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Special Economic Zones as Catalysts for Transition

Nov 1996
Working Paper
By  John Litwack, Yingyi Qian
One of the early strategic decisions in Chinese reform was the establishment of several special economic zones. These areas received both relatively high levels of investment and favorable tax treatment. We interpret this strategy as an appropriate response to two critical problems facing the reformers at this time: (1) A limited ability to commit due to the lack of institutions to constrain the state from expropriation, and (2) a political constraint to meet significant basic requirements in social policy. The interaction between these two problems can cause the economy to be caught in a low-equilibrium trap if limited resources are spread too thinly. By concentrating resources in special economic zones, this trap might be avoided in at least some areas of the economy, which could also eventually generate important spillover effects elsewhere. Thus, in the presence of important commitment and political problems, special economic zones can serve as catalysts for transition, despite the resulting (inefficient) diversion of resources and growth in regional inequality.