Dual Track Reforms: With and Without Losers

The dual track approach to market liberalization has been widely recognized as the key to the success of the Chinese economic reform. In this paper we study the effectiveness of this strategy in economic environments where the status quo government control is incomplete. We show that in a dynamic context contractual arbitrage will emerge, potentially resulting in efficiency losses and/or adverse distributional effects. By establishing a necessary and sufficient condition for the dual{track approach to retain its appeal in a dynamic context, our analysis provides a clear guideline to the broader applicability of this reform mechanism.