This paper addresses the methods of state-owned enterprises’ ownership reform and the smooth institutional transition of the economic system in China. By using the theory of endogenous ownership arrangements developed in Tian (1995), a three stage method of China’s economic reform will be provided. It will be shown that a smooth institutional transition to a market economy needs to go through three stages: (1) economic liberalization; (2) marketization; and (3) privatization. In the first stage, the entry and competition of enterprises of all kinds of ownership make the non-state owned sector of the economy develop quickly. In the second stage, competition among enterprises of all kinds of ownership, and the introduction and development of the market system lead to a reduction of state-owned enterprises. In the third stage, state-owned enterprises will face large scale bankruptcy and privatization. The first stage began with rural economic reform in China in 1979. The second stage began in 1992. The third stage has not begun and should not be expected to begin too soon. It is preferable that the third stage does not start taking place for about 5-10 years until the non-state owned economy has become a large proportion of the economy, say above 80 percent of GNP, and the social security network is almost completed.
