Incremental Reform and Distortions in China's Product and Factor Markets Xiaobo Zhang and Kong-Yam Tan The purpose of economic reform is to reduce distortions and enhance efficiency. This could happen, for example, if increased interregional competition as a result of fiscal decentralization led local governments to impose trade protection measures against each other. For permissions, please e-mail: journals.permissions oxfordjournals.org 279 280 THE WORLD BANK ECONOMIC REVIEW panel data set of 32 industries at the two-digit level of aggregation in 29 provinces, Bai and others (2004) find, after an initial decline, an increase in regional specialization of industrial production, suggesting diminishing impediments to regional trade flows. The second approach, drawing from the risk-sharing literature, is to check the degree of consumption smoothing across time and space, which is an important indicator of capital mobility and asset market completeness. As in Young, the analysis uses the following sum of the squared deviations of the sectoral output shares of China's provinces from the group average to the degree of product market integration: Unweighted measure : Weighed measure : XX Sij À j 2 S i j 1 2 XX i j N wi Sij À j 2 S where Sij denotes the share of sector j in province i's output; Sj is the group average Sij across provinces; wi denotes the province's share of total GDP of N 286 THE WORLD BANK ECONOMIC REVIEW TABLE 2. Graphing the unweighted and weighted measures of the composition of output shares for 1978 2001 shows similar results--the composition of output converges up to the early 1990s and diverges thereafter (figure 1). The results are supported by an independent early study by Yang and Zhou (1999), who find gains in aggregate output of 0.7 percent, 3.1 percent, and 5.8 percent based on the same three hypothetical percentage transfers of labor using 1992 as a baseline. This article has examined the changing patterns of distortions during the reform process, how past policies have contributed to these distortions, and the estimated cost to the economy through lower output and greater regional and sectoral disparity. However, in response to the increasing fragmentation in product markets, the government has undertaken measures to remove local protections. While empirical estimates and policy simulations can provide rough order of magnitude estimates of structural problems, policy recommendations on gradual elimination of these distortions need to take into account complex issues of political feasibility, sequencing, implementation problems, downside risks of policy measures, nature of vested interests and how to overcome them, the need to minimize negative side effects, and the effects on equity, regional disparity, and rural-urban inequality.