Scenario 1: Top-down dimensions
This scenario involves the continuation of the current intergovernmental relationships into the future. In this structure the central government controls the majority of fiscal resources and the appointment of major officials. Within provinces, the provincial government controls the appointment of major local officials and most of the province’s fiscal revenue.

The structure differs to the former planned economy as it involves rule by law and a market economy. Because of these two factors, the central government can effectively realise the ‘State’s will’ and push forward with national reforms and development in areas such as social security, education and trans-regional infrastructure.

Nonetheless, as discussed previously, this scenario is not sustainable in the long run. It induces vertical and horizontal governmental opportunistic behaviour. The social cost of remaining in this structure would also be quite high.

Many economic and social problems in China — such as massive conflicts, petitions, farmer questions, local governments’ huge debts and risks, distorted markets and corruption — are the result of two-type governmental opportunism.

Without grassroots democracy and a checks-and-balances mechanism for government through constitutional rule, these problems might develop into crises. As Weingast points out, crisis shocks are the driving force for evolution towards a self-enforcing federalism or nation. To build up the so-called ‘harmonious society’ in China a sustainable intergovernmental relationship must be established.

Scenario 2: A good market economy
As far as we can see from the practices around the world, this structure is probably the most sustainable. It features a stable vertical structure and an effective horizontal checks-and-balances mechanism. China already has some of the conditions in place required for evolution towards this structure.

The key for China to shift to Scenario 2 is to reform its arrangement in the personnel dimension, or to develop its democracy. Although grassroots elections are developing steadily in China, they are still at a relatively early stage. To what level, and when, direct elections can develop in the future in China is still unclear.

At the horizontal level, China needs to establish effective checks-and-balances mechanisms at various levels of government through the rule of law, so that the market can function well. The expansion of civil society and liberty with rapid economic growth will allow the rule of law and democracy eventually to be well established in China.

Scenario 3: A bad market economy
This structure looks sustainable in terms of vertical intergovernmental relationships, but is not effective for economic growth. Under this scenario, the rule of law is not well established and the law institutionalises the privileges of interest groups, even with democracy. This produces opportunistic behaviour on the part of horizontal government.

At present, vested interests (instead of ideology) are the biggest impediment to China deepening its economic and political reforms. Corruption and social injustice are serious issues. The law has already institutionalised the privileges of some interest groups and the market has serious distortions. If this situation does not change, China is likely to evolve to Scenario 3.

If constitutional rule cannot be established and liberty cannot be guaranteed, democracy alone will not be sufficient to eradicate corruption and the privileges of interest groups, since horizontal governmental opportunistic behaviour will prevail. This would produce poor economic performance and social injustice.

Scenario 4: mixed efficiencies
This is a mixed structure with different relationships coexisting at different levels of government. The central–provincial relationship would be as in Scenario 1, while the provincial–local relationship would be as in Scenario 2. This structure is very likely to occur in China in the future.

With the central–provincial relationship already reaching Scenario 1, two further steps are needed to shift to this mixed structure. One is that grassroots democracy spreads up to the county level in the near future. Another is that the fiscal relationship between provincial and local governments becomes institutionalised. If this were to happen, the vertical intergovernmental relationships within each province would be substantially similar to those in Western countries.

At the central–provincial level, the vertical relationship would not be substantially changed, but the horizontal checks-and-balances mechanism would be effectively established through a strengthening of the rule of law.

This mixed structure implies that China could develop a unique vertical intergovernmental arrangement deeply rooted in its 5000-year history, tradition, culture and vast population. This mixed structure also provides room for the central–provincial relationship to further evolve as conditions mature. This is consistent with China’s gradual approach to reform since 1978.

In this mixed structure, avoiding vertical governmental opportunistic behaviour remains a major challenge and is dependent largely on the rule of law and the moral merit of the top leaders.

A sustainable federal nation requires different levels of government to balance in order to prevent vertical opportunistic behaviour between them. Meanwhile, it is equally essential to establish a checks-and-balances mechanism through the rule of law and democracy to prevent horizontal governmental opportunistic behaviour in the market. Economic performance is conditioned on preventing endogenous transaction costs resulting from these two types of behaviour.

In terms of fiscal arrangements, China’s central–provincial relationship is already very similar to that in Western countries. The central government controls most of the nation’s fiscal resources and, financially, the provinces rely heavily on transfer payments. The key difference between China and Western countries is in the personnel dimension. The dual top-down arrangements in the personnel and fiscal dimensions in China have resulted in a very strong central government. Preventing vertical governmental opportunistic behaviour is therefore a major challenge for China—and it will not be sufficient to simply borrow the top-down fiscal arrangement from the West.

This chapter sees four major possible scenarios for the future evolution of intergovernmental relationships in China. A mixture between Scenarios 1 and 2 is very likely to emerge as grassroots democracy grows in China. It also provides room for further evolution towards a stronger structure based around the rule of law in the more distant future.

Yongsheng Zhang is a Senior Fellow of the Development Research Centre, State Council, China. This essay has been adapted from the authors contribution to ‘China: The Next 20 Years of Reform and Development’, Ross Garnaut, Jane Golley and Ligang Song (eds).