on the basis of market demand, with interest rate controls gradually relaxed so that the demand for commercialized financial institutions to carry on financial activities in the rural financial market can be met.

　　Because financial markets are so inter-linked it is not going to be possible to liberalize deposit rates until deposits in the whole system are liberalized, but in the future, this also should be the goal. In other Asian countries, raising deposit rates induced massive savings and helped the poor more than did the extension of new loans.

　　Improving Supervision

　　A third issue is the lack of an effective supervisory framework. Successful operation of all financial institutions requires public confidence. An environment that builds public confidence includes: a.) well-defined laws and procedures that govern the accounting, auditing and reporting requirements for all financial institutions; and b.) a stable, growing economy that enables small entrepreneurs to undertake new ventures and to sustain over time profits required for loan repayment and the provision of local employment while producing the goods and services in demand in the community. To create such an environment there is a need to establish an effective supervisory framework that will enhance ideas about supervision, improve supervisory technology and raise the quality and efficiency of supervision. This framework will include means to inspect and to enforce relevant regulations and laws.

　　Expanding Rural Financial Options

　　One of the most effective strategies used by reformers in their management of China's transition to market socialism is a focus on competition within the market. This addresses the problems associated with state-owned-enterprise through growth of a non-state sector, reducing the role of the former and assuring competition within the market.

　　Extending this approach to a market transition to rural finance calls for a policy shift that allows locally-owned alternatives to emerge as competition for a reorganized RCC, ADB and ADBC system. Competition will extend the reach of these existing financial institutions and will spawn innovation in the delivery of financial services.

　　There are many options. RCCs can be privatized and allowed to set up branches in other counties. Private banks can be allowed to emerge. Foreign banks should be encouraged to participate in rural areas.

　　In addition, a Rural Savings and Credit Association, patterned somewhat on credit unions in other countries also is recommended as a model. This model can provide a legal basis for the unofficial and informal credit institutions and programs evident in rural China. A starting point for a Rural Savings and Credit Association will be either an existing affinity group or the creation of affinity groups to meet the condition of offering financial services to members only. In most cases, the organization would be based locally and would be focused on servicing the needs of those within the community. Ideally each affinity group would constitute a local informal network that can facilitate assessment of the suitability of clients who have applied for loans.

　　As low-income households typically cannot offer full collateral, knowledge of the client serves as the basis for initiating a ladder approach to developing a credit history – initial small, short-term loans for consumption, moving up to larger loans for investment purposes. Co-insurance of loans may be considered in the form of group lending, which draws in members of an extended family. A Rural Savings and Credit Association option will require regulatory and legal changes that will enable micro-finance programs to operate on a financially sustainable basis. To make such changes the China Banking Regulatory Commission will need to clarify definitions of property right relationships and, where necessary, advance legislative changes to assure transparency and accountability required for the development of sound savings-credit institutions. If successful, this would likely displace part of the informal sector and would allow for more regulation and control over this part of the rural financial system.

　　Encouraging Micro-Finance

　　In the final analysis, even if the rural financial reforms were successful and a more functional, wider-ranging rural financial system were operating, in an economy such as China's there will still be those that will not be serviced by the more liberalized sector. In most cases, the excluded will include the poor, those that belong to minority groups and those that live in deep and isolated regions of China. These peoples, despite their poverty and remoteness, have demand for credit and deposit services. To serve these needs, we strongly urge that China continues to allow experimentation with micro-credit programs. International and domestic groups should be encouraged to set up peer-monitoring and other innovative programs that target the poor. Local government micro-credit schemes have been less successful and though their efforts should be encouraged, recognition of the role of non-government organizations should be made and efforts made to reduce regulation and interference of them by local governments and financial organizations.

　　Part III. A New Framework of Nation's Grain (Food) Security

　　POLICY BRIEF 9: Food Security Successes and Defining a New Approach

　　We recognize the importance of food security in China's development strategy. But, we also know its cost. We believe that, if China redefines its national food security goal and shifts its focus to household food security for the poor, the nation's development targets and poverty reduction objectives can be met without compromising the nation's food security.

　　China is one of the most food secure developing countries in the world, a status achieved through many decades of hard work. China's success in increasing food and fiber supply in the past 50 years to satisfy its growing population has been well recognized. From a nation that could not meet minimal nutrition needs of its population in the early 1950s, per capita food availability reached 3040 kcal per day in 2000, a level that is14% higher than the average of developing countries and 8% higher than the world average. Since the early 1980s, China has shifted from being a net food importer to a major net exporter to world markets. China has a foreign exchange reserve ranked second in the world that could assure food purchasing power if the nation were to experience short term grain shortages. The improvement in food security in terms of national aggregate supply and household living standards creates a healthy social and political environment and lays a sound foundation for economic development.

　　Despite the record of recent years, as in previous episodes of price increases (e.g., 1988/89 and 1994/95), there has been a resurgence of concern about China's grain security by national leaders after prices rose between late 2003 and the first six months of 2004. In response, the government launched several policies to promote grain production. For example, a 10 billion yuan direct subsidization program was implemented in 2004 that is supposed to distribute cash payments to farmers in areas that are major grain producers. Leaders are planning to expand this subsidy program. Perceiving part of the problem to be a fall in cultivated land area, leaders imposed strict controls on the conversion of cultivated land to non-agricultural uses. The nation's Grain for Green program, one of the largest land set aside programs in the developing world, also was drastically scaled down.

　　The actions taken by the government in 2004 raises several critical questions. Is China's food and grain supply security a serious problem? What will the situation likely be in the future? What priority commodities should be covered by food security plan? Should China shift its focus from aggregate supply of food security to household food accessibility? What is the impact of the conversion of land to industrial and infrastructure use? Has China's Grain for Green program contributed to the recent price rises? Can China rely on long-term productivity growth for grain security?

　　Food and Grain Security

　　Because of the tremendous progress that China has made toward ensuring its national food security over the past five decades the Task Force suggests that there are currently no serious threats to national food and grain security in China. In 2003 both exports and net exports (export less import) of food and grain reached historic highs. Since the mid-1990s, China's grain production and grain stocks were so high that they led to more than 5 years of falling grain prices. As a natural consequence of the laws of supply and demand, production gradually fell during this time. By early 2003, the excess supplies of grain in storage (in government stocks and in household reserves) that had hung over China's grain markets for the previous several years gradually disappeared and grain price began to stabilize. The increase in grain prices at the end of 2003 and throughout the early months of 2004 should be viewed as a normal and expected market reaction resulting from many years of low prices. All modern, market-oriented agricultural economies operate this way.

　　The rising grain prices in late 2003, far from signaling a problem in the grain sector, should be interpreted as a return to a normal market environment and provide leaders with an opportunity to meet other policy objectives. China's grain prices in May 2004, when measured in real terms, were about the same as average grain prices during the mid 1980s and early 1990s and lower than those in the late 1980s and the mid 1990s. The increases in grain prices should be welcomed and should be seen as a victory for China's policies that were seeking to raise incomes. High grain prices also are a solution to high grain prices. When China's farmers have faced high grain prices in the past, they have responded. High prices provide farmers with incentives to produce. In fact, they have already led to significantly higher production of wheat and early rice in 2004. Many believe that grain production in 2004-2005 will rise. Hence, high prices play a role in national food security. Finally, grain price increases provide a good opportunity for deepening grain market reform.

　　While China appears to have attained a high degree of food security in terms of national aggregate supply, there are still households that do not always have access to enough food. It is closely related to China's remaining poverty problem. Despite the rapid reduction of poverty in China over the past two decades, there are still more than 100 million people in both rural and urban below the international poverty line ($1/day in purchase power parity terms). It is known that, many poor households occasionally suffer from hunger or malnutrition. However, the reason for this is not that there is not enough food being produced throughout China. It also is not because there is not enough food available. The major problem for such households is that they often suffer from lack of entitlement (that is, such households do not have access to enough income to purchase the food that is available on the market). Hence, while there has been significant decline in the number of people under poverty and poverty reduction efforts will continue to make progress, for the foreseeable future, China will still be home to many poor people and this poses the greatest threat to food security.

　　The poor quality of China's food and potential food safety problems pose another possible set of food security concerns. According to some estimates, nearly 25% of cultivated land is contaminated to varying degrees by the over-use of inorganic fertilizers and pesticides. Soil and water scientists have found that fertilizer residues especially (in the form of nitrates) have been increasing in the soils and water sources in certain areas. Although it is unclear how such figures are generated, it has been reported that about 10% of China's grain, more than 20% of livestock products and nearly half of the nation's vegetable and fruit production suffer from quality problems. Excess fertilizer and pesticide use also is a wasted cost. Perhaps more worrisome, given the rapid increases in livestock production, is the high incidence of animal diseases and pests and the serious problem of animal wastes. Such problems are not solved by trade policies or by trying to force farmers to produce more (in fact, such policies often lead to poor food quality and food safety problems), but rather are addressed by increased investment in agricultural research, extension and rural education.

　　Although some aspects of the nation's grain reserve management system have been improved during the past several years (e.g., the separation of commercial trading from storage operations), it is still one of the weakest and least understood parts of China's food security program. In many ways, despite the reforms, the grain reserve system is dysfunctional. The rules for management and release are unclear. When should grain be sold? How much? At what price should grain be sold? At what price should grain be purchased? It has been estimated that China is wasting millions of dollars and prices are not being stabilized. There also is confusion among the different holders of grain. What is the role of the provincial and local grain reserves? How can provincial authorities coordinate their actions with the national government's grain reserves? The lack of transparency creates chaos in grain markets and contributes to variability in grain prices. Since no one knows the level of stocks or the quantities of planned (or actual) release, domestic producers and traders and international trading agencies can not make decisions based on full information. Indeed, the national grain reserve system is directly responsible for the absence of any grain storage by the private sector. Private trading companies and commercialized state grain corporations can not hold stocks since they would be at the mercy of unpredictable administrative decrees. In short, China's grain system operates in a way that is not transparent, is not accountable, and is at odds with the nation's market system. No other country runs its grain reserve like China. In fact, economists have shown that in the 1990s China's grain management system has made China's prices fluctuate more than in the past and more than the world market.

　　The most important reason to reform China's grain system and food security, however, lays in the productivity of its agricultural sector. Research by China's own economists has shown that in the future, even if the nation completely liberalized all trade (which is beyond its current trade commitments under the WTO), most important agricultural products would continue to be produced at or near self-sufficiency levels. If China increases its investment in agricultural research, extension, irrigation and better manages its land and water resources, cereals self-sufficiency will remain above 90%. Importantly, if leaders aggressively invest today, by 2020 rice and wheat—the nation's major food grains—will still be almost fully produced in China. We project that China will continue to export rice to East Asian countries with self-sufficiency rates reaching 104 to 108%. Wheat will remain at 93 to 98% levels of self sufficiency. Although the nation would become a net importer of feed grains, soybeans, edible oils and sugar (which would promote trade relations with many important trading partners), by 2020, the export of vegetables, fruits, livestock and aquatic products will make China an even more important net exporter of food.

　　In short, even under a completely free trade regime, China would not have a food security problem. This is because at a national level the overall extent of climatic variation across the landscape (and thus variation in grain production) in China is lower than almost all countries in the world. Importing 10% of grain for feed is feasible for China and should not be considered as a threat to national food and grain security. Ten percent of China's grain demand is equivalent to only 2% of the world's total production and less than 10% of world grain trade. This level of imports will not have a great impact on national grain security. The main way China can protect its food and grain security is to invest in agricultural technology and water management and promote poverty reduction programs that will raise the income of China's poor.

　　Food Security and Changes in Cultivated Land

　　The Task Force also believes that the concerns of the government over the conversion of cultivated land to industry, urban building projects and forests are unwarranted. Unlike the current policy debate—which is not based on reliable data—Task Force Brief 10 provides recommendations using a new and powerful set of data. In short, we find that the impact, of all conversion of land since the mid 1980s through today, on grain prices is very small and plays almost no role in the recent rise of prices. Research by the Center for Chinese Agricultural Policy also shows that Grain for Green has not affected food security and is not an important cause of recent price increases. Slowing down the growth of the non agricultural sector and stopping China's land set aside program to pursue a policy of restricting the conversion of land to other uses does nothing but hurt China's modernization and enviromental goals while having little impact on food security. See Task Force Brief 10 for details.

　　Policy Recommendations

　　The Task Force's major policy recommendations on food security are: 　　

　　

•  Shift in emphasis from grain security to food grain security

　　In order to maintain the spirit of China's food and grain security policies without imposing excessively costly and ineffective restrictions, the national government should redefine its food security goals in terms of rice and wheat.　　

　　

•  Shift in emphasis from aggregate national food supply to household food accessibility

　　High priority should be given to poverty reduction efforts that will seek to raise the average incomes of the poor and protect them against negative income shocks. 　　

　　

•  Emphasizing long term productivity growth instead of short term subsidy program

　　China's food grain security will rely mostly on raising long-run productivity. Subsidy programs such as the "Grain direct subsidy program" that was implemented in early 2004 will be very costly, will not be appreciated by households in the long run, will reduce the government's fiscal resources for public services, and have much less effect on national grain security than investment in R&D, extension, education, health, irrigation and other rural infrastructure. China should not follow other countries and should build a productive, undistorted agriculture that raises the income levels of its producers and provides the nation with a high degree of food security. 　　

　　

•  Balancing land uses between agriculture and non-agriculture

　　Efforts are needed to ensure that land use policies do not impede the ability to continue fast industrial growth. Employment, income and productivity growth are all associated with the conversion of land from low-productivity agriculture to high productivity industry and services. Good land use planning is needed. However, land use policies should not be homogeneous nationwide and priority should be given to fast growing industrializing regions. Grain for Green should not be slowed for food security reasons. See Task Force Brief 10 for more details.　　

　　

•  Changing national grain reserve management practices

　　Leaders need to undertake grain market reform and change the management practices of the grain reserve system. Rules for storage, purchases and sales of grain reserves need to be clear. No nation that wants to run a modern and efficient agricultural economy can keep its stocks secret nor have an opaque reserve system. 　　

　　

•  Improving China's food quality regulation and monitoring system

　　To ensure food quality and safety, international standards should be consulted to modify China's Food Sanitation Law or set up new regulations. Many countries are willing to share information on their food safety and quality assurance programs.

　　POLICY BRIEF 10: Cultivated Land Protection

　　Assessing China's Cultivated Land Issues

　　Land is a critical input that is needed to keep the development process moving, allowing for the rapid shift of people in an orderly way from rural to urban. However, it is possible that as cultivated land is converted to built-up area it will conflict with national food security goals. While little was heard about this conflict in the late 1990s through late 2003, as grain prices rose through the early part of 2004, policy makers and scholars began to debate the role of cultivated land conversions and the rise in prices. On the one hand, local leaders and developers in many parts of coastal China and in suburban areas around inland cities are in the middle of a period in which they have already committed large amounts of capital to development zones, factories and housing projects and stress the need for access to land so their plans can be fulfilled. Tens of millions of jobs in construction in the short run and hundreds of millions of jobs in the longer run depend on completing these projects and continuing on with more in the future. On the other hand, others have labeled the conversion as an irreversible destruction of cultivated land that will hurt national food security.

　　Major Issues in Land Protection and Acquisition

　　Many issues have emerged regarding conversion of cultivated land to non farm uses:

　　• The major issue is the perception that China is losing farm land at an alarming rate. The concern is that the reduction in land is reducing grain output, raising prices and weakening the nation's commitment to national food security. In recent years, estimates that China has lost more than more than 5 million hectares have been used to show that reduction of cultivated area is a major problem.

　　• Although there are many relevant policies and regulations, it is often said that the major problem in land protection is their weak enforcement. Regulations specify that only provincial governments and central government have the authority to approve cultivated land acquisition. For acquisition of basic cultivated land, the only jurisdiction is that of the State Council. Despite such clear regulations, however, it is known that large areas of cultivated land have been acquired without authorization.

　　• It is also said that land acquisition has resulted in large numbers of landless and unemployed farmers. According to the Ministry of Land Resources, during the period of 1987-2001 about 55 million farmers have lost their land base. Observers worry that this could lead to social instability.

　　• One of the most pervasive problems, even in times when formal approval has been given, is that compensation to farmers is very low. On average, compensation amounts to only 5% to 10% of the land value. Farmers often do not know the details of the transaction and, even when they are given fair payment, believe that they were not treated fairly. The main benefits from the conversion of cultivated land into non-farm use accrue to local officials, local government coffers and land developers.

　　A number of factors contribute to rampant land acquisition:

　　• First and foremost, observers believe that unclear definition of land ownership is one of the most fundamental reasons for these problems. China's Land Management Law, rural land states that land is "collectively owned." Land is untitled. Distribution has historically been controlled by village leaders with support from township officials. Such vague definitions lead to confusion when land transactions are being made.

　　• There is no clear land use planning procedure. In almost no part of China is there any formal differentiation between land for public use, land for business use and land for agriculture. To add to the confusion, the Constitution and the Land Management Law state that to meet the need of the public interest the state may acquire land. Other regulations state that users of land cannot negotiate directly with the owners of the land; the government purchases the land from the collective and sells it to the final users. This procedure occurs even when the acquisition is for development. According to a 16 province survey, nearly half of the acquired land has been used for housing and business activities. Only 10% of acquired land is for public goods.

　　• Given China's ownership structure and the role that the government plays as middleman in most transactions, it is not surprising that land acquisition almost always proceeds without consulting farmers. Arbitration procedures and appeals in disputed cases are not very well defined and are biased in favor of the government. When assessing the incentives for converting land, it quickly becomes evident that local governments have strong incentives to acquire land for many reasons. There are almost always budgetary gains associated with the land acquisition process. According to research, the budgetary gains from the process of land acquisition can account for 35 to 60% of government revenues.

　　• In response to these emerging issues, the government—both in the past and in more recent years—has developed a number of measures to address land management issues. There has been a shift in land policy to emphasize cultivated land protection, central control over cultivated land and other measures. In general, both laws and regulations on land management have become clearer and stricter.

　　Analysis: What are the problems? What are not problems?

　　Changes in cultivated land; changes in agricultural potential

　　The Task Force believes that, at least until 2000, well-founded research can show that the food security concerns of the government over the conversion of cultivated land to industry, urban building projects and forests are misplaced. Based on Landsat digital images covering China's territory from the mid 1980s to 1999/2000, and more recent data from the Ministry of Land and Resources, scientists for CAS have explored the changes in total cultivated land and its productivity, and their likely impacts on grain production. The basic findings are:

　　• Between 1986 and 2000, although the cultivated land converted to other uses totaled 3.06 million hectares, new cultivated land created from other uses was 5.71 million hectares. Therefore, rather than suffering a decline in cultivated areas, China actually recorded a net increase in cultivated land of 2.65 million hectares.

　　• Although it is true that the quality of land that has moved out of cultivation is generally of higher quality than newly opened cultivated land, according to careful, GIS based research, the total net decline in bioproductivity is less than 0.5%. Hence, China's overall production potential (increased cultivated areas—2% minus decreased quality—0.5%) still rose by almost 1.5% between 1985 and 2000.

　　• Landsat-based analysis also shows that most of the change is occurring in the coastal areas and around cities—exactly in the places where the conversion should be occurring. In other words, there is no evidence of excessive waste, such as turning vast tracts of wheat or rice land in central provinces into empty development zones.

　　• Less is known about changes in more recent years. The Landsat-based data end in 2000. According to statistics from the Ministry of Land Resources, cultivated land loss has accelerated in recent years. However, if these data are accurate, then, while true, it is important to understand that the nature of recent land conversions is different than in the past. The main reason for grain area declines due to conversion of cultivated land in recent years is the nation's Grain for Green program launched in 1999. In 2003, about 80% of the total decrease in cultivated land was due to the land set-aside program. Between 1997 and 2003, there has been little change in rate of conversion of cultivated land into urban expansion or industry. Moreover, unlike the land being converted into urban area, Grain for Green land is, on average, extremely low quality. According to a State Forest Administration report, the average grain yields are only around 50 jin per mu.

　　• Compared to the rest of the world, China's protection of cultivated land is outstanding. International experience shows that rapid economic growth is often accompanied by a large shift of land from agriculture to industry, infrastructure and residential use. For example, in the 1990s Japan lost cultivated land at a rate of one percent per year. A similar trend is found in South Korea since the 1970s. The US is losing its agricultural land with a range of 0.1 to 0.3 percent per year to development and conservation set aside. Compared to the rest of the world, the fall in cultivated area (including Grain for Green) is only a fraction of other countries.

　　Impact on prices or imports

　　• Since there is a net increase in total cultivated area and only a marginal decrease in quality between 1985 and 2000, not only is there no negative impact of cultivated land conversion, food security increased because of the greater output potential. It also is important to note that the increase in employment from converting land to industrial uses is significant and real and will improve household food security for those rural residents that gain new employment and enjoy rising incomes.

　　• According to research conducted by the Center for Chinese Agricultural Policy, the price impact of Grain for Green was minimal. Of the 40 percent grain price increase that occurred between 2003 and 2004, less than 5 percentage points are due to the Grain for Green program. Research shows that the reason for the small drop is twofold: one, the initial net decline from the land set-aside is small since the yields on the retired cultivated land is so low; two, yields on the rest of farmer's cultivated land increases since they have more time available and can intensify their production on their remaining land.

　　• With virtually no price effects, the analysis shows that the impact on imports is even smaller, that is virtually zero.

　　Rights to Participate in the Land Acquisition Process and Right to Receive Fair Compensation

　　Although the Task Force believes that the trends in the shifts in cultivated land are not problematic, the process is problematic and often leads to disenfranchised farm households who have lost their land without the right to participate in the process and without the right to fair compensation. In recent years, there are very few cases where rural households end up being satisfied. Compensation is low or does not take place. The lack of transparency in the process, even when fair and justified, leaves people suspicious and unhappy. Conversion of cultivated land to non farm uses is inevitable but, the process that alienates the former owners of the land can/must be addressed.

　　Rational Land Use Plans

　　While the Task Force does not believe that too much land has been converted and that it is generally occurring where it should be expected, this is not to say that land use planning does not need to be improved. Currently, as in many rapidly developing nations, long term land planning is not well done. Resources are needed to ensure well-publicized parameters and principles that set and guide land acquisition and development of industrial, residential and other infrastructure needs. In addition, the World Bank has generated evidence that land pricing and conversion regulations create a bias that gives developers and local governments incentives to convert land in suburbs and ignore development opportunities inside the city limits. In China, as in other parts of the world, the cost to build inside the city versus the rural suburbs is often several times higher in terms of land and land preparation costs. Regulations and political voice of the residents and users inside the city limits often refocuses attention outside the city. Although such decisions often are consistent with short run cost minimization, when all costs and externalities are included, building in the rural suburbs can be much more expensive and undermine the living spaces within the cities.

　　Key Policy Implications

　　It is our recommendation that the fundamental principle underlying the policy is that cultivated land should be allowed to be converted into non farm uses. This is an inevitable part of development. Restricting it will slow down development. If China invests heavily in productivity-enhancing projects and agricultural research and development, cultivated land conversion will NOT be a threat to national food security.

　　However, this process needs to be carefully managed not just to ensure that the loss of irreplaceable good quality cultivated land is minimized but more importantly to ensure that the rural households that are dispossessed by the acquisition of their land are adequately compensated. To ensure a more orderly and equitable transfer of cultivated land to higher value uses and to protect the interests of the predominantly poor rural households adversely affected by this process, the Central government needs to: clarify land ownership rights and improve the legal recourse and protection available to all whose land rights are threatened.

　　Since Grain for Green has not contributed greatly to recent price rises and is not a threat to food security, future program expansion should not worry about its production effects. There may be other reasons to slow down the expansion of Grain for Green; food security is not one of them.

　　Other distortions, such as poor land use and uneven land prices between urban core areas and suburban areas, should be rectified. Better land use planning is needed. The nation should gradually move towards a market-based, government-regulated land market system.

　　Part IV. Environmental Impacts of Policy Changes

　　POLICY BRIEF 11: Environmental and Rural Development

　　The reform policies of 1978 and beyond unleashed a torrent of human energy as the Household Responsibility System was implemented. This combined with new technology in seeds, fertilizers, pest control and irrigation resulted in phenomenal output growth. Food grain security goals were achieved. At least one third of China's grain output is now used for animal feed as Chinese consumers add animal products to their diets. China has had a positive trade balance in agriculture for 20 years. Consumer attention is now focusing on diet diversity, food safety and quality assurance.

　　In the process of building up China's food production capacity, in some places and in some sectors an accumulated environmental debt remains as a legacy. It has many dimensions and includes soil erosion on cultivated lands, degradation of grasslands, salinity on irrigated lands, ineffective river basin management, depletion of groundwater and surface aquifers, pollution of soils, air and water from excessive application rates of fertilizers and pesticides and poor management of livestock wastes. If left unchecked, these environmental problems could be a serious threat to farm incomes and the nation's food security aspirations. Some problems may grow as China tries to comply with WTO standards and as consumers consider their food purchase choices.

　　The current environmental malaise is not a technology problem. The science associated with good land and water stewardship is well known. Much of the relevant science and technology is already in China. But, investment in applied research and demonstration is low. Public extension services have been drastically reduced. The formal education level of most farmers is low. Standards and regulations pertaining to crop input manufacture, application rates and waste management are not enforced vigorously. Input prices, especially for water, do not reflect environmental costs. The tenure situation on cultivated land and grassland is not conducive to good stewardship. Poor access to capital/credit makes adoption of new technology for better land and water management difficult to obtain.

　　China has been able to supply enough food for its growing population primarily by increasing the intensity of its farming systems and use of modern inputs. Inorganic fertilizers and pesticides are key ingredients in this rising intensity. While judicious use of modern technologies is essential to efficient food production the world over, inappropriate uses such as excessive application rates or imbalances in input combinations result in serious environmental problems and food safety concerns.

　　China is now the world's leader in both inorganic fertilizer and pesticide consumption. In the past 30 years, while world total nitrogen fertilizer application increased by 7 times, China's nitrogen use in crop production increased 45 times. On average, nitrogen use per hectare is about 3 times the world average. Pesticides have been used on a large scale since the 1950s to protect crops from damage inflicted by insects and diseases. Recently, China surpassed Japan as the world's leading pesticide consumer. Various pesticide compounds have been produced and applied to crops. Many that have been taken off the market in other countries are still widely used in China. Among them are pesticides that are known to leave toxic residues in the environment.

　　Intensive fertilizer and pesticide use can have several adverse effects and the concerns are rising. In addition to the direct costs of fertilizers and pesticides, long term, highly concentrated application of fertilizers and pesticides may contaminate farm produce, pose serious danger to the agro-ecosystem and adversely affect human health. There is growing concern regarding the increasing use of fertilizers and pesticides that cause pollution of rivers, lakes and the sea from run-off and seepage and become sources of ecological problems. China's accession to WTO has raised food safety concerns due to residual effects of high rates of fertilizer and pesticide applications

　　Several studies have shown that high rates of fertilizer and pesticide application are partially due to ineffective extension services to advise farmers on input rates and nutrient balance. Application rates are often excessive from both biological and economic perspectives. Overuse of nitrogen has been increasing and is often more than 30% in rice production. Half of the applied nitrogen often volatilizes into the atmosphere. Excessive application rates of pesticides are even more serious. For example, in rice production overuse of pesticides is about 40% and in cotton production it is more than 50%. Use of proven Integrated Pest Management (IPM) techniques is still not widespread. Pesticide application rates in China are still increasing while they are decreasing everywhere else in SE Asia. Health risks to pesticide applicators, many of whom are women, are alarming.

　　Research by CCAP shows that both fertilizer and pesticide uses could increase with trade liberalization if more effective regulations and technology extension systems are not implemented. Trade liberalization will impact fertilizer and pesticide use through its effects on product and input prices and, therefore, will affect crop production patterns (or crop area allocations) and application rates of inputs.

　　Fertilizer use is expected to increase by about 1% in 2005 and 2.4% in 2010 due to China's WTO accession (2001-2005) and further trade liberalization under Doha Round (2005-2010). The increases in fertilizer use come from both crop structural changes and higher application rates. Liberalization will cause domestic fertilizer price to decrease by about 0.5% in the coming years as imports of cheaper and better fertilizers rise slightly. The area of vegetables, fruits and rice will expand.

　　The analyses show that the impacts of trade liberalization will have more impact on pesticide use than fertilizer. Liberalizing the pesticide sector will lead to reductions in prices of pesticides by about 1% per year in 2002-2010. Decreases in pesticide prices and price increases for horticultural crops and rice (the crops with most intensive pesticide use) may significantly increase pesticide demand. The CCAP study shows that trade liberalization will raise pesticide use by 3.2% in 2005 and nearly 6% by 2010.

　　More economically rational application rates of crop inputs and wider use of IPM and other new technologies could substantially mitigate application rates, total usage and environmental concerns. Recent study by CCAP shows that nitrogen fertilizer use by rice farmers can be reduced by 20% to 30% without yield loss through site specific nitrogen management (SSNM). But extension of SSNM requires substantial investment in training and agricultural extension. Other recent studies by CCAP show that GM rice could reduce pesticide use by more than 90% in rice production and Bt cotton could reduce pesticide input in cotton production by about 65%. Relative changes in fertilizer ingredient prices may result in better nutrient balance in fertilizer products used by farmers. Science and technology to support such changes are readily available from domestic and international sources. Food safety challenges from domestic and international consumers of Chinese products may induce or even force reductions in pesticide usage.

　　Trade liberalization is expected to reduce comparative advantage for several crops including maize, wheat, cotton, sugar and edible oil. Increased imports of these land intensive products due to WTO could reduce the pressure to expand agriculture in marginal areas and thus have a positive impact on land management on fragile landscapes. Pressure on scarce water supplies might also be reduced.

　　Demand for livestock products is increasing in response to rising incomes, changing food preferences and WTO induced changes in relative prices. Increased livestock production and its concentration near urban areas will increase the environmental pressure associated with animal waste management. Public policy responses and regulatory enforcement will be critical to mitigate associated environmental and health risks.

　　Future Directions and Policy Implications

　　Environmental and economic goals in agriculture can be compatible and complementary. There are many examples in developed and less developed economies. The lessons learned in other countries can help China to leapfrog a few generations of international experience in dealing with environmental externalities.

　　It is difficult, if not impossible, to definitively separate the environmental effects of the many developmental changes occurring in rural China – liberalization of input and product markets, off farm employment, education, feminization of agriculture, new technologies, deterioration in public extension services and WTO. It is important for the national government to ensure compatibility between economic and environmental objectives of rural development policy and institutional changes.

　　Economic and environmental objectives can be complementary. The volume and general safety of the world food supply testify to that reality. People live longer and healthier than ever before – food supply, nutritional balance and safety are important aspects of that outcome, in China and elsewhere. China, therefore, needs to ensure that its food production system is compatible with international standards and practices. Some measures appropriate to that objective:

　　• The Task Force suggests that China needs to consider policy reform in its public agricultural extension system and food safety and regulatory institutions. These are urgent needs. Reform of China's food quality regulation and monitoring systems is critical and is in China's own public interest as the nation becomes more urbanized, but it is particularly critical in China's future economy under globalization. China's discerning urban consumers will purchase their food where safety and quality are assured, even if it must be imported to satisfy those demands Upgrading China's food quality and safety regulations and enforcement capabilities to international standards is an urgent public policy imperative. China's domestic food industry and its export aspirations are dependent on these policy and institutional adjustments.

　　• Facilitate the development of farmer associations. Farmers, in their own best interests, will manage their production systems for both economic and environmental outcomes when the policy and institutional framework is conducive to such behavior. Farmer associations have been very instrumental in these changes in other countries.

　　• Increased investment in public R&D with more emphasis on applied research. Appropriate technologies for better environmental management have been proven in China. Their widespread application needs appropriate economic incentives and education of farmers who ultimately use this information in their own production decisions.

　　• Build on success. There are many good examples of international institution cooperation with Chinese scientists that need further attention to extend their reach into agricultural practice in China. A good example is IRRI and Chinese scientist cooperation in development of IPM systems for pest control in rice. Initial successes in areas like Bt cotton and GM rice suggest high rates of return and positive environmental benefits from additional investment in biotechnology.

　　• Improve public good services in rural China. Good environmental management by Chinese farmers depends on education and other public good services, access to financial services and higher incomes.

　　• A change in focus from national grain self-sufficiency to food self-reliance would have positive environmental impacts arising from reduced grain production on marginal lands with scarce water supplies. This is entirely consistent with China's decision to enter the WTO.

　　• A CCICED Task Force on Environmental Goods and Services from Agriculture (EGSA) could be considered. There is great potential for EGSA in many areas, including carbon sequestration, reduction of soil erosion losses, IPM technology for pest management in intensive production systems, biomass energy production from agricultural wastes, water use efficiency and biodiversity improvement. A new Task Force could further elucidate these and other opportunities and assess their potential.

　　Appendix: CCICED ARD Task Members

Name	Organization	Position
Donato B. Antiporta	Food and Agriculture Organization of the United Nations	Senior Policy Adviser
Jun Han	Development Research Center (DRC) of the State Council	Director General, Rural Department
Jikun Huang 　　(Co-chairs)	Center for Chinese Agricultural Policy, Chinese Academy of Sciences	Director
Bingsheng Ke	RCRE, Ministry of Agriculture P.R.China	Director General
Henry Rempel	University of Manitoba, Canada	Professor
Scott Rozelle	University of California, Davis	Professor
John H Skerritt	Australian Centre for International Agricultural Research	Deputy Director
Bernie Sonntag 　　(Co-chairs)	Agriculture and Agri-Food Canada (AAFC)	Director General(retired)
Edward W Tyrchniewicz	University of Manitoba, Canada	Professor
Linxiu Zhang	Center for Chinese Agricultural Policy, Chinese Academy of Sciences	Deputy Director
Funing Zhong	College of Economics and Trade, Nanjing Agricultural University	Dean