HEALTHCARE REFORM IN TRANSITIONAL CHINA: ITS IMPACT ON ACCOUNTING AND FINANCIAL MANAGEMENT.

Although the provision of adequate healthcare is an important goal for nearly all governments in the developing world, few are able to allocate sufficient resources to the healthcare industry, given the myriad alternative uses for

scarce public funds. For this reason, the currently fashionable emphasis on privatization for reasons of enhanced efficiency has additional pragmatic grounds for garnering governmental support. To the extent that healthcare is provided by the private sector, the need for government subsidies can be ameliorated. In solving the government-outlay problem, however, privatization can result in new and potentially more formidable problems. Among these are cost determination, issues of equity (accessibility to care, universal coverage, primary versus tertiary care), and market failures.

In this paper we discuss healthcare provision within a two-track framework of public-private cooperation. China is presented as a case study to illustrate the difficulties facing a developing country that adopts a market-driven healthcare strategy in the context of transitioning from a command economy to a market economy. One of China's greatest challenges in this endeavor is that of creating meaningful market prices. To this end, the reform of China's accounting system is also analyzed, with suggestions offered for even further reforms. In this transition, however, China needs to strike a careful balance between getting the most out of the more efficient free market structure and using government interventions to mitigate the effects of market failures and rising inequality, as this analysis indicates.

The contribution of this paper, therefore, lies in providing an analysis of the recent reforms of China's healthcare system and the accounting structure which supports it, while evaluating the outcomes in terms of both the benefits and dangers of relying on market mechanisms. We conclude that some aspects of the healthcare system would benefit from an even greater reliance on market forces (e.g., the "two-track" pricing scheme for hospitals and the development of a managerial accounting system), while others are shown to require more government intervention (e.g., equity concerns and basic health services).

THE PUBLIC-PRIVATE ROLE IN HEALTHCARE PROVISION: A GENERAL FRAMEWORK

In a study of 17 Organization for Economic Cooperation and Development (OECD) countries (OECD 1994), the researchers categorized each country's healthcare system based on the degree of public or private financing and public or private provision of services. They found that, despite a wide range of government involvement levels, all countries were concerned with equity issues. Therefore, even those countries with primary reliance on private markets, such as the United States, resorted to public funding of healthcare services for the poor, disabled, and elderly.

The other end of the spectrum was characterized by a much greater public role. In fact, China's healthcare system shares some characteristics with those of Ireland, Spain, Italy, and the United Kingdom in its reliance on both public financing and public provision. However, even countries with a heavy public presence in both the funding and provision of healthcare nearly always allow private supplementary insurance schemes to exist as well (Glaser 1991). This struggle to achieve a viable balance between public and private healthcare is a worldwide concern.

While market-driven production and distribution systems generally enhance economic efficiency, the healthcare sector suffers from several significant market failures that call for careful government intervention to improve efficiency. Musgrove (1996, p. 1). identifies three rationales for state intervention in healthcare: (1) to address the failures of private insurance markets for healthcare, from both an equity and efficiency standpoint; (2) to promote equity (providing healthcare to the poor); and (3) to provide public goods or goods with large externalities.

Economic Efficiency and the Market

The beauty of the free market system is that in its purest form, and in the absence of market failures(1), it is capable of providing goods and services more efficiently than any other organizational form. Even in the presence of market failures and the need for government intervention, finding the "right prices" is critical for efficient allocation of resources. While the consumer makes decisions based on personal income, preferences, and price, the producer must have more external information available. The evaluation of cost requires detailed information on the value of resources used in the production of each commodity. These determinations are complicated and require substantial information, as well as accounting professionals who are trained to present the information in a coherent and standardized manner. The price and cost signals on which market transactions are based must reflect the true underlying costs; otherwise, reliance on the market will not ensure efficiency in the healthcare industry. The Chinese privatization and accounting reforms represent the first steps toward more efficient provision of healthcare services.

Insurance Markets and Equity

By the 1970s, near universal coverage and accessibility had been achieved under the Chinese command structure despite complaints of low service quality (Yu 1992). While the quality of services can generally be expected to improve under the market system, it cannot guarantee universal coverage and accessibility to those who cannot afford services. In mature market economies with highly developed financial markets, access to healthcare is determined by a combination of public and private insurance schemes. Private insurance markets pool risk and ensure access for those who are able to pay the premiums. In a purely private market, those who cannot pay are then denied access to healthcare. To offset this problem, public funding extends access to those who are unable to pay, and covers hospital "bad debt" so that all emergencies can be treated. Even in mature economies, the debate continues over the relative weight to be assigned to public versus private insurance programs. For China, equity issues call for a greater degree of government intervention. First, a larger percentage of the population is financially unable to pay private premiums, leaving large groups uninsured in the absence of government assistance. Second, with less developed capital markets, private insurance programs cannot pool risk as efficiently as they can in mature markets. For both reasons, public subsidization of insurance schemes must play a larger role in China.

Health Expenditures as Public Investment

In addition to providing a basic human need, expenditures on healthcare are generally considered to be important investments in human capital. In the case of China, this investment role is doubly important since human resources may be the most abundant resource available to the economy. From a purely economic perspective, healthy individuals are much more productive than sick ones, and can therefore contribute more to the economy. Healthy individuals tend to learn better and live longer, lending their expertise and experience to the labor force over an extended period of time. In addition, healthy individuals consume fewer healthcare resources because preventive care is less expensive than curative care, freeing those resources for alternative uses. A healthy, well-educated population provides an engine of economic growth for China.

For decades China has followed a highly successful policy of focusing on primary healthcare for its large population. Its achievements can be seen in Figures 1 and 2 below, which compare China's health standards to those of other countries with similar 1997 per capita Gross Domestic Product (GDP). China has enjoyed lower infant mortality rates and higher immunization rates, despite having a lower income than these comparison countries until 1997.

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In recent years, China has shifted its focus away from preventive public healthcare in favor of hospital-based tertiary level services, causing healthcare costs to rise and budget deficits to mushroom. This phenomenon, combined with growing national incomes and greater consumer demand for quality healthcare, has resulted in an increased reliance on the market to relieve the pressure on the government.

Although the private market is able to improve some aspects of healthcare provision, inequality and market failures are exacerbated. This is a particularly difficult problem for China, which is in a position to receive larger marginal benefits from increases in publicly funded health services than do wealthier countries, for a variety of reasons. From a funding perspective, there are still many low-cost interventions yielding high returns that can be implemented at early stages of development, including sanitation improvements, nutritional education, immunization programs, and maternity care. In terms of outcomes, marginal increases in health standards at low levels of income provide larger gains in the productivity of the labor force than would be expected at higher levels of income and care. Therefore, public promotion of healthcare is particularly critical for China.

The prevalence of poverty in China also contributes to an increased role for government in the healthcare sector. Whether the intervention takes the form of direct provision of health services to the poor, subsidization of private provision of these services, or subsidized insurance schemes, the accessibility of health services to the poor depends upon public assistance. Finally, in order to make risk pooling through private insurance schemes efficient (abstracting for the moment from difficulties associated with the moral hazard problem), well-developed capital markets must exist. Again, China can gain from public intervention in this area.

Externalities and Public Goods in Healthcare

Externalities are forces resulting from activities that affect people who are not party to those activities. A concrete example of this phenomenon is the case of immunizations. Parents will decide whether to immunize a child based on their own analysis of the costs and benefits for that child. What they may not take into consideration is the impact of their decision on others. If their child is immunized, the risk of other children contracting the disease is reduced by virtue of the fact that their own child will not transmit the disease. Therefore, the advantages of immunization actually go beyond the direct benefits to their child. When they decide whether to pay the cost of immunization, however, they may compare only their private cost to their own private benefit, choosing to forego the immunization too often. Reliance on market forces alone in the presence of externalities will hurt efficiency, because decisions are not based on all relevant consequences. Efficiency can be improved in this case by subsidizing immunizations (lowering the private cost) so that more people will choose to purchase this service, resulting in greater overall benefits for the society.

Public goods are distinguished from private goods through the twin characteristics of non-excludability and non-depletability. Within the context of healthcare, protection of the public water supply comes close to being a public good, despite the possibility of depletion. As long as the water quality is protected, everyone enjoys the same benefits, regardless of whether or not they pay for them (non-excludability). In addition, under normal conditions one person's decision to drink a glass of water does not preclude another's decision to brush his teeth (non-depletability). Therefore, individuals have no incentive to pay for this protection, and it must be publicly provided.

Immunization exhibits characteristics of a public good as well as the previously described externality. At low levels, immunizations produce private benefits plus some externality in the sense of reduced risk of infection for others. At higher levels, immunization takes on more typical public good characteristics, such as non-excludability, as the risk of infection for others falls toward zero, culminating in a pure public good upon effectively complete eradication of a disease, such as small pox (Musgrove 1996, p. 11). Therefore, for situations exhibiting positive externalities or public good characteristics, government funding improves efficiency.

CHINA'S HEALTHCARE COVERAGE AND HOSPITAL FINANCIAL HIERARCHY BEFORE REFORMS

Prior to reforms, healthcare coverage for the Chinese population was financed primarily by means of three programs. The rural sector used a cooperative system, while the urban sector had two financing plans: the government insurance system, which covered civil servants, workers in public agencies, universities, handicapped military officers, and university students; and the labor insurance system, which covered state-owned enterprise (SOE) employees and their dependents. Patients not covered under these three programs paid for health services out-of-pocket. By 1975 the government and labor insurance systems covered almost 100 percent of the urban population, and the cooperative system covered almost 85 percent of the rural population. Overall, the three healthcare financing plans covered nearly 90 percent of China's population in 1975 (World Bank 1997, p. 1).

Chinese hospitals did, and still do, function as self-sufficient units, not only providing medical services to the public, but also providing housing, meals, and other social welfare benefits to their employees. Hospitals sell pharmaceuticals at retail prices and engage in the manufacturing and packaging of traditional Chinese medicines. The Chinese hospital is therefore a multi-faceted entity engaged in a wide range of economic activities. A select number of hospitals with the most advanced facilities were owned by the central government. Rural and other urban hospitals were owned by provincial governments. The Ministry of Finance would first approve the budget for the Ministry of Health, which then allocated funds to the provincial health bureaus. The health bureaus then proceeded to allocate their funds to each hospital. Accordingly, hospitals were subject to the jurisdiction of the Ministry of Health, which was subject to the fiscal directives of the Ministry of Finance. In this sense, all hospitals in China were, de facto, state-owned before economic reforms.

ECONOMIC REFORMS, HEALTHCARE TRANSFORMATION, AND HOSPITAL BEHAVIOR

Public Funding Crisis

China's economic reform policy is predicated on two tenets: decentralization and privatization. Decision making power is decentralized to local governments and enterprises, as they become individually responsible for profits and losses. Meanwhile, private ownership of property is encouraged as a key incentive for individuals to work harder and more efficiently in order to keep the benefits accruing directly from their own efforts. These economic reforms have notably improved many aspects of China's economy. Their impact on China's healthcare system, however, has been quite different. Decentralization and privatization inadvertently created a budget crisis for China, resulting in the decision to decrease funding for social services such as healthcare. After a decade and a hall of economic reform, the central government's role in financing healthcare diminished to hall of what it used to be; patient out-of-pocket payments more than doubled as a share of national health expenditures; and the rural cooperative medical system virtually ceased to exist.

Privatization and Two-Track Pricing

Economic reform allowed private ownership of health facilities and clinical practices, and encouraged private investment in new hospitals in the form of foreign joint ventures. Hospitals were given the freedom to seek additional funding from the production and sale of medicines and medical equipment, and the operation of stores, hotels, and factories. In fact, hospitals that operated profit-making businesses were offered tax relief for the first three to rive years (Yu 1992). Under these incentives, hospital management is now primarily focused on service competitiveness and profitability.

In the rural sector, the cooperative medical financing system collapsed as increasingly affluent households refused to participate, preferring instead to finance their specific choice of healthcare out-of-pocket. Increasing numbers of doctors gave up their jobs in the village health stations in order to establish lucrative private practices linked to area hospitals. The collapse of the cooperative medical financing scheme, and the decrease in government funding, shifted rural healthcare financing to a fee-for-service payment system relying on direct out-of-pocket payments from patients.

On the other hand, while giving hospitals freedom to make operational decisions, the central government still exerted tight control in critical areas of the hospital economy. This "schizophrenic" approach to implementing healthcare reform can be illustrated through the case of prices. The government adopted a "two-track" approach to health service pricing, under which most prices remained centrally determined, while others were liberalized. The Central Pricing Commission, which sets the general guidelines for hospitals, asserts that health services should be affordable to all. Therefore, on one track, basic health service fees are set at levels below current costs. In 1984, for example, the centrally determined price of an appendectomy charged in major hospitals was only 31 percent of the average cost of the procedure (Hsiao 1995, p. 1051). On the other track, however, prices for medications and new diagnostic and therapeutic procedures are set at levels above current costs, thus allowing for a profit margin. For example, hospitals are allowed to charge a dispensing fee plus a maximum markup of 15 percent over the wholesale price for western medicine and 25 percent for Chinese herbal drugs. The prices of diagnostic and therapeutic services such as CT scans, MRI, and multi-channel blood analyzers are based on the average cost per budgeted number of procedures. This pricing method enables hospitals to generate more profits simply by increasing the use of new equipment (Hsiao 1995, p. 1051-1052).

Two-track pricing created an incentive for hospitals to maximize the prescription and sale of drugs and medical procedures in order to cross-subsidize losses incurred in providing basic health services. Pharmaceutical expenditure in 1993 comprised 52 percent of total Chinese health expenditures compared to an average of 14 percent in OECD countries for that year (World Bank 1997, p. 20). This shift in emphasis from primary to tertiary care created important equity concerns, as discussed below.

THE STRUCTURE OF CHINESE HOSPITAL FINANCE AND ACCOUNTING, 1980-1998

Budgetary Impact of Reforms

Economic reforms in the 1980s altered the governmental budgetary structure. In order to relieve budgetary pressure, the government encouraged its subordinate units to generate direct revenue through the sale of goods and services. Such revenues are categorized as off-budget funds that are retained by the units as discretionary income. Though included in the overall state budget, off-budget revenues are not distributed through the central budget appropriation (Tang et al. 1994, pp. 162-164). In this way, hospitals were in a position to generate large amounts of off-budget revenues through four operational categories: (1) medical services, (2) retail sale of pharmaceuticals, (3) sale of various remedies and solutions manufactured in-house, and (4) miscellaneous services. However, off-budget revenues notwithstanding, prices of most medical procedures remained pegged to outdated indexes. For example, 1994 prices were based on a 1989 index that was nominally adjusted in 1990 while the average annual inflation rate from 1989 to 1995 was 11.1 percent (SSB 1996, p. 225). Moreover, while prices of medical services remained fixed, controls on the prices of medical inputs (wages, equipment, etc.) were lifted, resulting in systemic operating deficits.

Recurring deficits ensured a continued dependence on some form of government subsidy. Hospitals were required to report in their budget the amount of estimated operating deficit. The government would then provide subsidies on the basis of one of the following: (1) the amount of the deficit, (2) a percentage of specified expense items such as wages, facility repairs, etc., or (3) a fixed monetary amount. Consequently, although hospitals were supposedly individually responsible for operations, they still relied on government subsidies to remain financially viable. Such dependence guaranteed a high level of government influence on the strategic and operational management of the hospitals.

At fiscal year-end, actual surpluses and deficits from each of the four operational categories were combined, and, together with any budgetary deficit subsidies from the government, were allocated to a number of hospital funds designated for specific uses. These funds were collectively defined as Designated Items Funds and were used to (1) replenish productive assets, (2) further business operations, and (3) reward workers in order to motivate them toward operational excellence. In addition to operational sources, hospitals directly obtained funds from the Ministry of Finance and the Ministry of Health that were earmarked for specific uses (equipment acquisition, repairs, and debt repayment). Separately, resources that were restricted for the purchase of specific equipment and facilities could also be received from individual donors and investors. Finally, hospitals also obtained bank loans to finance specific capital projects. Figure 3 illustrates the flow of hospital funds during this rime period.

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Accounting Paradigm

In order to understand more fully the benefits and limitations of the reforms in the Chinese healthcare accounting system since 1998, we must place these changes within the context of accounting theory. Hospital accounting in China appears to conform with current positive accounting theory on the development of financial statements. Watts (1977) was one of the first to develop this accounting theory in an agency framework of shareholders (principals) and managers (agents). This theory posits that managers (agents) often act only in their own best interest and therefore need a set of incentives that would make them also act in the shareholders' (principals') interest. In constructing managerial incentives to achieve this end, both shareholders and managers incur agency costs such as expenditures by shareholders to monitor management, and expenditures by management to comply with the shareholders' expectations.

In order to reduce these agency costs, shareholders and managers resort to using audited financial statements as an optimum monitoring tool. The rationale is that shareholders, who are outsiders, need financial statements in order to monitor the manager. Rather than have outsiders collect the financial information independently, it is less costly if managers, who already have access to such information, produce the financial statements internally, then have the statements audited by an independent outside party. Thus audited financial statements become the accepted norm for shareholders to monitor managers. Indeed, the larger the proportion of resources provided by outsiders (both equity and debt), the higher the monitoring level, and thus the greater the need for audited financial statements.

Watts & Zimmerman (1978, 1990) further extended the theory to include all costs incurred in the firm's contracting activities. They defined contracting costs as transaction costs, agency costs, information costs, renegotiation costs, and bankruptcy costs. They also broadly defined contracting parties as managers, employees, suppliers, claimholders, and customers. In other words, accounting is viewed as a crucial part of All activities engaged in by All parties related to the firm. As a system that measures, rewards, and punishes managerial performance, accounting is an integral part of the firm's contracting technology. Watts & Zimmerman (1990, p. 135) state: "How the firm is organized, its financial policy, and its accounting methods, are as much a part of the technology used to produce the firm's product as are its production methods."

The type of information produced by the accounting system is therefore determined by the nature of the contracting parties and the contracting costs generated. In the case of China's healthcare system prior to reform, hospital managers were acting as agents on behalf of the government (the principal) because resources were provided exclusively by the government. Contracting activities were carried out primarily between the government and the hospitals, and the government's concern was whether hospital managers used the resources in accordance with governmental plans. After the reform, hospitals were told to obtain financial resources from multiple sources, including banks, donors, and investors (see Figure 3). Thus the contracting parties became more diverse as they included private as well as governmental entities. Meanwhile, contracting activities became more diverse as hospitals also entered into more new and independent negotiations with suppliers, employees, and patients. These new contracting activities required a different type of accounting information than had been prepared before the reforms.

Prior to the reforms, the Chinese accounting system was used to obtain aggregate data (e.g., average cost data), the purpose of which was to enable the government to administer financial control through collective economic plans. It was neither a management accounting system nor a financial accounting system, both of which would have provided vital information for individual decision making both for managers (insiders) and banks/private investors (outsiders). The accounting system was based on compulsory imposition of rigidly standardized accounting procedures. The Ministry of Finance, in conjunction with the financial departments of other ministries, is ultimately responsible for administering accounting regulations pertaining to each sector of the economy. In the health sector, decisions on the design of a hospital accounting system are made jointly by the Department of Planning and Finance within the Ministry of Health and the Ministry of Finance. Once the overall framework is established, local implementation of accounting regulations is made under the joint supervision of the local Finance Bureaus and the Financial Departments of the local Health Bureaus.

Economic reforms ushered in a different operating paradigm requiring financial information that the centrally planned hospital accounting system was unable to provide. Yet the reforms did not alter the fundamental political superstructure regulating the accounting system. Due to their dependence on government subsidies, Chinese hospitals continued to use a governmental budgetary fund accounting framework that focused on the flow of funds rather than income determination. The fundamental accounting equation was defined as fund source = fund application and All the accounts were categorized either as fund source or fund application. Asset and expense accounts were listed together as fund application accounts whereas liability, revenue, and net asset accounts were listed together as fund source accounts. This system operated on the basis of accrual accounting. It used the debit/credit method of bookkeeping to produce six financial statements: (1) a statement of fund application and fund source; (2) a statement of operating revenues and expenses; (3) a statement of changes in specific purpose fund balances; (4) a statement of receivables and payables; (5) a statement of fixed asset repairs and acquisitions; and (6) a statement of hospital statistics.

Need for Further Hospital Accounting Reform

The governmental fund accounting system focused on showing the flow of funds rather than operational efficiency. This information gave decision-makers a basic idea of where the funds came from and how they were used, but not whether the funds were used efficiently to achieve maximum return on investment. Related to this deficiency was the preponderance of special funds. Special funds obtained to finance certain operating expenses clouded the transparency of operating results in several ways. First, important expense items were not disclosed. For example, patient bad debts were not disclosed in the statement of operating revenues and expenses. Therefore, provision was not made for uncollectible patient accounts and the current asset, patient accounts receivable, reflected only the gross amounts. Managers were thus unable to assess the quality of their receivables.

Second, funding for the replenishment of fixed assets was supplied through specific purpose funds, resulting in the absence of depreciation expense in the statement of operating revenues and expenses. While management was aware of the need to replace equipment due to wear and tear, such a need was met through specific government subsidies. The omission of depreciation meant that the statement of operating revenues and expenses reported a surplus or deficit that did not convey realistic operating results. Meanwhile, the statement of fund application and fund source reported assets that were grossly overvalued due to the absence of accumulated depreciation.

The preponderance of special funds distorted information in a third way. In order to motivate workers, hospitals were ordered to establish a separate employee welfare fund, bonus fund, and hospital superintendent discretionary fund, from which resources were taken either to subsidize living expenses or to reward exemplary performance. The funds received an annual allocation from the surplus generated from operations and government subsidies. During the annual budgeting process, hospital management would begin by first calculating the amount they would like to see allocated into these incentive funds. This amount would then determine the budgeted surplus. Management then used the predetermined surplus, budgeted revenues and government subsidies to derive the necessary budgeted expenses ex post. During the fiscal year, management would then attempt to stay within an unrealistically tight expense budget by not making necessary repairs and by bypassing essential operations and purchases.

Under these incentives, management behavior was driven by short-term financial considerations. Not surprisingly, in reality the budgeted surplus seldom ever materialized, and more government subsidies were frequently relied upon to pay the workers their welfare subsidies and bonuses.

Fourth, under the government's two track pricing policy, hospital managers attempted to cross-subsidize deficits arising from providing under-priced health services with profits from pharmaceutical sales. From 1980 to 1990, pharmacy revenue alone comprised an average of 60 percent of total off-budget hospital revenues (Yu 1992, pp. 50-51). Since off-budget revenues are not under complete government control, policy makers were concerned that hospitals were profiteering from excessive pharmaceutical prescriptions, at the expense of the average uninformed patient. The government thus needed a new system that would make hospitals more accountable to the government for their sale of pharmaceuticals.

All said, the hospital accounting system served neither the needs of external resource providers (financial accounting) nor that of internal management (managerial accounting). The underlying accounting philosophy was still that of a governmental unit operating within the parameters of government funding and its requisite planning. As economic reforms progressed into the mid-1990s, the diminished role of government funding in the healthcare sector became ever more apparent, as did the increasing inequity caused by the incentives to provide tertiary urban care rather than primary rural care. Eventually government policy toward the allocation of funding within the healthcare sector had to be radically changed.

The change in policy was summarized by the slogan "three preservations and three sacrifices." First, government would preserve funding for preventive medicine and sacrifice funding for hospital services. Second, government would preserve funding for basic health services provided to the rural areas and sacrifice funding for the urban areas. Third, government would preserve funding for the fundamental non-elective medical procedures and sacrifice elective medical procedures. This policy meant that future government funding would be directed away from hospitals and go primarily towards public health services in the rural areas. Hospitals would have to obtain capital and operating revenues through avenues other than government subsidies. The public/private dichotomy would begin to follow the framework presented earlier in this paper: private provision of tertiary level hospital services to maximize efficiency, with the government subsidizing basic public healthcare to improve equity and offset market failures. This pattern conforms well to World Bank recommendations for healthcare changes in other transitional economies (Staines 1999).

Operating within an increasingly market-driven and competitive milieu of the mid-1990s, hospital decision-makers faced the need for information that would allow them to perform cost-benefit analyses, evaluate operational efficiency, and maximize return on investment. These developments also coincided with the desire of the Chinese government to reform its overall accounting systems so as to "link tracks with international practices." A new accounting system was now needed as never before.

THE NEW HOSPITAL FINANCE AND ACCOUNTING STRUCTURE, 1999-PRESENT

November 1998 saw the publication of Hospital Accounting Regulations: Accounts and Financial Statements (Ministries of Finance and Health 1998a) and Hospital Finance Regulations (Ministries of Finance and Health 1998b). A new hospital accounting and financing system had come into being and was implemented in All state-owned hospitals effective January 1, 1999. The fundamental relationship between hospitals and the state has not changed. Hospitals remain state-owned and dependent, to a certain degree, on government subsidies and directives, thus allowing for the continued use of accounting reports to exert government financial control. Within this context, however, reforms have altered the financial structure in various ways. Figure 4 depicts the flow of hospital funds within this new structure.

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One can see from Figure 4 that the new system is a streamlined version of the old financial structure. Instead of operating within a convoluted array of special funds (see Figure 3), hospitals now contend with only three major funds: the operating fund, the fixed assets fund, and the specific purpose funds (capital repairs and acquisition, welfare, and endowment). The operating surplus is now defined as the result of budgetary subsidies, medical operations, pharmaceutical operations, and other operations. With the exception of budgetary subsidies, which are carried forward into the next accounting period as a separate account, the rest is allocated into two funds: the welfare fund and the operating fund.

More significant is the fundamental transformation of the accounting equation from a funds flow model (fund application = fund source) to that of assets = liabilities + net assets. Going beyond merely streamlining the number of funds, the Chinese government has moved its hospital accounting system more in line with Western systems. In fact, the current Chinese system resembles the US hospital accounting system that was in place prior to the Statement of Financial Accounting Standards No. 117 (FASB 1993) when the AICPA accounting and audit guides for the hospital industry were still in effect. The three hospital financial statements are: (1) the balance sheet, (2) the statement of revenues and expenses, and (3) the statement of changes in fund balances.

Several key features define this new system. First, hospitals are encouraged to engage in more diverse business type transactions such as seeking resources from outside investors and donors, increased debt financing, engaging in mergers and acquisitions, making equity and debt investments, and extending hospital operations to other cities. Furthermore, a chief financial officer position has been established to head a separate hospital finance department, in order to manage within this new financial milieu.

Second, to reflect adequately the economic realities of operations, hospitals are required to make provisions for bad debt based on three to rive percent of the outstanding balance in patient medical accounts receivable. However, no accounts may be written off until they have been outstanding for three years. In the area of depreciation, hospitals are required to transfer an amount equivalent to a portion of total fixed assets cost from the operating fund into the capital repairs and acquisitions fund. This transfer constitutes a provision for depreciation.

Third, the socialist side of this equation remains apparent despite a more market-oriented structure: Hospitals remain state-owned and rely on government subsidies for their survival. Moreover, the state retains control in the area of revenue management. This control can be seen in the tighter scrutiny that has been exerted on the off-budget sale of pharmaceuticals. In seeking to restore a rational balance between hospital services and pharmacy sales, the government could have chosen to liberalize the prices of medical services. In this way, hospitals would no longer have needed to cross-subsidize systemic medical service deficits with pharmacy sales. However, the government has chosen instead to increase its administrative control over pharmaceutical revenues by putting a limit on the maximum revenue that can be generated from pharmaceutical sales. Pharmacy revenues in excess of a predetermined limit must now be remitted to the government (Ministries of Finance and Health 1998b, p. 4).

Finally, Chinese hospitals still do not have a clearly established cost and managerial accounting system. In place of a formal managerial accounting system, the new rules defined administrative expenses as indirect costs and allocated them to medical expenses, pharmaceutical expenses, and other expenses to be matched against the respective revenues. Thus the new accounting reports also serve as a very primitive form of management cost reports. The Ministries of Finance and Health have announced that hospitals should establish cost accounting systems relevant to their respective operating milieu. Although no centralized effort has been made to develop a hospital management accounting system, the mere mention of such a need is an indication of awareness. A well-defined management accounting system may emerge in the future as some medical universities in China have begun pilot projects on measuring the cost of hospital services.

EQUITY AND EXTERNALITIES IN HEALTHCARE

In the last two decades of economic reform, China saw its healthcare financing system develop from a centrally-funded model to that of a hybrid between laissez faire and government funding. In the rural sector, the government adopted a laissez faire policy, resulting in the development of small-scale community financing schemes in place of the monolithic rural cooperative system that collapsed as a result of reforms. A study of 30 poor rural counties found that 16.5 percent of villages maintained some type of community financing scheme. The schemes were funded through the collection of set fees from each household, forming a pool of resources. One third of these schemes covered services ranging from primary care to inpatient care, whereas two thirds of these schemes only covered primary care. All schemes incorporated coinsurance and copayment fees for inpatient services (World Bank 1997, pp. 49-51). In 1994, the government announced a new general policy directive in rural healthcare financing. The main points were: (1) the government role is to establish policy; (2) each community organizes its own collective basic healthcare financing; (3) funding will come from government, collectives, and individuals; (4) priority should be given to preventive health; (5) schemes should vary according to local economic capacity; and (6) the schemes should be accountable to the people (World Bank 1997, p. 52).

In the urban sector, the most notable change in healthcare financing has been a series of experimental insurance schemes. The most successful one so far, currently operating in about 50 Chinese cities, is a plan that requires the employer and worker to contribute 10 percent and one percent, respectively, of the worker's annual wages into a fund. The fund then allocates six percent to the worker's individual account, and the remaining rive percent to a common fund. Health expenses are first paid from the worker's individual account. If expenses exceed total resources in the individual account, the worker pays a maximum deductible of rive percent of annual income. Any expenses still in excess of what has been paid are covered mostly by the common fund, up to a limit (World Bank 1997, p. 58).

Developments in both rural and urban sectors illustrate the importance of combining government policymaking with private initiatives. The Chinese government has provided a policy framework in which private parties are allowed to experiment with various types of financing. Although these experiments may result in more cost-effective delivery of services, equity is still a concern since these plans cover only the employed. Government subsidies are needed to cover health services for the unemployed and the poor. At the writing of this paper, experimentation with various types of financing schemes is still ongoing.

Apart from its inefficient hospital system, China has compiled an enviable record in providing public health goods, as indicated above. China's low infant mortality rates and high immunization rates reflect the high standard of basic healthcare the population has enjoyed for decades. These successes should not be put at risk by the push toward market-based healthcare and the encouragement of tertiary level care. The impact of China's current privatization policy on the population's health status will only be evident a decade or two from now. In this sense, the externality issue argues against a complete reliance on market forces when the population at large is impacted by healthcare decisions made by individuals, as in the case of immunizations against infectious diseases. Continued government intervention (perhaps in the form of costly subsidies) is required for efficient allocation of resources in externality cases, running counter to the prevailing desire to reduce the role of government in the Chinese economy.

CONCLUSION

China's healthcare transformation illustrates several key lessons in using a two-track framework of public-private cooperation. First, healthcare improvement cannot be defined solely as increases in the level of hospital-based tertiary care. All too often, developing countries redirect their funding priorities toward hospitals to the detriment of public health spending. The result is a sharp increase in health expenditures without the concomitant improvement in health status.

Second, basic preventive public health services behave differently from hospital-based tertiary health services in regard to funding policies. The former is a good that has externality implications, whereas the latter responds better to privatization. Therefore, government subsidies are critical to public health services, whereas private funding is a viable option for hospital services. In choosing to concentrate central government funding on preventive medicine, basic rural health services, and non-elective medical procedures, the Chinese government's recent policy of "three preservations and three sacrifices" acknowledges this point.

Third, given that the hospital sector in China is moving toward a market framework, an appropriate accounting system is a sine qua non. The new accounting system now resembles the US hospital financial accounting system prior to 1993. It is a fund accounting system structured within the framework of assets = liabilities + fund balance. Compared to the old system, the new one is more streamlined and transparent. The number of special funds has been reduced and more expense accounts have been added to reflect business reality. The new system thus better enables financial statement users to assess the flow of resources and its effect on financial position. In this sense, the new system is better suited to decision making in the current milieu of economic reform. However, this system only produces financial statements that do not allow for cost determination and other significant managerial decision-making tasks. In the minds of those who operate the Ministries of Finance and Health, unfortunately, a financial accounting system seems to suffice for All decision-making purposes, irrespective of what kind of information managers really need.

Fourth, as is partly illustrated in the previous paragraph, the remnants of central planning still persist. The government continues to exercise control over hospital operations as evidenced by the budgetary nature of hospital financing. Subsidies, although significantly reduced, still comprise a prominent feature of hospital operations. Hospitals must submit their annual budgets for prior governmental approval even though most of their revenues are now derived from off-budget sources. Moreover, the two-track pricing policy remains in place despite price reforms in other sectors of the economy. Faced with distortions caused by differential government regulation--low prices for basic services, higher cost-plus prices for pharmaceuticals--one solution would have been to liberalize basic services, thereby effecting a rational balance. Instead, the government resorted to its habitual solution of exerting more control by requiring hospitals to remit pharmacy revenues generated above a government-determined ceiling.

There is no question that China is moving toward market-based healthcare, and that the market generally does a remarkable job of providing this service efficiently. The challenge for China lies in these areas: developing an insurance scheme which comes as close as possible to maintaining the universal coverage enjoyed by the population under the command structure; maintaining a level of government funding and subsidy to counteract the externality and public goods problems; and continuing to generate the appropriate accounting standards and train the necessary professionals to ensure that the price signals on which the market relies are accurate, timely, and lead to efficient resource allocation decisions.

(1) We are referring here to the standard market failures of externalities and public goods discussed below.

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David K.W. Chu
College of the Holy Cross (USA)

Kolleen J. Rask
Collefe of the Holy Cross

The authors wish to thank the two anonymous referees for their helpful comments. Any remaining errors are, of course, out own.

Address for correspondence: David K.W. Chu, Department of Economics, College of the Holy Cross, Worcester, MA 01610 USA, [e-mail].