Major Issues and Policies in China's Financial Reform 9781623200725, 9781623200312

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Major Issues and Policies in China’s Financial Reform Volume 2

Chen Yulu Guo Qingwang

2

Honolulu • Hong Kong • Beijing • Singapore

Published by Enrich Professional Publishing, Inc. Suite 208 Davies Pacific Center 841 Bishop Street Honolulu, HI, 96813 Website: www.enrichprofessional.com A Member of Enrich Culture Group Limited Hong Kong Head Office: 11/F, Benson Tower, 74 Hung To Road, Kwun Tong, Kowloon, Hong Kong, China China Office: Rm 309, Building A, Central Valley, 16 Haidian Middle Street, Haidian District, Beijing, China Singapore Office: 16L, Enterprise Road, Singapore 627660 Chinese original edition © 2013 China Renmin University Press Editors in chief: Chen Yulu and Guo Qingwang Deputy editors: Zhang Jie, Wang Changyun, and Qu Qiang English edition © 2017 by Enrich Professional Publishing, Inc. With the title Major Issues and Policies in China’s Financial Reform Volume 2 Translated by Barbara Cao and Phoebe Poon Edited by Phoebe Poon All rights reserved. This book, or parts thereof, may not be reproduced in any form or by any means, electronic or mechanical, including photocopying, recording or any information storage and retrieval system now known or to be invented, without written permission from the Publisher. 978-1-62320-031-2 ISBN (Hardback) ISBN (pdf) 978-1-62320-072-5 This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Enrich Professional Publishing is an independent globally-minded publisher focusing on the economic and financial developments that have revolutionized New China. We aim to serve the needs of advanced degree students, researchers, and business professionals who are looking for authoritative, accurate, and engaging information on China.

Contents Chapter 7 Eight-Character Policies .................................................................. 1

He Qing

Chapter 8 Large Treasury, Small Bank ........................................................... 31 Liu Xiaolu Chapter 9 Loans for Appropriations ............................................................... 49



Wang Changyun

Chapter 10 Credit Difference Contracting ........................................................ 65

Lei Chengyao

Chapter 11 Full Loan Financing ......................................................................... 83

Zhang Chengsi

Chapter 12 Eating from Separate Stoves ........................................................... 95

Lü Bingyang

Chapter 13 Food First, Construction Second .................................................... 115

Liu Xiaolu

Chapter 14 Tax for Profit ..................................................................................... 143

Wang Xiuzhi

Notes

............................................................................................................. 161

Bibliography ............................................................................................................. 165 Index

............................................................................................................. 175

7

Chapter

Eight-Character Policies

MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 2

“Eight-character policies” were principles expressed in slogans of eight Chinese words formulated in response to the economic predicaments in the early development of the People’s Republic of China, also known as New China. The national economy had maintained rapid development ever since the birth of the new regime, but it was not smooth sailing all the way. During the 60-year course, the central government and the Communist Party of China (CPC) has put forward an “eight-character policy” twice as the Party-state grappled with economic crises and failures, trying to figure out its economic ideology. Subsequent to the catastrophe of the Great Leap Forward, the central government proposed in 1960 “readjustment, consolidation, enrichment, and improvement” (tiaozheng, gonggu, chongshi, tigao 調 整，鞏固，充實，提高) as a guideline to mitigate the repercussions; and to achieve a full recovery from the Cultural Revolution, the policy of “readjustment, reform, rectification, and improvement” (tiaozheng, gaige, zhengdun, tigao 調整，改革， 整頓，提高) was brought up to instruct economic reconstruction in line with the direction of Reform and Opening Up in 1979. In today’s world where domestic and international environments are rapidly changing, these principles will still provide insight to Chinese leaders as to how to grasp economic trends, ensure economic stability, and address emerging problems in accordance with specific situations.

The First “Eight-Character Policy” Background After three years of economic recovery succeeding the founding of the new Chinese state, it initiated large-scale industrialization and Socialist transformation of agriculture, handicrafts, and capitalist industry and commerce in 1953. By 1957, the targets of the 1st Five-Year Plan had been overfulfilled, as a result of which a modern industrial system was established, agricultural and industrial output rose by a large margin, and people’s standards of living improved. In April 1956, the Eighth National Congress of the CPC passed the Suggestions on the 2nd Five-Year Plan compiled under the leadership of Zhou Enlai, but this proactive plan failed to be implemented, as a tendency of unrealistic and impetuous advances began to dominate the economic construction. During the 2nd Plenary Session of the CPC’s Eighth National Congress in May 1958, the “General Line for Socialist Construction,” namely “go all out, aim high, and build socialism with greater, faster, better, and more economical results” (鼓 足幹勁，力爭上游，多快好省地建設社會主義), was passed. The congress also proposed the ambitious goals of catching up with the United Kingdom in seven years and the United States in eight to ten years. Since then, a general mood of

2

Eight-Character Policies

impetuosity prevailed in the Party. It was under such a guiding ideology that People’s Commune Movement and the Great Leap Forward were launched. During the Great Leap Forward, the CPC Central Committee set up unrealistic targets for agricultural and industrial output, in particular for iron and steel production. To meet the targets, all other trades and industries made way for steelmaking, and backyard furnaces were built in every commune and urban neighborhood to help melt iron. These actions, however, only threw the entire national economy into a tailspin. The central and local governments’ blind increase of investment in capital construction resulted in the short supply of materials and goods and a declining rate of projects completed and put into use. The commercial sector’s campaign of bulk purchase and sale ended up causing overstock and waste, while banks’ unrestrained loans to commercial and industrial companies brought about excessive investment and inventory, eventually causing inefficient production and capital shortages. While the Great Leap Forward was going on, the People’s Commune Movement was introduced in rural areas. Administrative units known as “people’s communes,” which were described as “large in size and collective in nature” (yi da er gong 一大二 公), and which practiced equalitarianism and indiscriminate transfer of resources (yi pin er diao 一平二調), were established. Base-level production units in the communes had no autonomy in management and members were lax in discipline as they were not held accountable for their work. Equalitarianism was practiced at the expense of people’s enthusiasm in production, which was manifested in low economic efficiency. In the end, the poor economic performance brought about huge losses to human and material resources and significantly lowered people’s standards of living. There were far-reaching consequences in the following aspects:

Imbalance between industry and agriculture The most notable consequence of the Great Leap Forward and the People’s Commune Movement was the sharp decline in agricultural production. Universal steelmaking and capital construction siphoned off a large part of the labor force from agricultural activities, thus greatly impairing agricultural output. From 1957 to 1960, grain yields decreased by 26.4% and total agricultural output dropped by 22.7%,1 while the gross value of industrial output, by contrast, multiplied by 1.3. The ratio between industrial and agricultural output was enlarged from 5.7 : 4.3 to 8 : 2.2 The dramatic shrinking of agriculture’s share indicates that industrial and capital construction expanded more than agriculture could support, and this structural imbalance further added to the difficulties in economic construction.

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MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 2

Imbalance within industry Under the slogan of “take steel as the key link” (yi gang wei gang 以鋼為綱) put forward in the Great Leap Forward, the mining and quarrying sector was compelled to “go all out and go fast” (da gan kuai shang 大幹快上), but still failed to meet the demand from steelmaking. Similarly, road building in the transportation sector lagged coal and iron growth, despite some investments in railways and highways. As most factories were preoccupied with producing means of production, the output of light industrial goods plunged, and the ratio of light to heavy industry changed from 55 : 45 in 1957 to 46.5 : 53.5 in 1958.3 The supply of daily necessities made from industrial goods was also impacted, leading to strained commodity markets.

Excessive capital construction and imbalance between accumulation and consumption Since the Great Leap Forward, China’s economic construction had constantly expanded, which led to a high accumulation rate and a low consumption rate. During the period of the 1st Five-Year Plan, the proportion of national income spent for accumulation stood at 24.2%, but it rose to an average of 39.1% between 1958 and 1960.4 The accumulation rate was 43% in 1959, the highest level since the founding of New China (see Fig. 7.1). Besides that, capital construction mostly focused on projects for production. The neglect of nonproduction ones brought about a continuous decline in people’s consumption of daily goods such as grain, pork, and cotton between 1957 and 1960. This meant that even feeding and clothing the huge Chinese population became a problem. Investment as a percentage of GNP, 1952–1966

Fig. 7.1 45% 40% 35% 30% 25% 20% 15%

19

65

19

64

63

19

19

62

19

61

19

60

59

19

58

19

19

57

19

56

55

19

54

19

19

53

19

52 19

66

Year

10%

Source: National Bureau of Statistics of the People’s Republic of China, China Statistical Yearbook, various years.

4

Eight-Character Policies

Huge fiscal deficits, high inflation, and imbalance between supply and demand To support the fast expansion of capital construction, fiscal expenditure soared to exceed the budget and starting from 1958, the government ran a deficit three years in a row. In 1960, fiscal revenue was at its height of CNY64.3 billion, but it went down by 37% to CNY35.6 billion in 1961, before further declining to CNY29.4 billion in 1962 (see Fig. 7.2). Excessive deficits and loans pushed the central bank to increase money supply when the output reduction in agriculture and light industry created an acute shortage of goods in the market, pushing up commodity prices. Fig. 7.2

40%

Growth rate of government revenue, 1956–1966

30% 20% 10% 0% -10% -20% -30% -40%

Year 1956

1957

1958

1959

1960

1961

1962

1963

1964

1965

1966

Source: National Bureau of Statistics of the People’s Republic of China, China Statistical Yearbook, various years.

Decline in living standards During the Great Leap Forward, as piece-rate pay and bonuses were cancelled, income of urban households shrank. Worse still, the supply of light industrial products and agricultural and sideline products could hardly meet market demand due to the reduction in production and growth of the urban workforce. Rural households also faced a shortage of food since farmers’ private plots and their sideline businesses were called off while the boom of public catering brought with it immense waste, which was aggravated by exaggerated output reports and large state purchases of grain. Life in rural and urban areas alike was hard.

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MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 2

It is clear from the above analysis that the period of 1959 to 1962 was the most difficult period for the Chinese economy. As seen in Fig. 7.3, its annual growth rate dropped from 11% to –15% during the 1st Five-Year Plan period. In 1960 to 1962, China’s GNP plunged by nearly 30%, from CNY14.57 billion to CNY11.49 billion. With the national economy hitting the bottom, people’s living standards suffered. The economic slump forced the Party-State to reexamine the Great Leap Forward and reconstruct the economy. In view of the existing problems, the government put forward the first “eight-character policy” to guide economic readjustments. Economic fluctuations, 1954–1980

Fig. 7.3 30% 20% 10% 0% -10% -20% -30%

Year 1954

1957

1960

1963

1966

1969

1972

1975

1978

Source: National Bureau of Statistics of the People’s Republic of China, China Statistical Yearbook, various years.

Measures The Great Leap Forward and the People’s Commune Movement caused serious economic imbalances. Having noticed this fact, the Party leaders decided to revamp and adjust the economy. In the autumn of 1960, Li Fuchun, Director of the State Planning Commission, proposed a “six-character principle,” “readjustment, consolidation, and improvement,” while preparing the national economic development plan. After being modified by Premier Zhou Enlai, this principle was announced by the central government as a part of the Report on the Controlled Figures for the 1961 National Economic Plan in September 1960. In the report, the

6

Eight-Character Policies

“six-character principle” was expanded to include “enrichment,” which was later widely referred to as an “eight-character policy.” The four groups of eight characters summarized the following goals: to adjust the proportional relationships among different economic components; to consolidate existing economic achievements; to enrich the productivity of certain sectors for better economic effects; to improve product quality and managerial skills and boost labor productivity. In January 1961, the 9th Plenary Session of the Eighth Central Committee of the CPC discussed the 1961 national economic plan and decided to promote the “eight-character policy” throughout the country starting from 1961. In such a way, the guideline of China’s national economy shifted from “take steel as the key link” and full-scale Great Leap Forward to overall readjustment, so that the imbalanced economy could go back on the track of sound development. After the 9th Plenary Session of the Eighth Central Committee, especially after the 1962 conference of 7,000 comrades, the Party engineered massive readjustments in the national economy, which were mainly reflected in the following aspects:

Restoration of agricultural production In September and November 1960, the central government successively issued the Instructions on Vigorously Developing Agriculture and Increasing Grain Production and Urgent Notice on Current Problems of Rural People’s Communes. In 1962, a revised version of the Regulations on Rural People’s Commune was issued. These documents proposed a series of policies and measures to achieve agricultural recovery, and put an end to public catering and the partial supply system, replacing it with contribution-based distribution.

Cutting down of investment on capital construction In 1962, the total investment of capital construction was significantly reduced to CNY6.76 billion from CNY12.33 billion a year earlier while state investment decreased to CNY5.66 billion from CNY8.98 billion. At the same time, extrabudgetary investment slumped to CNY1.1 billion, its lowest level since 1953.

Readjustment of the urban-rural relationship Within two and a half years from January 1961, 19.4 million workers were laid off, and 26 million urban residents were relocated to rural areas. These measures significantly lightened the pressure of urban material supply on rural areas and

7

MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 2

reduced the state’s expenditure on wages.5

Slowing down of industrial development and improvement of the industrial structure A great many industrial companies were ordered to close down, suspend operations, merge with others, or shift to other lines of production, while the surviving enterprises were required to make rectification in management so as to improve their economic efficiency.

Readjustment and strengthening of economic regulation In September 1960, the Political Bureau of the CPC Central Committee decided to set up six central offices to centralize economic management and work hard to enhance economic planning and fiscal administration.

Lessening of currency in circulation and stabilization of markets The purchasing power of nonindividual consumers was limited to lessen the pressure on market supply. Daily necessities were supplied by ration at fair prices whereas selected consumer goods were brought under a premium price policy. This helped not only ensure the supply of daily necessities for workers and regulate supply and demand of other commodities, but also withdraw excess money from circulation and ease the market tension.

Resumption and development of daily industrial goods and handicrafts production In addition to ensuring the supply of fuels, raw materials, and equipment, the government also strove to research new types of industrial materials to fill the deficiency in agricultural raw materials, and increase the production of industrial goods which were in short supply to relieve the market shortage.

Increase of channels of circulation to improve the business environment The government restored supply and marketing cooperatives as well as cooperative stores and groups, which had been either dismantled or amalgamated since the Great Leap Forward. It also reformed the management of state-owned businesses, opened up the trade of rural fairs, and enlarged the acquisition of agricultural and sideline products.

8

Eight-Character Policies

Results Thanks to the above readjustment measures, China’s economy began to pick up since 1961. First, rural relations of production were adjusted to facilitate the recovery of productive forces. The “Communist wind” ceased to blow in the countryside, and farmers regained enthusiasm for production. In 1962, the agricultural labor force grew by over 15 million from a year earlier, with the total size outnumbering the level of 1957, the year before the Great Leap Forward. In agricultural output, the downward trend which had lasted three consecutive years was reversed to realize growth of CNY43 billion, or 5.8%, compared with 1961.6 As can be seen in Fig. 7.4, China’s agricultural production experienced a period of substantial growth since 1949. Grain output nearly doubled between 1950 and 1959, from 110 million tonnes to 200 million tonnes. Although it plunged by 62% (i.e., 60 million tonnes) in 1960 compared to 1958, after a series of readjustment measures, grain production began to rebound in 1961 and finally managed to maintain the same level as 1958 in 1965. Fig. 7.4

Grain output, 1949–1965

Million tonnes 230 210 190 170 150 130 110 90

Year 1940

1951

1953

1955

1957

1959

1961

1963

1965

Source: National Bureau of Statistics of the People’s Republic of China, China Statistical Yearbook, various years.

9

MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 2

Second, industrial production was recovered, and the proportions of agricultural, light, and heavy industries were basically balanced. The ratio between industrial and agricultural output changed from 4 : 1 in 1960 to 2: 1 in 1962. In terms of industrial production, the ratio between light and heavy industries improved to 47.2 : 52.8 from 42.5 : 57.5 a year ago. The total volume of industrial production had fallen by 43.7% between 1960 and 1962, from CNY163.7 billion to CNY92 billion, but it returned to the level of 1960 by 1966 to reach CNY62.4 billion due to the implementation of the first “eight-character policy” (see Fig. 7.5). Gross value of industrial output, 1949–1966

Fig. 7.5 CNY1 billion 180 160 140 120 100 80 60 40 20

1965

1964

1963

1962

1961

1960

1959

1958

1957

1956

1955

1954

1953

1952

1951

1950

1949

1966

Year

0

Third, an overall balance was achieved in fiscal revenue and expenditure and the pressure on market supply was eased. In 1962, the four-year fiscal deficit was reversed to a surplus position. Commodity prices dropped by 35% from the last year, the tight supply started to be alleviated, and people’s standards of living were recovering. Owing to the economic readjustment, urban household consumption rose again to CNY257 in 1966, after it reported a fall of 27% between 1960 and 1962, from CNY284 to CNY206. Similarly, rural household consumption also staged a comeback after a sharp decline in 1960 and climbed from CNY76 to CNY106 in 1966, up by 39% (see Fig. 7.6).

10

Eight-Character Policies

Fig. 7.6

Annual consumption of urban and rural households, 1953–1966

CNY

1,800

Urban household Rural household

1,600 1,200 1,000 600 200

1965

1964

1963

1962

1961

1960

1959

1958

1957

1956

1955

1954

1953

1966

Year

0

Source: National Bureau of Statistics of the People’s Republic of China, China Statistical Yearbook, various years.

This movement of economic readjustment started in 1961 and ended in 1965. Despite some adverse incidents during the process, it generally achieved desirable results. The country fought through the hardest times since its founding, and people’s standards of living significantly improved. In the First Session of the 3rd National People’s Congress convened in December 1964, Premier Zhou Enlai announced in the Report on the Work of the Government that after the economic readjustment, China had basically readjusted the relationship between industry and agriculture, and also the relations among the various branches of industry, enhanced industry’s capacity to support agriculture, increased enterprises’ production capacity, and reduced equipment damage or disrepair. He also declared in the report, “At present, the task of readjusting the national economy has been basically accomplished, there has been an all-round upsurge in agricultural and industrial production, and the entire economy has taken a turn for the better and is entering a new period of development.”7 This summarized the official recognition of the success of the policy of “readjustment, consolidation, enrichment, and improvement” after five years of effort, being the fruit of lessons learned by the Party-state in the process of national economic construction.

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MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 2

The Second “Eight-Character Policy” Background Following the end of the Cultural Revolution in October 1976, China entered into a new era of Socialist modernization, as a series of measures were adopted to achieve speedy recovery and enhance production. In 1977 and 1978, China’s national economy started to pick up. Agricultural and industrial production went up, with grain output hitting a historical high, and people’s standards of living also improved. With the downfall of the “Gang of Four,” stifled enthusiasm for production was released, contributing to some extent to the recovery of the national economy. However, for a continuous period, the Leftist outlook among the Party leaders which had patronized rash advances in economic construction had not altogether subsided. The extreme campaign of “Learning from Dazhai Village in Agriculture” started by Mao was carried on regardless of local conditions, although its objective of realizing agricultural mechanization in a short time ran counter to reality and unrealistic pursuit only dampened farmers’ enthusiasm. In fact, the actual production of agricultural machinery and fertilizers fell far behind the stated targets. In industry, the leaders set unrealistic goals for steel, energy, and transportation, resurrecting the slogan of “catching up with the United Kingdom and overtaking the United States.” These goals were far beyond the then financial and material capacity and technological level. In order to surpass the Western economies in a short time, ambitious infrastructural projects were launched and foreign technologies and equipment were introduced in huge quantities without consideration of compatibility. The result was a great waste of resources. These mistakes diminished what could have been favorable conditions for economic reconstruction after the smashing of the “Gang of Four,” and eventually upset the major relational balances in the national economy, holding back economic efficiency. The adverse impacts were mainly manifested in the following aspects:

Lopsided balance between accumulation and consumption Excessive investment in capital construction gave rise to a high accumulation rate. The growth of accumulation outpaced the growth of national income, stressing the government financially. High accumulation stifled the development of agriculture and light industry, suppressed people’s consumption, and prevented people’s standards of living from improving. All these in turn contributed to the further imbalance between consumption and accumulation.

12

Eight-Character Policies

Structural imbalance between agriculture and industry and within industry During this period, the government prioritized the development of industry, especially heavy industry, which continued the disparity between agricultural and industrial development. Moreover, within the industrial sector, raw material, processing, and energy industries also experienced uneven development. Light industry grew slowly, and neither the quality nor quantity of its products could meet the needs of the people. As seen in Fig. 7.7, the ratio of the three economic sectors in output value was 28 : 48 : 24 in 1978. Industrial output as a percentage of GNP reached an all-time high, and before that, the highest level was recorded in 1960 during the Great Leap Forward, with the ratio of the three sectors being 24 : 44 : 32. Output value of the three sectors, 1952–1995

Fig. 7.7 CNY1 billion 1,000 900

Primary industry Secondary industry

800

Tertiary industry

700 600 500 400

1978

300

1960

200 100 0

1952

1957

1962

1967

1972

1977

1982

Year

Source: National Bureau of Statistics of the People’s Republic of China, China Statistical Yearbook, various years.

Problematic economic regulation and low economic efficiency In economic regulation, the practices of “unified state control over revenue and expenditure,” “centralized procurement and distribution of resources,” and “eating from the same big pot” (i.e., equal distribution of rewards regardless of contributions) were still in effect, and corporate management was in a mess, resulting in low efficiency in construction, production, and circulation. At the end of the Cultural Revolution, a considerable portion of Chinese enterprises were barely

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MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 2

surviving on poor management and inefficient production. Many quality indicators for industrial goods were lower than record levels, and business indicators such as capital utilization rate were far below the levels before the Cultural Revolution. In the field of circulation, redundant intermediate links and low turnover rates created a tremendous backlog of materials. Capital construction was unreasonably prolonged before going into operation, thus producing huge waste. All those were accountable for the low corporate profitability. In December 1978, the CPC convened the Third Plenary Session of its 11th Central Committee. This meeting was of great significance in the history of the Party because it officially put an end to the Leftist ideology adopted before and during the Cultural Revolution and shifted the policy focus of the Party to Socialist modernization starting from 1979. The Central Working Conference in April 1979 discussed the current economic situations and responding strategies, and resolved to restore national economic balances within three to five years while reforming the current economic system. During this conference, the new “eight-character policy” of “readjustment, reform, rectification, and improvement” was put forth, with “readjustment” as the core. By issuing this policy, the Party leaders intended to adjust the relational imbalances in the economy, reform irrational economic management systems, rectify problematic enterprises, and improve corporate managerial skills and technology.

Measures Major measures adopted in accordance with the second “eight-character policy” were:

Readjustment of rural policies to boost agricultural production In April 1979, the Fourth Plenary Session of the 11th Central Committee released the Decision on Several Issues on the Acceleration of Rural Development, which proposed 25 policies and measures for developing the rural economy. They included:

1. Protecting the ownership and autonomy of the collective economy at the grassroots level, opposing egalitarianism and indiscriminate transfer of resources, and insisting on distribution according to work; 2. Guaranteeing the private plots of farmers, supporting household sideline production, and encouraging the development of rural fairs;

14

Eight-Character Policies

3. Reforming the rural planned system to allow rural production units larger autonomy and flexibility; 4. Updating the agricultural structure, guiding agricultural production in light of local conditions and advantages, adjusting the proportions of different crops while ensuring the stable growth of grains, and implementing the policies of “taking agricultural production as the key, ensuring all-round development on the basis of local conditions, and focusing on certain lines of production,” and “developing agriculture, forestry, animal husbandry, sideline production, and fishery simultaneously”; 5. Strengthening the government’s policy support to agriculture, increasing fiscal expenditure and bank credit to agriculture, lowering the prices of farm-oriented industrial products such as agricultural machinery, fertilizer, and pesticide, and reducing the agricultural-industrial price scissors; 6. Cutting the procurement of grain from areas which had insufficient supply. Starting from 1980, new forms of responsibility systems, such as assigning fixed workloads or output quotas to households, were introduced to elevate the productivity of agriculture.

Reduction of capital construction and adjustment of investment distribution The scale of capital construction was shrunk to adapt to the supply of raw materials, equipment, and funds as well as the capacity of energy and transportation. Projects under construction were checked up on, which led to the stoppage or suspension of a number of large and medium-sized projects. The development of heavy industry was slowed down to upgrade industrial products and adjust the product structure, with numerous high-consuming, loss-making enterprises notorious for dubious product quality closed down or merged with others. Measures were taken to improve the production of coal, power, oil, transportation, and building materials: equipment and technologies used in power and coal enterprises were upgraded to expand their output, and additional investment was put in to enhance the construction of transport infrastructure, such as by revamping backward sections of railways.

Acceleration of the growth of light industry To improve the production and circulation conditions of light industry, the government gave it priority in six areas including bank loans and capital construction. In return, light industrial firms were asked to focus on the market,

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MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 2

raise their product quality and variety, and be more service minded. Support was especially extended to enterprises of collective ownership and enterprises specializing in small commodities. Moreover, heavy industry was adjusted to cater to the needs of light industry and the market, and some military enterprises were rearranged to manufacture goods for daily use. The market was regulated under the guidance of government plans, with some autonomy for marketing and sale given to producers of certain types of products, and the production of popular goods, high-end and brand-name products encouraged.

Raising of the share of consumption in national income and people’s standards of living In rural areas, the government raised the purchasing prices for agricultural and sideline products by a large margin, and cut agricultural tax and reduced the quota of produce subject to unified or fixed state purchase in certain places, while in cities, it increased salaries and employment opportunities in general and adjusted the pay scale and subsidies in selective areas. The government also enlarged its nonproduction-oriented investment, such as in science and technology, education, culture, public health and urban construction.

Results With the implementation of the above measures, China’s economy was significantly improved. Concluding past experience, the Central Working Conference in December 1981 decided to make further readjustments to the national economy. The general goals identified were: to stabilize the economy, readjust the economic structure, dig out the potential of development, and improve efficiency. This meeting also set forth the targets of “two balances and one stabilization” — to maintain fiscal and credit balances and stabilize commodity prices. The economic readjustments initiated in 1981 followed through on the second “eight-character policy” and reinforced it. By 1985, the following achievements were salient:

Balanced economic development The economy was developed in a balanced, stable, and coordinated manner. During the period of the 6th Five-Year Plan, total social output, gross agricultural and industrial output, and national income all grew at a steady speed of around 10% per year, which had never been seen after the 1st Five-Year Plan. The longterm imbalances in the economy had also been corrected.

16

Eight-Character Policies

Growth in industrial output, national income, and fiscal revenue Industrial output, national income, and fiscal revenue grew side by side. During the 6th Five-Year Plan period, the annual growth rate of industrial output was 10.8%; national income, 9.7%; fiscal revenue, 11.5%.8 The three economic indicators grew at the same pace and China’s economic performance had obviously improved. The budget deficit was eliminated by 1985.

Development of state, collective, and private sectors The state, collective, and private sectors of the economy developed hand in hand. Diverse forms of economic ownership flourished in many urban and rural areas after the Third Plenary Session of the 11th Central Committee of the CPC. In terms of gross industrial output, the share of the collective economy decreased from 78.7% to 70.4% between 1980 and 1985, whereas that of the collective economy rose from 20.7% to 27.7% and that of the private economy ascended to 0.4% (see Fig. 7.8).

Development of agricultural production and township enterprises Agricultural production and township enterprises developed considerably. During the 6th Five-Year Plan period, the household responsibility system which linked remuneration to output was widely implemented, and agricultural output grew steadily. The proportion of crop farming in total output declined while those of forestry, animal husbandry, sideline production, and fishery went up. Township enterprises saw a substantive growth with a dramatic increase in the number of their employers.

Development in capital construction The aggregate investment in capital construction escalated by 44.6% in 1985 from the last year and by 92% compared to 1980.9 A larger portion of capital investment was diverted to nonproduction projects.

Growth of domestic markets and trade Domestic markets were flourishing and commodity production grew both in quality and variety thanks to the policy of invigorating the domestic economy and reforming the circulation system. Multiple types of economic ownership and operational methods coexisted, and private businesses grew rapidly.

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MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 2

Increase in foreign trade and economic and technological exchange In 1985, the total volume of imports and exports reached USD69.61 billion, 30% higher than a year ago and 84% higher than 1980 (see Fig. 7.9). China’s exports jumped from the 28th place to the 16th between 1980 and 1985. At the same time, China’s foreign investment also experienced a significant rise.

Improvement in government revenue Government revenue gradually made an upturn during the 6th Five-Year Plan period, and by 1985 the central government managed to make ends meet. The proportion of operating expenses for culture, education, science, and public health services in fiscal expenditure expanded to 17% in 1985 from 12.9% in 1980.

Rise of living standards People’s standards of living also improved. In 1985, household consumption was 23% higher than 1984 and 79% higher than 1980. During the 6th Five-Year Plan period, the annual growth rate of household consumption reached 8.8% and the growth rate of farmers’ income arrived at 10.1% (see Fig. 7.10).10 Fig. 7.8

Share of nonstate sector in gross industrial output, 1976–1995

40% 35% 30% 25% 20% 10%

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

Year

Source: National Bureau of Statistics of the People’s Republic of China, China Statistical Yearbook, various years.

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Eight-Character Policies

Fig. 7.9

Total volume of imports and exports, 1950–1986

CNY1 billion 300 250 200 150 100 50 0

1950 1953 1956 1959 1962 1965 1968 1971 1974 1977 1980 1983 1986

Year

Source: National Bureau of Statistics of the People’s Republic of China, China Statistical Yearbook, various years.

Fig. 7.10

Consumption levels of urban and rural households, 1976–1986

CNY 900

Urban households

800 700

Rural households

600 500 400 300 200 100 0

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

Year

Source: National Bureau of Statistics of the People’s Republic of China, China Statistical Yearbook, various years.

Comparison of the Two “Eight-Character Policies” Both “eight-character policies” were devised for adjusting the development patterns of the national economy, and they shared the interlinked goals of regulating imbalances in the economic structure to promote coordinated development and

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MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 2

guaranteeing the constant and stable growth of the national economy, as economic imbalances would aggravate economic fluctuations while economic ups and downs would exert an influence on different economic sectors, which would in turn exacerbate the structural imbalance. Despite the similarity, the two policies each had specific goals and directions. “Consolidation and enrichment” in the first policy was less radical, so economic order was contingent on government policy, as described in the saying “whenever control is tightened, things are doomed; when control is relaxed, things run into chaos” (yi guan jiu si, yi fang jiu luan 一管就死， 一放就亂). That was why “reform” and “rectification” were called on to seek more fundamental changes to the economy. The following will discuss the similarities and differences in the contexts and achievements of the two policies:

Ideological background The two policies were put forward against a similar ideological backdrop: the dominance of ultra-Leftism in the leadership. To make it plain, the turbulence that the second “eight-character policy” had to address was very much the legacy left by the limitations of the first “eight-character policy.” As discussed, the Great Leap Forward that backgrounded the first “eightcharacter policy” started in 1955 with Chairman Mao Zedong’s mobilization of the masses to achieve “greater, faster, better, and more economical” results in building Socialism. As a result, “rash advance” (maojin 冒進) became commonplace. “Anti– rash advance” cries once rose from within the Party, but they were castigated as politically erroneous by January 1958. Between 1958 and 1959, gestures to temper Leftism eventually grew into the purge of defiant leader Peng Dehuai, who was chided as “Rightist,” and the quench of all dissenting voices against the Great Leap Forward policy at the Lushan Conference of July 1959. Under dictatorship and personality cult, discussions on economic indicators and development speed became a matter of “class struggle.” Later on, after the implementation of the first “eight-character policy,” Mao was to label measures taken to redress problems created by the People’s Commune Movement, such as the abolition of production quotas for individual households, the free daily supply system, and public canteens, as “evil winds of the Rightists.” Thus the Cultural Revolution was staged; history repeated itself, and the Chinese economy was soon plunged into deep water. The second “eight-character policy” emphasized reform and rectification out of the realization of the deep ideological roots of the economic chaos in the aftermath of the Cultural Revolution. While the crushing of the Gang of Four in 1976 put a symbolic end to the movement, Mao’s successor Hua Guofeng failed to end the personality cult of Mao, and in fact perpetuated it by a statement known as the “Two

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Eight-Character Policies

Whatevers” (liangge fanshi 兩個凡是) — “We should firmly uphold whatever policy decisions Chairman Mao made; we should always follow whatever instructions Chairman Mao issued.” This explains the continuation of unrealistic high targets in seek of quick results by such campaign as “Learning from Dazhai Village in Agriculture” until December 1978. The mistakes committed during this period could in fact be compared with the situation of the Great Leap Forward, just that while the 1958 movement was launched to enrich the country within the shortest time possible, the programs in 1977 and 1978 were implemented to recover the losses caused by the Cultural Revolution. In both periods, economic policies were characterized by pursuit of breakneck growth in spite of long-term repercussions.

Economic background Both “eight-character policies” sought to arrest the rash advances in economic construction in the respective periods so as to bring the national economy back to the track of sound development, raise economic efficiency, and elevate people’s standards of living. Characterized by unrealistic targets, blind guidance, and exaggerated output reports, the Great Leap Forward severely disturbed normal economic operations, broke the structural balance of the economy, and worsened people’s livelihoods. Agricultural output plummeted while industrial and capital construction swelled; heavy industries which had no place in everyday consumption grew disproportionately large; and stock continued to pile up despite meager consumption rates. In the end the government ran huge deficits and prices skyrocketed. The people were impoverished. As already demonstrated, the ideological context had not been fundamentally reshaped since the end of the Great Leap Forward despite the first “eight-character policy.” Ultra-Leftism abated for a while but soon returned, only to be strengthened during the Cultural Revolution. Leftist thought was so rampant that even beyond the movement, only partial remedy to the economy was permitted, often along the approach of the Great Leap Forward. Thus, the post-1976 remedial programs largely inherited the economic problems of the Great Leap Forward period: high accumulation caused by excessive investment in capital construction, financial stress on the government, straining of material resources, an imbalanced economic structure, and so on. In terms of management, both periods enforced the egalitarian practice of “eating from the same big pot.” Corporate management was in a total mess, leading to low economic efficiency in construction, production, and circulation.

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Readjustment measures Since the two policies were brought forth under similar economic backgrounds, and the government faced the similar tasks of correcting economic imbalances and improving economic efficiency and the quality of life, measures adopted during the two periods also bore some resemblances. The priority of both policies was to restore agricultural production. During the period of the first policy, the Chinese government issued the “60-article regulations for agriculture” which called an end to public catering and the partial supply system and boosted agricultural recovery. These policies played a decisive role in relieving the difficulties of the rural economy. By comparison, the Fourth Plenary Session of the 11th Central Committee in 1979 also put forward 25 measures to further develop the rural economy. These measures included protecting the ownership and autonomy of the collective economy, adhering to the principle of “distribution according to work,” giving greater autonomy to base-level rural units, and diversifying the economy. The reform measures after 1979 laid a solid foundation for the future promotion of the household-responsibility system and the substantial growth in agricultural output. There were also similarities in industrial policy. After the Great Leap Forward, the government decided to curtail capital construction and slow down industrial development for the purpose of improving the industrial structure. At the same time, it reinforced the centralized management of the national economy through better state planning and lowered the profit share retained by enterprises. Similarly, the Third Plenary Session of the 11th Central Committee also decided to balance the proportions of different industrial sectors to accelerate the development of light industry by ordering problematic industrial companies to shut down, suspend production, merge into others, or switch to other lines of production. For the remaining industrial companies, the government requested them to optimize their management strategies to maximize profitability. Measures were taken to improve living standards in both periods. It was a policy focus after the Great Leap Forward to adjust the urban-rural relationship, by downsizing the nonagricultural and urban population to mitigate the supply pressure on the countryside. Additional measures were adopted to improve state finances, such as by diminishing the currency in circulation and stabilizing the market. During the period of the second “eight-character policy,” the reform focus was laid on upgrading the production and circulation conditions of enterprises and boosting the development of handicrafts and daily-use industrial goods. For rural residents, the government largely increased the procurement prices of agricultural and sideline products and considerably cut agriculture tax and state purchase

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Eight-Character Policies

quotas, while for urban residents, increased pay, subsides, and job opportunities. Overall, it also enlarged investment in nonproduction projects, such as science, education, culture, public health and urban facilities. The two policies were divergent in part of their guiding principles and measures, though. Specifically, the first policy stressed “consolidation and enrichment” while the second one accented reform. With regard to agricultural development, the former strove to restore agricultural productivity, eliminate extreme equalitarianism, and implement “distribution according to work,” whereas the latter mostly focused on institutional adjustments, through arousing farmers’ enthusiasm for production, encouraging structural optimization and diversified production in agricultural organizations, and promoting the householdresponsibility system. In the aspect of economic regulation, adjustments made after the Great Leap Forward attached great importance to centralized economic management with better economic planning; however, the focus after the Third Plenary Session of the 11th Central Committee was shifted to enhancing the role of the market. Both domestic and foreign markets were opened up, with a bettered circulation system and opportunities for economic and technological exchange. The most fundamental departure of the second “eight-character policy” from its 1961 counterpart was the diversification of ownership systems from a single “public ownership” into “whole people” (i.e., state), “collective,” and private ownerships. To answer market needs, while insisting on the leading role of state ownership, the government encouraged and supported the growth of the collective and private sectors, as well as the production of petty commodities. The boom in township enterprises was a result of this initiative. Thus, the second “eight-character policy” was evidently more radical. It did not stop at incremental changes but went further to perform a comprehensive economic overhaul by bringing in market principles.

Readjustment results The two “eight-character policies” proved to be effective in achieving their respective targets. They both redressed the economic imbalances, reversed the downward trend of economic development, and raised economic efficiency and people’s quality of life. But due to the difference in historical background and focuses of readjustment, the long-term effects of the two policies varied. From 1961 onwards, China’s economy began to get better as the first “eightcharacter policy” was gradually carried out. By the end of 1962, agriculture and industry had been on the way to recovery, and in 1963, China’s economy showed clear signs of improvement before it further picked up in 1964. It was on this foundation which Premier Zhou Enlai made the positive declaration at the 3rd

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National People’s Congress between December 1964 and January 1965. However, the strength of Leftist ideology had never dissipated from the Party leadership. Even in 1962, during the Tenth Plenary Session of the 8th CPC Central Committee in September which approved of economic readjustment as the top priority of the whole nation, the question of class struggle was brought up again and aggrandized by Mao Zedong’s famous warning against forgetting class struggle: “We must remind ourselves of this every year, every month, and every day.” He also opposed the system of strict production responsibility which assigned output tasks to each production team, individual, and household, and criticized the practice as encouraging “individualism” and “taking the capitalist road.” After the Tenth Plenary Session of the 8th CPC Central Committee, in 1963, the Party launched the campaigns of “Four Cleanups” — to cleanse politics, the economy, organization, and ideology — in rural areas and “Five Antis” — anti– embezzlement and theft, -speculation, –extravagance and waste, -decentralization, and -bureaucratism — in urban areas to remove the “reactionary” and capitalist elements within the Party. Collectively referred to as the “Socialist Education Movement,” these campaigns carried on until the eve of the Cultural Revolution for which they sowed the seed. At the same time, overestimating the risk of international threats in the early 1960s, the Party leaders became determined to gear up the country for war, channeling massive resources into defense-related industries, especially through the Third Front Movement in the Northwest and Southwest. Economic readjustment came to a standstill and was eventually taken over by class struggle. It was not until 13 years later when the Third Plenary Session of the 11th Central Committee was convened that China’s economy resumed growth. After the Cultural Revolution came to an end, the focus of the Party and the central government went back to Socialist modernization. In the meeting to discuss state plans in March 1977, 10 “whether” questions about economic development were brought up for public debate, which helped correct the radical ideology inherited from the Gang of Four. The discussion concerning “whether practice is the sole criterion for testing truth” in 1978 reaffirmed the significance of “distribution according to work,” confirmed the decisive role of productivity in economic development, and explicated the importance of commodity production and exchange. The discussion also expanded to cover the topic of economic structure. Autonomy for enterprises and base-level rural units was affirmed, and economic tools were sanctioned for regulating the economy. A new era of economic restructuring ensued, during which process a household contract responsibility system with remuneration linked to output and a regulation system combining both centralized and decentralized management was implemented in villages.

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Eight-Character Policies

These systems conformed to the characteristics of China’s agriculture and the development of rural productivity, thus greatly encouraging the enthusiasm of farmers for production. A Socialist market economy with Chinese characteristics with state ownership as the basis alongside other forms of ownership was established. The lasting effects of the second “eight-character policy” after the Cultural Revolution owed much to the insistence on ideological reform.

Ideological Implications Both raised in the planned economic period, the two “eight-character policies” focused on redressing economic imbalances resulting from the wrong judgement of the policymakers. However, while the first policy worked totally within the framework of the planned economy, the second policy started to leverage the power of the market, which paved the way for the implementation of the Reform and Opening Up policy. Since then, the Chinese economy has been set on a track of steady development. Those who supported a planned economic system would argue that strict government control of the economy would reduce the chances of volatility to which a market economy, being prone to excessive supply and consumption, would be more vulnerable. However, contrary to this understanding, China’s 60 years of development evince how economic fluctuations can be just as large under a planned economy, while a market system can provide a desirable institutional environment for economic readjustment. With the progress of the second “eight-character policy,” the leadership arrived at three general conclusions:

“The planned economy is ineffective in curbing economic fluctuations and imbalances” In a planned economy, the economic activities of the entire country rest solely upon the plans and decisions of the policymakers, making it overly dependent on human factors. More importantly, that power is centralized in the hands of a few heightens the risk of perpetuation of policy errors. The market system, despite its susceptibility to excessive supply and consumption, provides a relatively objective price mechanism which may prevent irrational human judgments. The 1st Five-year Plan between 1953 and 1957 provided an initial successful experience of the highly centralized planned economy, as centralized planning to attain the goal of Socialist transformation of agriculture, industry, and handicrafts accelerated the pace of industrialization and modernization. For a time, the Chinese leaders proudly observed that China had shed its image as a backward

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MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 2

agrarian country. However, this also came with a price: The overwhelming focus on industry, especially heavy industry, inevitably resulted in drastic imbalances between agricultural and industrial development and among different industrial sectors, depriving the nation of its economic backbone. The strategy of “going all out and going fast” might dramatically pull up the economy, but high investment rates without corresponding support from consumption and distribution would not be sustainable in the long run. Such an extreme strategy was clearly a policy failure, but due to centralized leadership, not until economic difficulties dumped the country into economic stagnation and recession were the leaders compelled to introduce rescue policy to halt the national economy from further crumbling. Macroeconomic decisions themselves hinged on information on production, exchange, and distribution in the economy, which took time to transmit, not to mention that without constraints, policymakers could devise economic plans to serve their political agenda rather than serve actual economic needs — which was very much the case during the Great Leap Forward and the Cultural Revolution. The inherent limitations of the planned economy in checking and correcting inferior policy decisions allowed problems to pile up until nearing the boiling point. It was for this reason that the effects of the first “eight-character policy,” introduced within the framework of a planned economy, did not persist and the second “eightcharacter policy” brought in the principles of “reform” and “rectification” for a gradual change to a market economy.

“‘Seeking truth from facts’ is the prerequisite for economic construction” The idiom “seeking truth from facts” (shishiqiushi 實事求是) had been borrowed by Mao as a guiding principle suggesting pragmatism even before the founding of New China. As early as 1956, the Eighth National Congress of the CPC made realistic judgements on China’s economic conditions and confirmed the short-term goal of boosting productivity by issuing the Second Five-Year Plan. Unfortunately, the 1958 Great Leap Forward was divorced from objective reality. In 1960, by introducing the first “eight-character policy,” Mao and the Central Party Committee brought back the spirit of “seeking truth from facts.” In the Ninth Plenary Session of the 8th Central Committee of the CPC in January 1961, Mao himself reiterated the importance of restoring the practice of truth-seeking via investigation, and projected the year of 1961 as “a year of investigation and study,” as well as “a year of seeking truth from facts.” The first “eight-character policy” was conceived under the reinstated pragmatic principle. The first effort of readjustment eventually died down because of the giving up of the truth-seeking principle in the resurgence of Leftist thought. Like its preceding

26

Eight-Character Policies

counterpart, the second “eight-character policy” was a result of the restoration of the truth-seeking spirit. To cast off such irrational ideologies as “Two Whatevers” that fed blind optimism and rash advances and normalize economic development, the Third Plenary Session of the 11th CPC Central Committee reaffirmed the ideological guideline of “seeking truth from facts” alongside the proposal of the “eight-character policy.” From then on, it has been firm in the Chinese leaders’ belief that only by adhering to the ideological guideline of “seeking truth from facts,” would they be able to respond timely to the changing situations and keep the economy on the right track. So far, the Economic Reform starting in 1978 has proved to be effective in realizing an economic soft landing and responding to the financial crises of 1997 and 2008. All along, the leaders have been cautious about overheating and carefully contained it by macroeconomic regulation and control.

“Reform is the only route to development” The first “eight-character policy” was in fact followed by not only initiatives to rectify the errors of the Great Leap Forward but also experimental reforms such as pilots of business trusts to manage the economy by economic organizations, the devolution of some autonomy to state-owned enterprises and reduction of egalitarianism, and expansion of local government power. However, until the Third Plenary Session of the 11th CPC Central Committee in 1978, there was no through institutional change. Vice Premier Li Xiannian recognized, “in the past 20 years, we have launched reforms to the economic system more than once, and made many achievements. In the aspect of corporate management, however, we have mostly focused on the transfer of administrative power, getting stuck in the cycle of centralizing and decentralizing power, and thus can hardly fulfill the requirements of economic development.” The communique of the 1978 meeting pointed out that one of the major defects in China’s economic management system was the excessive centralization of power, and the central government should give greater autonomy to lower-level governments and enterprises, streamline administrative organization over enterprises, and reform the relationship between Party and government, and state and enterprises. In March 1979, instrumental leader Chen Yun raised the innovative idea that the Chinese economy should comprise planned and market components, so as to allow the self-regulatory effects of the market to come into play. Shortly after that, Deng Xiaoping stressed the importance of solving institutional problems in the economy and put the goals of “Four Modernizations” — agriculture, industry, national defense, and science and technology — which Zhou Enlai had proposed, back on the table. By 1979, Deng acknowledged the market system as compatible to Socialist

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countries, which heralded a series of flexible arrangements. In the following days, the household contract responsibility was established, reforms were launched to redress the relationships between the central and local governments, and between the government and enterprises, special economic zones were set up, economic opening up to the outside world was sped up, the reform focus was shifted from villages to cities, and the scale of reform was extended beyond economic readjustments to politics, science and technology, education and social life. In spring 1992, Deng made the landmark speech during his tour in southern China that precipitated the announcement of the goal of establishing a Socialist market economy at the 14th National People’s Congress in October 1992. “The proportion of planning to market forces,” said Deng, “is not the essential difference between socialism and capitalism. A planned economy is not equivalent to socialism, because there is planning under capitalism too; a market economy is not capitalism, because there are markets under socialism too. Planning and market forces are both means of controlling economic activity.”11 And in November 2012, the 16th National People’s Congress recognized the completion of the new economic structure. The mutual promotion between economic readjustment and reform is what distinguished the economic policy after the Cultural Revolution from that after the Great Leap Forward, and also the key to the developments after the second “eight-character policy.”

Conclusion The first “eight-character policy” took place almost half a century ago and the second one also dates back to 30 years from now. At the present day, the Socialist market economy has been fully developed and Leftist adventurism in economic construction has been refuted. It seems unlikely for the Chinese leaders to commit the same mistakes again, but the lessons learned from the two policies are still pertinent to the globalized situation of today, for averting possible economic crisis and realizing coordinated and sustainable development.

Balanced economic development Although the Socialist market economy has been basically established, the risk of economic imbalances still exists. Against the backdrop of a market economy, state guidance is needed to channel capital and human resources to industries where the efficiency is highest. Otherwise, the national economy will be in peril of lopsided development; then even if the market mechanism comes to the rescue, a heavy

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price will have to be paid. In the face of economic globalization, it is imperative to keep a close eye on domestic and international economic indicators and make corresponding macroeconomic changes.

Agricultural and rural issues Even to this day, agriculture remains the foundation of China’s economy. Not only is it responsible for the feeding of China’s 1.3 billion population, but it also provides raw materials and markets to the secondary and tertiary industries. Whether agriculture still plays a fundamental role in the economy and whether the rural economy is prosperous are of great political and social significance to China. However, compared to developed countries, China is lagging behind in agricultural development: the living standards of farmers are very low, and their income is growing at a slow pace. The fact that farmers are unable to share the fruits of economic development and social progress is contrary to the targets of China’s economic construction. If this situation cannot be addressed in time, it will induce a series of profound problems. The goal of building a new Socialist countryside through guaranteeing agricultural production, increasing the value added and competitiveness of agricultural products, invigorating the rural economy, and raising the income of farmers, which the Chinese leaders have already proposed, must remain on the top of their agenda in the foreseeable future.

Structural adjustment While China’s national strength is rising steadily, how to optimize the economic structure to provide constant impetus for economic growth becomes an important topic. To this end, it is necessary to close down and suspend a large number of outdated production facilities, upgrade the technology of traditional industries, and give both financial and policy support to high-tech, high value-added, and internationally competitive enterprises. The service sector is where employment is most needed, and it is in line with the government’s target of bettering people’s lives to develop services. Yet, compared to traditional industries and situations in developed countries, the service sector in China only occupies a small share in GNP. To develop the service sector should be one of the basic goals of China’s economic policies over the long term.

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Sustainable development In a very long period after the launch of the Reform and Opening Up policy, China’s economy has been developing on the basis of high consumption. While consumption is necessary to sustain economic growth, a balance has to be found between development and conservation. Now that national power has been consolidated, resource saving and environmental protection should be moved up in priority on the government agenda. It is a must to promote the policy of energy conservation and emissions reduction if China wants to build a resource-saving and environmentally friendly society. This goal can be achieved by stopping a group of less efficient and high-consuming enterprises, supporting the development of technologically advanced yet less energy-consuming enterprises, and promoting the growth of cultural industries and tourism. The ideas of sustainable development and environmental protection should be listed as a principal policy in economic construction and adopted nationwide.

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8

Chapter

Large Treasury, Small Bank

MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 2

The system of planned economy denies the usefulness of commodity currencies and provides for a product economy. Naturally, planned economies value administrative means over economic tools in economic regulation, and the central treasury over the central bank in capital allocation. The description “large treasury, small bank” (da caizheng, xiao yinhang 大財政，小銀行) is a reflection of such characteristics of a planned economy in the relationship between China’s Ministry of Finance and the People’s Bank of China (PBC) prior to the launch of the Reform and Opening Up policy. In capital arrangement, the treasury almost undertook all capital activities, providing both fixed capital and prescribed working capital to state-owned enterprises (SOEs), whereas the central bank only fulfilled the temporary needs of SOEs for current funds. In other words, the treasury supplied nonrepayable long-term funds to SOEs while the central bank offered repayable short-term funds. In such a way, the role of the PBC was confined to a very limited scope. In policy measures, fiscal policy dominated over monetary policy, and the allocation of fiscal funds was the only way to regulate capital demand around the country whereas the central bank merely supported fiscal expenditure through increasing money supply in times of fiscal deficits. In the administrative structure, as the treasury gained an upper hand in both capital allocation and policymaking, the central bank was in a subordinate position. In 1969, the PBC was merged into the Ministry of Finance and became a secondary affiliated organization of the latter. At this point, the central bank was degenerated into “coffers” and “cashier” of the treasury. This situation continued until 1978 when the PBC finally resumed its independency as a ministry-level organ.

Background Under the fiscal system of “unified control over revenues and expenditures” in the era of the planned economy, governments at all levels must seek approval from the Ministry of Finance when planning their revenues and expenditures; therefore, the Ministry of Finance in fact controlled the fiscal activities of the entire country. Meanwhile, the PBC headed a highly unified monobank system, treating all banks as equal subordinate components. In this way, the PBC not only played the role of a commercial bank, offering deposit, savings, and remittance services, but also functioned as a central bank to regulate the macroeconomy. The institutional arrangement of “large treasury, small bank” had multiple social and political implications. First, it implied a greater importance of the fiscal system than the banking system in capital allocation. Second, it gave more weight to fiscal policy than monetary policy in policymaking. Last, it required that

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the monetary authorities should be obedient to the fiscal authorities in exerting government functions. There was a rationale behind such an arrangement given the context of the planned economy. In the first place, the national economy was dominated by the public sector. From the SOEs in the industrial sector to the production teams in the agricultural sector, the basic production units were all placed under public ownership. The central government realized its direct control over rural households through state plans. Under such a system, it was as though capital was transferred from the left hand to the right hand of the government. When a certain enterprise was ordered to expand production, the central government could choose to either issue long-term loans through the central bank or appropriate funds through the treasury to provide the enterprise with the necessary funds for purchasing new equipment. With both the treasury and the central bank subject to the central government, the second measure was dominantly favored for the reason that direct fiscal appropriation was more convenient than requesting indirect bank loans. Next, banking operations were policy oriented. In a market economy, the central bank is usually separated from commercial banks with the former performing policy functions while the latter, economic functions. Private commercial banks must optimize their asset-liability structure in order to maximize their profits, and this attempt is reflected in their interest rates and loan size. In China’s planned economy, however, the central bank was the sole monetary organization in the country, and its subordinate branches had no incentive to pursue their own interests. For this reason, interest rates and credit size could not be a reference of the state of economic activities. By comparison, as enterprise profits and appropriations constituted the mass of fiscal capital, the relationship between fiscal revenue and expenditure was a better indicator of capital allocation. Last, the central bank had no independence in policymaking. The developmental origin of the central bank mechanism seems to suggest that the exercise of its policy function hinges on the basis of a market economy; the dominance of market factors in decision making is imperative for the central bank’s roles, whether as stabilizer of the currency value or “final lender” of commercial banks, to come into play. But in the Chinese planned economy where commercial banks did not exist, the major variables which could cause currency fluctuations were nonmarket factors, such as household income, enterprise investment scale, and the exchange rate. Consequently, the policy function of the central bank became no more than empty talk, as it only assumed the roles of “cash dispenser” in times of fiscal deficits and “bookkeeping agency” recording business transactions.

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Institutional Transitions As China furthered its policy of Reform and Opening Up, the planned economy gradually gave way to the market economy and both the fiscal and banking systems underwent tremendous changes. Specifically, the reform of “eating from separate stoves” which provided for the sharing of revenues and expenditures between the central and local governments after 1978 and the tax-sharing reform in 1994 facilitated fiscal decentralization between the central and local governments. As a result, the central treasury no longer monopolized public finances. In terms of the banking system, four specialized banks, namely, the Industrial & Commercial Bank of China (ICBC), China Construction Bank (CCB), Bank of China (BOC), and Agricultural Bank of China, were established in 1979, and they transformed into wholly state-funded commercial banks in 1995 and underwent shareholding reforms after 2005. Gone was the highly unified monobank system with the era of the planned economy, but is the phenomenon of “large treasury, small bank” no longer pertinent? This question can be examined from the perspective of government financing channels, which will bring the fiscal and banking systems before and after China’s Reform and Opening Up efforts into the same framework. Government financing activities are a government’s attempts to channel funds from the economic system in order to mobilize social-economic resources to perform its functions. In times of the planned economy, nearly all social and economic resources in the country were under the control of the central government, and government plans and economic activities were congruent, as evinced by the correspondence between the large central treasury unifying control over revenues and expenditures and the small but unifying central bank. But with the progress of China’s reform, the focus of economic activities was shifted from the public sector to the private sector and income distribution skewed away from the government towards enterprises and households. The sources of fiscal capital narrowed, while bank funds surged, forcing the government to search for new financing channels. Generally speaking, a government can absorb resources from fiscal and financial channels. The main fiscal channels are taxation, profit delivery from SOEs, and government debts, whereas financial channels include seigniorage and the financial surplus (difference between private deposits and loans in the financial system) in its control. The two types of channels correspond to capital allocation through the fiscal and banking systems, respectively. Since 1978, the financing pattern of the Chinese government has experienced two distinct stages: “weak treasury, strong bank” between 1978 and 1994, and “strong treasury, weak bank” from 1994 onwards.

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First stage (1978–1994): Weak treasury, strong bank From 1978 to 1994, China’s Economic Reform was conducted in line with the principle of devolving power and relinquishing profits in favor of SOEs (fang quan rang li 放權讓利). Local governments were given larger fiscal power and resources by the substitution of a fiscal “contracting” (baogan 包干) system for the unified control over fiscal funds, thus stimulating local authorities’ initiative in fiscal management. In SOEs, the “tax-for-profit” reform and separation of enterprise ownership from managerial authority greatly enhanced their enthusiasm for production and management. Moreover, measures such as raising the procurement prices of agricultural and sideline products and improving urban pay tilted the income distribution gradually to the household sector. On the whole, the devolution of power to SOEs had remarkable effects, with the economy experiencing unprecedentedly rapid development; however, the policy had the down side of inevitably shrinking the fiscal extractive capacity of the government. Fig. 8.1 shows the changes in fiscal extractive capacity. Fig. 8.1 0

Fiscal extractive capacity, 1978–1994 5

10

15

20

25

30

35 %

31.2

1978 25.7 32.9

1982

0.8 0.6

32.9 20.8

1986 1990

15.8

0.6

15.8

0.5

13.1 1994

0.6

11.2

1.5 2.2

Year Fiscal revenue/GDP

Domestic debt revenue/GDP

The sharp decline in fiscal extractive capacity implies an increasingly lower macroeconomic regulation power of the government through fiscal means. But because the basic functions of governments at all levels in promoting economic

35

MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 2

development, sustaining social stability, and providing basic public goods and services must not be sacrificed, its capacity of absorbing resources from the financial system was emphasized. Under such a situation, the pattern of government financing underwent various changes. By comparing the first four changes with the last two, it will be clear that the size of fiscal financing was constantly shrinking and growing out of the control of the central government, while the financing scale of financial institutions was continuously expanding, leading to a weak treasury and strong bank.

Shrinking of central government revenue Central government revenue occupied an increasingly smaller portion in the distribution of fiscal revenue. In its fiscal reforms after 1978, the Chinese government implemented different forms of fiscal contracting throughout the country, where the central and (provincial-level) local governments negotiated an amount to be turned in to or granted by the central government which would remain unchanged for a certain period of time. This new fiscal arrangement broke the traditional vertical hierarchy of fiscal authority and replaced it with a horizontal organizational structure where local governments were responsible for their own revenue and expenditure, greatly arousing the enthusiasm of local governments in boosting their local economy. But on the other hand, the fixed submission quota restricted central revenue growth as would result from economic development. From 1984 to 1993, the share of central fiscal revenue in gross fiscal revenue descended from 40.5% to 22%, while this percentage stays around 60% in most countries around the world regardless of the fiscal system. Such a low extractive capacity of the central treasury not only inhabited the provision of public goods and services of the central government, but also induced the blind pursuit of partial, regional fiscal interests by local governments, which fostered regional protectionism, led to duplicate initiatives, and impeded the building of an integrated market and industrial optimization nationwide.

Rise of extrabudgetary and extra-establishment revenues Extrabudgetary and extra-establishment revenues took up a growing portion in the government revenue system, in comparison to budgetary revenue. Following the power decentralization policy, reforms were also introduced to delegate some of the budgetary revenue and expenditure responsibilities to departments in charge of the specific projects, thereby excluding these revenue and expenditure items from the government budget. Fig. 8.2 compares the trend of changes between

36

Large Treasury, Small Bank

budgetary and extrabudgetary funds. The rapid expansion of extrabudgetary funds motivated competent authorities to boost economic growth and raise revenue, but it also created dual performers of government activities, with both fiscal and nonfiscal departments exerting public authority to perform income distribution, posing the risks of confusing economic regulation and corruption. In addition to extrabudgetary revenue, there was also extra-establishment revenue, which was not covered in the management of both budgetary and extrabudgetary funds, but was directly controlled by government departments, public institutions, and social organizations. In general, extra-establishment revenue came from discretionary or contingent arrangements in short of a clear legal basis and therefore could not be accurately calculated. When the adjustments to the division between budgetary and extrabudgetary funds in 1993 slashed extrabudgetary revenue, the negative impact on the financing power of the related authorities was offset by the growth of extra-establishment revenue. It was estimated that the sum of extrabudgetary and extra-establishment revenues almost equaled the size of budgetary revenue.1 Fig. 8.2

Changes in budgetary and extrabudgetary revenues

% 40 31.2 30 20 10 0

9.6

1978

25.7

22.9

12.3

15.2

22.9 16.6

20.8 15.8 17 15.8 15.8 14.6 13.114.5 12.6 4.1

1980

1982

1984

1986

1988

1990

1992

1993

11.2 4 1994

Year

Budgetary revenue/GDP Extrabudgetary revenue/GDP

Reduction of government revenue from enterprise profits First, the power devolution and profit relinquishment to SOEs reduced the revenue that the government received from SOEs. In the era of the planned economy, SOEs were the dominant component of enterprises, and the requirement of all profits to be turned in to the government meant a 100% tax rate. After the Economic Reform, the government gradually replaced the SOE profit delivery system by income

37

MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 2

tax, eventually fixing the tax rate at 33%. At the same time, it also gave tax cuts to enterprises of other types of ownership, such as tax breaks to enterprises in Special Economic Zones, economic and technological development zones, and other specific areas, and tax exemptions or reliefs to three kinds of foreign-invested enterprises (Sino-foreign joint ventures, cooperative businesses, and exclusively foreign-owned enterprises) and township and village enterprises. In addition, imperfect business financial audit and supervision systems gave rise to inefficient tax collection, which was reflected in a lower actual tax rate than the nominal rate. This was equivalent to giving more tax reductions to enterprises. It was estimated that the actual rates of value-added tax (VAT), business tax, and custom duties were only 12%, 3.97%, and 2.74%, respectively, far less than their nominal rates.2

Gradual development of government debt financing The development of government securities started from scratch and made considerable progress. After 1978, the burden from fiscal imbalance ascended along with the power devolution and profit relinquishment to SOEs. To cope with this pressure, the Ministry of Finance first resorted to overdrafts from the central bank, but with the continuously rising price levels, the rapid growth of income from money creation posed increasingly larger risks of inflation. In 1985, the inflation rate surged to over 9%, which forced the government to consider other possible financing channels. At this time, the rising share of household income in national income created favorable conditions for the issuance of national debts. As a result, the government started to sell debts to enterprises in 1981. Two years later, in 1983, the subscription ratio between individuals and organizations was almost half to half, and after 1985, individuals rose to be the largest subscribers of government debts. This situation continued until the central bank initiated open-market operations in 1994. During this period, although the absolute size of government debts grew very rapidly, its proportion in GDP was still small compared to other financing tools.

Expanded control of the government over the financial surplus An increasingly large portion of the financial surplus fell into the hands of the government through loans to SOEs. The power devolution and profit relinquishment to SOEs intended to tilt the income distribution towards enterprises and households while promoting economic growth, which had the effect of propelling the growth of bank deposits and loans (see Fig. 8.3). Given that stateowned banks held the monopoly of the banking industry, the government, with its

38

Large Treasury, Small Bank

weak extractive capacity, naturally induced or compelled these relatively well-off banks to provide loans for SOEs and public projects. Therefore while in times of the planned economy, banks only made loans to enterprises suffering from insufficient working capital in production and circulation, due to the lack of fiscal funds, both the self-owned circulating capital and fixed-asset investment of SOEs came to rely on bank loans after the 1980s. Fig. 8.4 shows the trend of changes in the shares of budgetary investment and domestic loans in total investment in fixed assets. These changes, on the one hand, could increase the production of commodities in short supply and support the rapid growth of energy, transportation, and other undersupplied products, but on the other hand boosted the debt ratio of SOEs. By 1994, the overall debt ratio of the state-owned sector reached 73.61%. The huge debt repayment pressure became a major factor for the constant dwindling of SOE profits (see Fig. 8.5). Fig. 8.3 0 1978 1980

Bank deposit and loan growth 10

20

30

40

50

40 43

60

58 65

55

1986

77

51

1988

62

1990

70 73

1992 67 69

1994 Year

90 %

55 52

1984

80

52

45

1982

70

79 82

Deposits in state-owned banks/GDP Loans in state-owned banks/GDP

Source: Zhou Li, “Changes in China’s Fiscal and Financial Capacity during Reforms.”

39

MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 2

Fig. 8.4

Changes in the sources of fixed-asset investment

% 45

Investment from domestic loans/gross investment

40

Budgetary investment/gross investment

35 30 25 20 15 10 5 0

1981 1982 1983 1984 1985 1986 1987 1988 1989 1950 1991 1992

Year

Source: Wang Guogang, China’s Finance in the 21st Century, 124.

Fig. 8.5

Decline in SOE profits

% 30 SOE profits

10.6 10.6

1986

1985

1984

1983

1982

1981

1980

1979

1978

5 0

10.4 7.2 3.2 2.9 2.7 2.5 2.2 1994

13.2

1993

14.4

1992

15

10

14.9

14.4

1991

16.1

16

1990

15.6

1989

15

1988

20

1987

25

Year

Source: Wang Guogang, China’s Finance in the 21st Century, 131.

Enormous gain from money issuance The income from the issuance of paper money, also known as seigniorage, which in the past referred to the profit gained by the government from its monopoly over coinage under the now obsolete commodity monetary system, was enormous. As this income is generated on the basis of the government’s coercive power, it is somehow similar in nature to tax revenue. When commodity money was used, seigniorage could come from two sources: mintage costs paid to the coin producer and gains from the coin producer’s adulteration of money. Under the fiat system

40

Large Treasury, Small Bank

nowadays, the public no longer needs to pay the mintage cost, but as the central bank monopolizes the money issuance right, it always acquires a purchasing power equivalent to the amount of the newly issued money. Meanwhile, although fiat money renders adulteration largely out of the question, the government can still profit from the depreciation of government liabilities as a result of oversupply. These are the two major channels by which modern-day governments obtain their seigniorage. After the start of China’s Reform and Opening Up era, its booming economy and growing market share greatly increased the demand for money, which created the conditions for the government to earn income from money supply. Back then, there were three principal channels for monetary base creation, namely, loans from the central bank, fiscal overdraft and borrowing, and RMB position for foreign exchange purchases. The first two channels were manipulated by the government for investing in designated key industries or filling up fiscal deficits, thus can be regarded as direct government financing. Moreover, there were severe years of high inflation in China’s economy due to complex factors, which had the inadvertent effect of bringing the government a sum of inflation tax. Table 8.1 roughly estimates the rate of seigniorage between 1985 and 1993. Table 8.1

Year

1985

③ ② Monetary ① Monetary base GDP (CNY1 base balance increment (CNY1 billion) (CNY1 billion) billion) —

259.74

1,196.25

345.20

1986

1,020.22

1988

1.492.83

1987

1989

1990

1991

1992 1993

Seigniorage revenues, 1985–1993

1,690.92

1,854.79

2,161.78

2,663.81 3,463.44

307.93

414.36

—

—

—

6.5

4.9

1.7

69.16

–2.36

18.8

4.8

4.3

33.49

3.1

856.36

192.30

1,319.01

—

–1.60

37.27

109.82

964.52

—

48.19

524.18

664.06

⑦ ④ Inflation Increment tax rate = ⑧ in RMB ⑤ ⑥ (Previous year Seigniorage position Inflation = (③ ② × current rate = ⑥ for FX rate –④)/① year⑤)/ +⑦ purchases (%) (%) current Year (%) (CNY1 ① billion) (%)

139.88

10.50

10.61

62.87

108.16

–12.61

354.49

27.51

7.3

18.0 3.4

6.4

14.7

2.2

5.9

5.7

6.0

4.5 9.4

—

6.6

1.9

4.1

9.1

4.4

10.3

1.0

7.0

0.9

6.6

2.1

6.6

4.1

13.5

Sources: 1. Wang Guogang, China’s Finance in the 21st Century, 109;

2. National Bureau of Statistics of the People’s Republic of China, China Statistical

Yearbook, 2002.

Note: The inflation rate was measured by the consumer price index.

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MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 2

Second stage (1994–2007): Strong treasury, weak bank The above-mentioned changes created the pattern of “weak treasury, strong bank” in China’s government financing. This pattern did contribute to some extent to the sustainable development of China’s economy. Some scholars regard the decrease in fiscal revenue as an effort made by the Chinese government in pursuit of an optimal tax rate, and believe this effort was conducive to economic growth.3 But as the above analysis has demonstrated, this pattern also had its disadvantages. After all, the reform of power devolution and profit relinquishment to SOEs was just the first step of market-oriented reform. Although it spurred remarkable profit growth through liberalizing commodity prices and the market, as long as the government continued to hold an enormous responsibility for macro- and microeconomic activities, it would be compelled to retain a firm grasp over the financial sector in order to raise money for the vast array of government actions. This increased the difficulty of financial marketization and prevented the financial sector from playing its role of resource allocation, which would in the long run drag the growth momentum of the economy. To make it plain, the pattern of “weak treasury, strong bank” did not so much suggest a reversal of the situation of “large treasury, small bank” as the transfer of fiscal responsibilities to the central bank in response to the changes in the environment. Thus even though the status of the central bank might appear to have been elevated, in reality the central bank simply continued to trail behind the treasury. Economic development demanded the Chinese government to take the second step of adjusting the pattern of “weak treasury, strong bank.” Around 1994, when the drawbacks of the power devolution and profit relinquishment to SOEs outstripped its benefits, a new round of reform measures was launched. Although with different targets, these new reforms all meant to put right misplaced fiscal and financial functions. Below shows some of the important reform measures together with their significance. The six points are made in correspondence with those of the first stage. Apparently, there was a pronounced tendency of shifts of government financing channels from the financial system back to the fiscal system, resulting in a strong treasury and weak banking sector. The 1994 tax-sharing reform reduced the need for governments to manipulate the financial surplus of the banking sector, through increasing the central government’s share in tax revenue and allowing local governments to levy their own taxes. On the other hand, the asset-liability management system raised the capacity of commercial banks for resisting the lending requests of governments, thus helping the banking system extricate itself from its minor position.

42

Large Treasury, Small Bank

Tax-sharing reform The 1994 tax-sharing reform was devoted to solving the disadvantages of the local fiscal contracting systems by defining the scopes of fiscal expenditure responsibilities of local fiscal authorities according to their respective administrative powers and delineating the revenues between the central and local governments. It helped regulate government fiscal activities and, by enlarging the share of the central government in fiscal revenue increments, reversed the central government’s adverse position in fiscal distribution. From 1993 to 1994, the share of central fiscal revenue surged from 22% to 55.7% and ever since continued to hover around 50%.

Other tax reforms In addition to the tax-sharing reform, other adjustments were made to the taxation systems in 1994. Major programs included: (1) establishment of a turnover tax system centering on VAT based on the principles of justice, neutrality, transparency, and efficiency; (2) unification of income tax to eliminate the discrepancies between enterprise and individual income taxes; (3) reform of the tax collection system to demarcate the tax types and levying power of the central and local governments along the line of the tax-sharing reform with separate vertical management of central and local taxes. This last reform greatly improved the country’s tax collection efficiency and narrowed the gap between nominal and real tax rates without significant changes to the nominal tax rate. Tax revenue took up a larger share in GDP (see Fig. 8.6). Since 1997, the growth rate of tax revenue had surpassed that of GDP, triggering musings about the extraordinary growth in times of proactive fiscal policy. If we focus on the proactive fiscal policy implemented in 1998 as an expansionary one, we may indeed read the tax revenue growth as offsetting the expansionary effect. If we take a step back and observe the extraordinary decline of tax revenue between 1978 and 1994, however, the growth will then be understandable as a correction to the preceding plunge.

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MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 2

Fig. 8.6

Growth of tax revenue, 1995–2007

31.08

Tax revenue/GDP

%

17.04

16.00 20.94

15.49 19.09

14.81 13.50 15.14 20.72

14.81 15.26

14.16

12.84 17.78

12.07 15.33

19.16

11.16 12.49

10

10.55

15

9.85 14.44

20

10.10

25

17.77

30

21.62

Tax revenue growth

35

5 0

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Year

Improvement of budgetary management The surge of extrabudgetary and extra-establishment revenues boiled down to two factors. First, due to legacies from the planned economy, the line between government and market behaviors had not been clearly defined, which led to an overfunctioning government lacking funds for its expectant duties, thus having to resort to extrabudgetary and extra-establishment sources. Second, the line between the central and local governments in terms of revenue and expenditure scopes was also blurry, urging local governments to retain extrabudgetary and extraestablishment funds for their own disposal for fear that the central government would meddle in. The introduction of the concepts of “public finance” and “tax sharing” after 1994 offered solutions to the above two problems, respectively. In recent years, discussion of the tax-for-fee reform (shui fei gai ge 稅費改革 or fei gai shui 費改稅) has materialized into pilot projects in some areas. Once promoted nationwide, this reform will sharply cut down the size of extrabudgetary and extra-establishment revenues, and items considered to be reasonable government revenues will be included in the government budget, increasing the proportion of budgetary revenue in GDP.

Expansion of government securities issuance The amount of outstanding government securities accounted for 7.43% of GDP in 1994 but 22% in 2007. During this period, the most striking case was the issuance of long-term construction bonds worth CNY800 billion after 1998 to boost domestic demand.

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Large Treasury, Small Bank

Banking reform to reduce government control of the financial surplus In 1994, the government decided to separate commercial banking services from policy functions performed through banks, which facilitated the transformation of specialized banks towards commercial banks. The existing policy functions were entrusted to three policy banks. After that, the Law of Commercial Banks was passed to stipulate the asset-liability ratio of commercial banks in order to shift their operational focus to the safety, liquidity, and profitability of capital. In 1998, the central bank removed the loan limit on state-owned commercial banks, promoted asset-liability management and risk management, and weakened its control over their business. In addition to that, the central government also required that branches of commercial banks should not be set up in accordance with administrative divisions to avoid the intervention of local governments. While relaxing the control over state-owned commercial banks, the central government encouraged the diverse development of financial institutions, which constantly lowered the share of the lending increments of state-owned commercial banks in the aggregate loan increments of all financial institutions. This proportion exceeded 70% in 1997, declined to around 60% between 1998 and 2000, and further went down to 37.49% in 2007. This was also a reflection of the government’s weakened capacity to obtain resources through financial establishments.

Decrease in income from currency issuance Starting from 1994, the PBC stopped granting policy loans to industrial and commercial businesses, and the Law of the Central Bank passed in 1995 explicitly banned the Ministry of Finance from taking out overdrafts or issuing securities to the central bank, which cut off the two major channels from which the government had profited from money creation. From 1997 onwards, economic deflation caused the government to make losses rather than earn inflation tax.

Persistent Problems So far, the pattern of “large treasury, small bank” has not been fundamentally changed despite two stages of transition and shifts of power positions between the central treasury and the central bank. The banking sector, especially stateowned commercial banks, remains heavily subject to government policies, and is far from being an independent entity of the market economy. The root cause of this phenomenon is the control of the fiscal authorities over financial resources.

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MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 2

Such fiscal decentralization attempts as “eating from separate stoves” and the tax-sharing reform have on the one hand undermined the ability of the central treasury as the “large treasury,” but on the other hand encouraged local treasuries to control banks’ financial surplus. Under fiscal decentralization, local governments are held responsible for local economic growth, and the promotion mechanism for government officials gives them yet more incentive to pursue local economic growth. To this end, local governments must collect as much capital as possible for developing the local economy. Prior to 1994, local governments could directly intervene in the operations of state-owned banks through administrative means. This was nominally put an end to after the commercialization reform of state-owned banks, but local governments have got around by developing local banks which they treat as “cash dispensers” by acting as majority stockholders. They have the local banks provide loans to designated projects or businesses, acquire insolvent urban credit cooperatives, offer financial support to financially distressed enterprises, and repay government debts.4 Governmental intervention has aggravated the financial position of these banks, posing potential risks to the banking sector. According to the statistics from the PBC, by the end of June 2003, the total loan balance of 112 commercial banks in cities amounted to CNY652.39 billion, among which up to 16.53% (CNY107.81 billion) was nonperforming loans. In some banking institutions, the nonperforming loan ratio even went above 50%. More than 73% of banks made no profit or even turned up on the negative; over 50 banks, making up 45% of all urban commercial banks, recorded a cumulative loss; 22 banks were considered of high risk with 13 on the verge of technical insolvency.5 Even though the restraint on the profitability of state-owned commercial banks has been strengthened, local governments still have ample capacity to eat into the resources from the financial sector. This is because local governments control land, minerals, and other resources which are deemed by banks as most reliable collateral, thus attracting tremendous financial support for highly resource consuming and environmentally destructive infrastructure construction and redundant, poor quality development projects. The following recurring path is clear in China’s financial activities: government land control → attraction of financial resources → investment in capital-intensive industries → duplicate construction, industrial isomorphism, and investment overheating → macroeconomic regulation → overcapacity → bad debts in banks → accumulation of financial risks. This is best epitomized by the practice of “operating cities” (jingying chengsi 經 營城市) by market means as one would an enterprise, which has gained popularity among local governments in recent years. Among the most important capital resources that local governments hold is land, which they conveniently put up as collateral in exchange for loans to ease fiscal stress, stimulate economic growth,

46

Large Treasury, Small Bank

and support enterprises’ development. Apart from external investments, almost all taxes coming from urban expansion and land use, mainly the business tax, income tax and farmland use tax from building and real estate industries, were enjoyed by local governments. The increase in land prices as a result of “operating cities” brought local governments enormous income from land transfer fees. Induced by such an almost impeccable development model, local governments competed to build local financing platforms to absorb more capital. Liu Mingkang, Chairman of the China Banking Regulatory Commission (CBRC), said at the Second Economic and Financial Situations Analysis and Reporting Meeting in 2010 that by the end of 2009, outstanding loans in local financing platforms totaled CNY7.38 trillion, up 70.4% over the same period last year and accounting for 20.4% of ordinary outstanding loans; the new loans made through these platforms reached CNY3.05 trillion, making up 34.5% of all ordinary new loans. Statistics from CBRC indicated that by the end of May 2009, a total of 8,221 investment and financing platforms were established across the country with 4,907 located in counties. Comparing the debts of local platforms with the financial strength of local governments, the debt ratio was 97.8% and the ratio in some urban platforms even exceeded 200%. Behind this scene, it is not hard to tell that the fiscal behaviors of local governments still play a leading role in the credit operations of the banking sector. The accumulated financial risks resulting from those government behaviors would eventually have to be settled by the central treasury. Back in 1998, in order to enhance the risk resistance of the four major state-owned commercial banks, the Ministry of Finance issued CNY270 billion of special treasury bonds to recapitalize these banks. Furthermore, the interest of local governments in investment not only has an impact on the “fictitious economy” on the financial level, but also poses a threat to the real economy. Overcapacity will lead to insufficient domestic demand, and once a global financial crisis like those in 1998 and 2008 sweeps, economic growth will encounter severe challenges. In face of such a situation, the central government will inevitably have to relax its control over the banking system in order to expand domestic demand. During the period of proactive fiscal policy between 1998 and 2003, the Ministry of Finance issued CNY800 billion of long-term treasury bonds for infrastructure construction and technical upgrading in key industries, and at the same time, the state-owned commercial banks offered CNY2,200 billion loans to support the projects of the treasury bonds at the demand of the central government. In 2008, the central government announced a CNY4 trillion stimulus package, apart from CNY1,180 billion government investments of which was financed through bank loans. In 2009, the Ministry of Finance planned to create CNY5 trillion credit, but the ultimate credit size reached an astonishing figure of

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MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 2

CNY9.6 trillion. The consequence of relaxed government control over banks is spelt out: a vicious circle of local governments expanding investment → the real economy suffering from insufficient demand → the central government expanding domestic demand → banks offering supporting loans → local governments further expanding investment. Ultimately, the economy will be forced to the point of no return of sustaining high growth at low efficiency, as only by maintaining high growth will the nonperforming asset ratio of the banking sector appear smaller because of the increase in total assets; if the economy fails to keep its growth momentum for reasons such as a global financial crisis, RMB appreciation, wars, and social disturbances, both the real and fictitious economies will be in peril of collapse.

Conclusion Although the phenomenon of “large treasury, small bank” had resulted from the planned economy, it is still pertinent to the economy of today, only that the pattern of “large central treasury, small central bank” has evolved into “large local treasuries, small commercial banks.” The persistence of this phenomenon reveals that its roots lie not simply in the planned economy, but in the whole idea of government-driven economic growth, under which the leading role of the fiscal authorities in government financing will remain, whether the banking sector takes a larger share or not. In the six decades since the founding of New China, the central government dominated economic growth in the first half while local governments the second half, and they have shared a disposition towards giving precedence to economic accumulation over the improvement of people’s livelihoods. As long as the government continues to drive the economy with investment, it will never give up its control over the financial resources held by state-owned banks. Thus, if the pattern of “large treasury, small bank” is to become a thing of the past, the precondition will be for the government to shift its focus from promoting economic growth to ensuring people’s wellbeing, and leave the decisions on investment, consumption, savings, and other factors affecting supply and demand to the market.

48

9

Chapter

Loans for Appropriations

MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 2

To defuse the situation where every sector and enterprise fought for investment projects and depress the excessive demand for investment capital, the then State Planning Commission (now National Development and Reform Commission), the Ministry of Finance, and the then People’s Construction Bank of China (now China Construction Bank) jointly commenced a pilot project to substitute repayable government-backed loans provided through the People’s Construction Bank of China for direct fiscal investment grants in 1979. This reform measure was introduced to all investment projects funded by budgetary funds starting from February 1985 and lasted until 1988. It played an important role in not only depressing excessive investment demand but also enhancing investment returns.

Background and Implementation Timeline The reform of “loans for appropriations” was germinated in China’s effort to reform its investment and financing system. In the strictly planned regime where the central treasury played a leading role in capital allocation in the first three decades of New China up to 1978, capital construction projects were funded by nonrepayable budgetary appropriations gratis to the project owners while banks only offered settlement services and acted as a “cashier” for the government and enterprises. In fact, everything from investment decisions and project approval to fundraising and use of funds was decided by the central government, and enterprises and public institutions only worked according to state plans. As far as merits were concerned, funding capital construction with state funds helped raise the national savings rate and concentrate capital on key construction projects. In 1978, the Third Plenary Session of the 11th CPC Central Committee opened the prelude to China’s Reform and Opening Up era. It resolved to complete the “readjustment, reform, rectification, and improvement” of the national economy within three years. After a series of regulation measures, the economy began to pick up. However, as the deep-seated problem of structural imbalance could not be reversed in a short time, China’s economic construction faced severe difficulties and challenges, such as oversized and prolonged capital construction resulting from enterprises’ and public institutions’ strong desire to make investment, and the slow progress of industrial construction and industrial restructuring. As capital construction was hovering at a high level and administrative costs rose over the affordability of the central government, there was a severe fiscal deficit of CNY13.5 billion, accounting for 12% of the fiscal revenue (CNY115 billion). This was a large hit to the state’s traditional fiscal philosophy to keep expenditure within the limits of revenue with a sizable surplus.

50

Loans for Appropriations

In the three decades prior to 1978, SOEs had been required under the system of unified control over revenues and expenditures to turn over profits to the central government while receiving compensation for their losses. Fixed-asset investments in SOEs all came from fiscal appropriations, and besides a small portion of seasonal and provisional capital need for replenishing working capital which was satisfied by bank loans, regular working capital approved by the government was also paid by budgetary funds. This also implies that under the old system, the appropriation of fixed capital and working capital for SOEs required the treasury to essentially engage in their operational activities, such as approving their accounting statements, verifying their fixed-asset retirement, and charging for profits. That is to say, the government shouldered unlimited liability for SOEs. The greatest ill of the gratis grants for capital construction was that they crippled local governments, government departments, and enterprises from developing a sense of balancing economic input and output. It was common that enterprises competed for investment and projects in order to expand production, as they could readily “eat from the same rice pot” of egalitarian government provisions. This was a major reason for the serious waste and overextension in capital construction. As some construction projects failed to form production capacity or achieve any results in the long run, how to better use fiscal funds in capital construction to make higher returns became a matter of concern. In mid-1979, the State Council approved the report on substituting government-backed bank loans for fiscal appropriations in capital construction jointly proposed by the State Planning Commission, the Ministry of Finance, and the People’s Construction Bank of China. On August 28, 1979, the State Council transmitted their documents of Report on the Trial Measures for Providing Loans for Capital Construction Projects and Provisional Regulations on Providing Loans for Capital Construction Projects. These documents explicitly stated that the source of capital construction investments would be changed from fiscal appropriations to government-backed bank loans on a trial basis. Since then investment capital required for construction projects would be granted by the People’s Construction Bank of China in the form of repayable loans. This signified the beginning of the important reform of “loans for appropriations” in China’s fiscal and financial history. On November 12, 1980, the State Planning Commission, the Ministry of Finance, and the People’s Construction Bank of China decided to run a pilot of substituting government-backed loans for some of the state appropriations for potential tapping, innovation, and technical renovation which were originally granted by the State Planning Commission and the Ministry of Finance. On November 18 of the same year, the State Council transmitted the Report on the Implementation of Replacing Fiscal Appropriations with Bank Loans for Capital Construction. It stipulated that

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starting from 1981, for enterprises which had instituted an independent accounting system and were able to repay their loans, their investment demand for capital construction projects would be fulfilled by government-backed bank loans, if not satisfied with their own capital. That is to say, for future state capital construction projects, the government would no longer provide funds and proprietors would have to apply for loans from the Construction Bank with both the principal and interest repaid by themselves. Since 1980, the pilot project of “loans for appropriation” was gradually expanded to all self-financed enterprises. Compared with gratis appropriations, bank loans would improve the efficiency of capital construction projects. First, project owners would have to conduct feasibility research to judge the possible economic benefits on the basis of their own interests. Second, project owners would be obligated to strictly follow the procedure for capital construction, which would help the implementation of an investment contract responsibility system. Third, by linking borrowing, funds use, and repayment, this reform introduced a sense of strict budgeting to the project owners so that they would increase the efficiency of funds use. Fourth, this reform gave project owners greater autonomy in choosing their own design and construction companies through competitive bidding, which would in turn propel the latter to adopt advanced technology and scientific management to shorten the construction period and lower the costs. Fifth, project owners would be motivated to closely monitor construction, operations, and investment returns instead of allowing the projects to be constantly delayed, operational targets to fail, and projects under construction to snowball in scale. Sixth, project owners would cooperate with the Construction Bank to promote projects of common concern and share the responsibility of funds management and use. Simultaneously to the trial run of “loans for appropriation,” the Chinese government also introduced a reform to the financing method of SOEs’ working capital. In 1983, the State Council approved and transmitted the Report of the People’s Bank of China on the Unified Management of the Working Capital of StateOwned Enterprises. According to this document, starting from June 1, enterprises’ working capital would be supplied and managed by banks, and the government would no longer grant working capital gratis. Observing the effects of the pilot of “loans for appropriations,” the State Council confirmed in October 1984 that starting from 1985, state-invested construction projects would all be financed by repayable government-backed bank loans instead of fiscal funds, with differential or floating interest rates applying to different projects, project-based loan terms, and the possibility of repayment exemption for a handful of loss-making projects. Fig. 9.1 shows the timeline of the implementation of “loans for appropriations.”

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Fig. 9.1

Timeline of “loans for appropriations”

Pilot reform

Expansion of reform

Financing working capital with bank loans

Full-fledged reform

Coexistence of appropriations and loans

End of reform

Aug. 1979

Jan. 1981

Jul. 1983

Feb. 1985

Jan. 1986

Dec. 1988

According to the State Council’s October decision, on December 14, 1984, the State Planning Commission, the Ministry of Finance, and the People’s Construction Bank of China announced the Provisional Regulations on Replacing Fiscal Appropriations for All Capital Construction Investment with Bank Loans. This document stipulated that all government investment in the capital construction of enterprises and public institutions would be financed by loans from the Construction Bank instead of appropriations from February 1, 1985. The major provisions of this document included: 1. The competent department and project owners of loan-funded capital construction should follow the state-prescribed procedure for capital construction and implement an investment contract responsibility system in order to shorten the project period, reduce construction costs, improve project quality, increase investment returns, and ensure timely repayment of loans; 2. Investment in capital construction should be financed by the People’s Construction Bank of China based on state plans, and the Construction Bank at all levels should implement the state’s investment and credit policies to regulate capital demand, ensure capital supply, and supervise capital application; 3. Loan-funded capital construction projects should be managed through a hierarchy. The total investment and investment share of each department and region should be decided by the central government. Large and medium-sized projects should be arranged by departments under the State Council and local governments according to administrative relationships before finally being approved by the State Planning Commission. Small projects could be solely decided by departments under the State Council or local governments in accordance with administrative relationships; 4. The past financing channel of direct budgetary investment should be cancelled, and loan-funded capital construction projects should be included in both the Five-Year Plan and the annual capital construction plan of the state;

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5. Differential interest rates should apply, with the annual rate for projects of electronics, textiles, light industry, petrochemical engineering, and crude oil processing being 4.2%; iron and steel, nonferrous metal, machinery, automobiles, chemicals, forestry, electricity, petroleum exploitation, railway, transportation, and civil aviation, 3.6%; agriculture, water conservancy, animal husbandry, aquaculture, meteorology, national defense, coal, building materials, postal services, and energy conservation, 2.4%; longterm investment and high energy consumption in areas suffering from energy shortages, 12%. After a period of trial implementation, an amendment was made to the above Provisional Regulations concerning the provision about the arrangement for projects that would be unlikely to afford repayment. In December 1985, the Regulations on Adjusting the Scope of Replacing Budgetary Appropriations for All Capital Construction Investment with Bank Loans were released. Again, the Regulations provided that capital construction projects listed in state plans which had been funded by state appropriations and which had an ability to repay should be financed through government-backed bank loans, but it waived the principal and interest for projects which would not generate enough profits to repay the loans, possibly undertaken by scientific research organizations, schools, or administrative units. The exempted projects, however, should not be managed by the provisions of the “loans-for-appropriations” arrangement. The document thus made it clear that from 1986, state investment in capital construction in the budget should be listed under either “budgetary appropriations” or “budgetary loans-for-appropriations investments,” the scale of the two types of investment determined in state plans based on the government investment structure and orientation; projects financed by government appropriations and government-backed bank loans should be managed under separate accounts and must not be mixed up or diverted to other uses.

Details On the basis of the Provisional Regulations on Replacing Fiscal Appropriation of All Capital Construction Investment with Bank Loans of December 1984, the reform of “loans for appropriations” was promoted in all enterprises and public institutions across the country in February 1985, and then further adjusted by the amended regulations of December 1985. The general practice at that time was that competent departments and the Head Office of the People’s Construction Bank of China

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jointly decided the implementing measures for a particular industry. The details of the reform are as follows:

Scope and recipients of loans All capital construction and technical renovation projects that had been supported by budgetary appropriations were to be operated with government-backed bank loans. Major loan recipients or borrowers were the project owners. Based on the nature of the capital construction projects, potential owners of large and medium-sized projects, including the importing of new equipment, should apply for loans through their superior competent authorities, and potential owners of other production- and nonproduction-oriented projects, such as building affiliated hospitals or schools, should directly apply for loans themselves.

Loan policy and quantum After a capital construction project underwent feasibility research, had its design instructions, preliminary design, and cost estimation approved, and was included in the Five-Year Plan and annual plan of the state, the People’s Construction Bank of China would assign the annual loan quota to the provincial-level branch bank and the handling bank in accordance with the state plan for large and mediumsized projects made by the State Planning Commission. The project owner could then sign a loan contract with the handling bank based on the annual quota. In most cases, the banks must conduct feasibility research on the loan projects.

Loan interest The loan interest of these projects was calculated based on the differential interest rates for different industries fixed by the People’s Construction Bank of China. The Construction Bank would use the actual spending of the project to compute the compound interest. If the construction project was finished within the period prescribed in the construction plan, the interest would be repaid year by year together with the principal upon the project’s completion; and the interest of a project exceeding the schedule would be financed with the self-owned capital of the borrowing enterprise or its superior authority. After the completion of the project, its undertaker should count the loan interest of the construction period towards the fixed asset value, and had the whole sum transferred to the operator. To avoid readjustment, the accrued interest during the construction period was

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not considered when making the cost estimates and was excluded from the total investment size. When judging the investment efficiency of a certain capital construction project, only the expenses incurred during the construction period were counted.

Loan repayment and exemption The major sources of repayment were pre-tax profits and the surplus after fulfilling the contracted profit obligation. A number of projects were deemed as loss making as early as they were planned and would have no capacity to repay loans. For nonprofit-making construction projects undertaken by hospitals, research institutions, and administrative organs, for example (but not enterprises), the building of schools, hospitals, research and design institutions, training centers, and nursing homes for coal miners, as well as projects for disaster rescue, reconstruction, and geological prospecting, their loans were offered with no interest, and the project owners were also exempted from repaying the principal.

Limitations While the “loans-for-appropriations” reform did bring notable results, a series of problems were revealed during its implementation ever since the start of the pilot in August 1979.

Lagged reform of corresponding management measures The delay of corresponding reforms in the management measures on capital construction projects and materials supply prohibited the “loans-forappropriations” reform from attaining the expected results. The state capital construction plan continued to be made on an annual basis, although the “loansfor-appropriations” arrangements were project based; that is to say, projects listed in this year’s plan might not be relisted in the next year’s plan. According to a research study organized the People’s Construction Bank of China in 1986, there were many cases where the planning departments left loan-funded construction projects of the current year out of the next year’s plan, some excluding the “loansfor-appropriations” expenditure from the budget while forcing the Construction Bank to make loans with its own deposit. Consequently, projects were delayed due to shortages in loan capital. Worse still, the bank was often unable to recover the loans. Moreover, there were also instances where the investments provided for

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by the annual loan plan were inconsistent with the sum in the project-based loan contract signed with the bank, and since loans must be supplied according to the government plan, it was impossible for project owners to speed up the construction, causing delays and reducing loan efficiency. For many years, the materials supply of capital construction had been carried out strictly according to the state plan and on a provincial basis. The “loans-forappropriations” reform was not matched with sufficient adjustments in goods and materials supply. It was reported that steel, wood, building materials, and machinery that were used in the construction projects were in short supply. Inadequate materials supply and the mismatch between production and demand created resistance to the promotion of the reform. In the actual implementation of the reform, project owners had no autonomy in deciding design companies and construction contractors, as their superior competent authorities held the dominant say. It turned out that design quality and construction efficiency of the projects were usually very low due to poor management. Project owners were vexed by a domino series of foreseeable troubles: the design company’s constantly delaying design delivery, in turn affecting the construction commencement date; then the construction company’s missing the completion date, thus retarding the scheduled production and impacting loan repayment; and then the bank’s fine and default interest for late repayment. In fact, the reform of “loans for appropriations” simply changed the appropriation limit into a loan quota, making it little more than a varied form of grants. This reform also brought about conflicts between enterprises and fiscal authorities concerning loan repayment. For example, a radio factory in Shanghai had borrowed to build a new production line for color TV printed circuit boards, which turned out to be a huge success with the products falling short of demand. The products of the factory’s old production line, however, only had a low market share due to poor quality. Viewing the new production line as snatching away the profits of the old line, the fiscal authority demanded that profits should be turned over from the new line instead of the old, which however affected the loan repayment capacity of the new line.

Unclear economic accountability During the implementation of “loans for fiscal appropriations,” the handling banks actually had no money, held no power, and bore no responsibility. First of all, the capital for the loans made to the capital construction projects were allocated by the Ministry of Finance to the People’s Construction Bank of China according to the loan projects approved by the State Planning Commission, before

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being lent to the borrowing enterprises. After the production was put into use, the repaid loans would also be turned over to the Ministry of Finance. During this process, the Construction Bank did not function like a real bank but still acted as a cashier of the treasury. Next, as for the loan decisions, base-level banks were only responsible for investigating and reporting facts, and had no say in the final decision. Administrative means remained dominant. Last, since the lending decisions were made by the government according to the state plan, banks were not held accountable for any loan defaults.

Significance Through the “loans-for-appropriations” reform, the form of budgetary investment in capital construction switched from fiscal appropriation to issuance of government-backed bank loans. This change fitted the demands of the then Chinese Economic Reform by providing an important innovation to the capital construction investment system.

Strengthening of management over budgetary investment When capital construction was financed by fiscal appropriations, investment management ended as soon as the project was completed and transferred to the enterprise responsible for operations. Project owners were in charge of the use of state assets, and state investments were recouped by the profits and taxes turned in by the operating enterprises. The share of profits and taxes turned over to the state by the project owners hinged on the earnings of the enterprises, and there was no hard constraint on the amount. In fact, there was no correlation between the profits and taxes paid by enterprises and the investments. The state promoted the production and operations of enterprises by setting mandatory targets and the enterprises themselves lacked the initiative and motives to enhance efficiency. In contrast, when fiscal appropriations were replaced by loans, enterprises bore the burden of repaying both the principal and interest after using government investments, and thus had to be concerned about the economic benefits from operations. The management of government investment was no longer limited to the stages before the project was put into operation, but extended to the whole process until the funds were fully recovered and put again into production. In this way, a complete investment management cycle from investment to product output to capital recovery was formed. For enterprises, since government investments must be repaid with interest and the share of profits turned over to the state was directly

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linked to the size of the investment, they were propelled to strengthen management to increase efficiency. At the same time, for the regulators of government investment, as capital was invested in the form of loans which require value preservation and appreciation, they had to be cautious in investment decision making.

Repositioning of state-enterprise relations To determine the relationship between the state and enterprises and increase enterprises’ vitality occupied a core place in China’s urban-oriented economic reform. From the founding of New China to the late 1970s, China practiced a system with centralized planning, all-round fiscal contracting, unified materials allocation, and nondiscriminating labor remuneration. The state directly participated in the operations and management of enterprises. The profits and basic depreciation funds of enterprises were turned over to the central government, while investments in capital construction were directly appropriated from budgetary funds. Due to state monopoly, enterprises lost their vitality and motivation. Not only did enterprises compete for construction projects and government funding, but they also showed a desperate thirst for investment. Some government departments and enterprises even deliberately inflated or suppressed the estimated costs, resulting in a large batch of black-hole projects. Some project owners went so far as to conduct the project survey, design, and construction at the same time, leading to horrendous waste. Blind and repeated construction was common. A lot of projects kept dragging on and on and were constantly going over the estimate, and construction costs grew faster than investment increases. The initiatives to separate government administration from corporate management after the closure of the Third Plenary Session of the 11th CPC Central Committee gave enterprises greater autonomy in management. Along with this, the relationship between the state and enterprises in capital construction investment was also changed. Governments at all levels started to retreat from the direct operations and management of enterprises, and SOEs were transformed into legal persons assuming rights and responsibilities. The supply of capital construction funds was no longer gratis. Such a change in the method of government investment was justifiable considering the overall reform context. Meanwhile, the tax reform was enabling enterprises to retain a certain amount of after-tax profits and most of the basic depreciation funds, so they had considerable funds for renovation and development, as well as a stable source of capital for repayment of loans. Thus, enterprises were able to take full responsibility for the rights, obligations, and risks stipulated in the project contracts. There were also other reforms in

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capital construction management, such as reforming design contractors from public institutions into enterprises, linking construction workers’ pay to project output, practicing the repayable use of working capital, introducing a bidding and contracting system of capital construction projects, offering lump-sum settlement upon project completion, and enlarging the scale of market regulation in materials supply. These measures not only further adjusted the relationship between the state and enterprises in capital construction, but also created favorable conditions for the reform in the investment system. It was right because of the need to redress the relationship between the state and enterprises that their rights and responsibilities were clearly defined in the regulations for “loans for appropriations.” To encourage project owners to optimize investment returns and improve efficiency, specific measures of reward and punishment were stated. For projects implementing a contracting system, the investment surplus was left to the project owner, half for repaying loans, and the other half divided among the production development fund, the collective benefit fund, and employee bonuses at the ratio of 6 : 2: 2. In terms of interest payment, the regulations stipulated that interest incurred during the scheduled construction period should be repaid year by year together with the principal after the project was put into service; if the construction period extended beyond the scheduled time, borrowing organizations or their superior authorities should pay the interest with their owned capital. Interest incurred after the project was put into operation and paid within the stipulated repayment period should be paid with the increased profits from the projects; beyond the due date, the interest repayment should be made with the self-owned capital of the operating enterprise. If the project was completed ahead of the contract date, or if the principal and interest were paid off ahead of time with the enhanced returns or the enterprise’s owned capital, the saved interest could be retained by the borrower and withdrawn for developing production and giving bonuses to employees. On the part of the lending bank, the regulations also provided that if it failed to offer loans on schedule which affected the construction process, it should bear all possible losses arising therein; such an expenditure for damages could not be listed as operating costs, and must be paid with the bank’s retained profits. The establishment of economic relations between the state and enterprises, as well as the close connection of their economic interests, aroused the enthusiasm of the State Planning Commission, the Ministry of Finance, the People’s Bank of Construction, and project owners, propelling them to focus on increasing investment efficiency by observing their due responsibilities with awareness of the concepts of capital turnover, interest payment, and input-output balance. For the state, this broke the “big rice pot” of investments on which enterprises had

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depended and hence reduced the waste caused by irresponsible use of funds.

Facilitating reform of investment management and commercialization of the Construction Bank Investments in enterprises primarily went to their fixed capital and working capital. Since China initiated its Reform and Opening Up policy, there had been moderate reforms targeting the management of investment capital every year. For instance, the central government had required the People’s Construction Bank of China to enlarge its own investments in capital construction and technical upgrades on an annual basis, and local governments had asked the Construction Bank to raise more funds for developing the local economy and introducing new technologies. The Construction Bank thus had to improve the management of construction funds, expand credit, trust, and commission services while developing services for foreign-invested companies, reform the management measures for materials preparation funds and the system of project costs settlement, and broaden the supply channels of working capital loans. The above reforms exerted profound impacts on the functions of the People’s Construction Bank and strengthened its role as a commercial bank. But it was owing to the pilot reform of “loans for appropriations” that the People’s Construction Bank of China was formally recognized as a financial institution directly under the State Council in 1979 and gradually took on the functions of a commercial bank. Since then, the management of enterprises’ construction funds was transferred to the Construction Bank. By holding the bank accountable for the operating profits, the new arrangement motivated the bank to reform to its internal organization and the financial management system and improve its investment operations and management skills. In this way, the reform of “loans for appropriations” paved the way to the People’s Construction Bank’s evolution into a commercial bank. After the Construction Bank was upgraded into an institution directly under the State Council in 1979, it was approved to further change into a specialized national bank, responsible for managing capital construction investment and performing independent operations and accounting in May 1983. More importantly, this reform enabled the Construction Bank to provide loans for capital construction and working capital with its own capital apart from handling funds allocated by the Ministry of Finance. By the end of 1993, the loans made with the bank’s own deposits reached CNY430 billion, 33 times larger than at the beginning of the reform.

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Evaluation The reform of “loans for appropriations” initiated in the 1980s made notable improvements in enhancing the investment decision making of project owners and the Construction Bank, optimizing the efficiency of the use of fiscal funds and construction capital. This reform, however, did not fundamentally resolve the conflicts in investment decision making and funds management. After the reform, SOEs’ impulse to make investment remained strong. In the same manner that they had been eager to secure fiscal appropriations, they now wished the bank to provide them with as much loan money as possible with little regard for their repayment ability. In fact, as the capital construction projects to be financed by loans were stipulated in the state plan, the first thing for the Construction Bank to consider when issuing loans was not repayment ability but the state plan, making these loans not bank loans as they are commonly understood. There was a huge discrepancy between the expected effects and actual outcome of the reform. It failed to truly change the nature of government investments from nonrepayable to repayable funds and thus could not straighten out the problems with obligations, rights, and benefits in capital construction investment. One fundamental cause was that loans to construction projects were first allocated to the competent authorities in the central government according to the state plan for their transmission to their subordinate units in charge of the projects. As the competent departments were not responsible for repaying loans, they gave little thought to loan repayment, and thus many loans were distributed to project owners with inadequate repayment ability. Another limitation was the running of government-backed loans within a planned regime, which dictated that state plans would always supersede nominal feasibility studies. Departments, institutions, or enterprises undertaking capital construction were instructed to apply for capital construction investment loans from their superior authorities instead of the Construction Bank, which was virtually left out of the process of state investment planning. Since the feasibility research had to be done after the investment plan was confirmed, the bank could not be liable for defaulted loans. As a result, the reform brought about new problems while leaving many old structural issues untouched; for example, the interest expense increased the construction costs and expanded the scale of budget outlays. In view of the problems arising from the reform, the State Council decided to set up a central capital construction fund in 1988 in order to ensure a stable source of funding for key national construction projects. By then, the practice of “loans for appropriations,” which had been implemented for nearly a decade since its first pilot in 1979, came to a stop. The Capital Construction Fund was primarily

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derived from the following sources: the central government’s share of the fees levied for the State Construction Fund for Key Energy and Transport Projects; the central government’s share of the construction tax; the portion of income from the Ministry of Railways’ project contracting reserved for budgetary capital construction expenditure; the principal and interest recovered from the budgetary investments on projects under “loans for appropriations”; and fiscal allocation. The Capital Construction Fund was to be managed by the China Development Bank according to the state plan, and the funds should be earmarked for fixed purposes with the income and expenditure clearly listed in the fiscal budget. It was also prescribed that at the year’s end, the outstanding balance could be carried over to the next year. Funds were appropriated to the China Development Bank by the Ministry of Finance. The Capital Construction Fund was divided into the two parts of operational and nonoperational funds. The former were allocated by the State Planning Commission to national specialized companies for financing key projects for developing infrastructure and basic industries. The latter were mainly used to fund the construction projects directly organized by central government departments in the areas of culture, education, public health, scientific research, and flood control on major rivers. Operational funds were further divided into “soft” and “hard” loans: soft loans directed to the country’s policy-oriented investments, and hard loans to projects with good repayment ability. Moreover, provincial- and subprovincial-level divisions were allowed to set up their own capital construction funds based on their financial capacity, and specific arrangements should be made by the Planning Commission of the same administrative level. The State Council also approved the setting up of six investment companies in the areas of energy; transportation; raw materials; electronics, machinery, light industry, and textiles; agriculture; and forestry. These state-owned investment companies practiced independent accounting and performed the functions of holding companies. While taking charge of the country’s policy-oriented investment, they had to ensure capital recovery and appreciation. In hindsight, the failure of “loans for appropriations” in developing into a fixed-asset investment model primarily lied in its institutional defects, which in many respects went against modern economic and financial theory. First, this arrangement confused the distinctions between investment and borrowing and between investor and creditor. Modern firms often raise funds through two channels: equity investments and debt financing. Equity investments are the money contributed by stockholders, the basic guarantee with which firms develop business, repay debts, and take out loans. They also form the basis of stockholders’ corporate ownership and limited liability to the company’s debts. It is most natural

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for the state, as the owner of solely state-funded enterprises, to finance the capital construction of these enterprises; to have SOEs finance capital construction solely by borrowing and yet take no responsibility for their losses while demanding them to turn in profits and repay debts on their own clearly run against modern corporate management theory and economic principles. Second, the provisions for “loans for appropriations” took no account of the capital source of loan repayment. All the capital construction investment projects undertaken by SOEs were as designated in national or local government plans. Some of these projects were not profitable, and even for the more profitable ones, the after-tax profits would be low given the 55% income tax rate and additional regulation tax. The heavy tax and profit delivery burden impeded the capital accumulation of enterprises, thus lowering their ability to repay loans. In fact, most of the enterprises could not afford even the interest and had to take out extra loans to cover it. The “loans-for-appropriations” reform created a large number of heavily indebted SOEs, many of them capital-less. The dire financial straits of SOEs ran on despite successive reforms to tackle the legacies of the planned economic regime. After the Asian Financial Crisis struck in 1997, it was estimated that the aggregate liabilities of state-owned industrial enterprises with independent accounting added up to CNY3,831.5 billion, and if calculated with the then one-year lending rate of 8.64%, they would have to pay a total of CNY331 billion, 7.7 times the aggregate enterprise profits and 1.14 times the sum of taxes and profits delivered to the state. The outbreak of the financial crisis sounded the alarm for China; therefore from 1997 onwards, a series of radical reforms were launched to accelerate the transformation of the state-owned banks towards commercial banks. As the banks adopted a credit responsibility system that hardened constraints on SOE-borrowers and the government stopped injecting capital in SOEs, leaving them with no new financing channels to replenish their capital, the long-masked problems in China’s SOEs began to reveal themselves. Due to SOEs’ poor credibility and the general lack of new financing channels, losses that had been rolled over materialized and the total losses skyrocketed. The reform of “debt-to-equity swaps” implemented in the 1990s was very much a remedy to the negative impacts of the practice of “loans for appropriations.”

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Chapter

Credit Difference Contracting

MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 2

Introduction A system to manage credit funds, “credit difference contracting” (xindai cha’e baogan 信貸差額包干) was conceived to reform bank loan issuance to meet the needs of the new economic and financial regimes under the Reform and Opening Up policy. The system lasted six years from 1979 to 1984, run as a pilot bridging the transition from centrally planned credit quotas to market-based loan supply by granting bank branches some degree of autonomy over lending decisions. Given its experimental and transitional nature, it was terminated to make way for a fullfledged market-oriented credit management system in 1985. The credit difference contracting system was one of the 10 initiatives proposed at the meeting of branch managers of the PBC in February 1979 in order to smooth the progress of Socialist modernization. The summary of the meeting noted: At present, all deposits taken by banks at all levels belong to the head office, to which loan funds are made on request. This practice works against the incentive of local banks as well as the acceleration of credit funds turnover and the rational and fugal use of credit funds. From now on, the credit plan management system shall be adjusted to, under the maintenance of centralized and unified bank business, implement the measures of “unified planning, hierarchical management, pegging deposits to loans, and contracting credit differences” (tongyi jihua, fenji guanli, cundai guagou, cha’e baogan 統一計劃，分級管理，存貸挂鈎，差額包干). Right after that, the bank hosted a seminar on the reform of the credit funds system in Xi’an, where the system of “contracting credit differences” was proposed. It was first experimented in six provincial-level districts including Shanghai, Jiangxu, and Shaanxi. The pilot was soon expanded, and in 1981, the credit difference contracting system was implemented nationwide. The above-quoted policy slogan sums up the major features of the system: 1. Unified planning: Local banks were to prepare their own credit difference — “difference” referring to that between loans and deposits” — plans following the head office’s unified provisions. The head office was responsible for maintaining the overall balance and centrally approving the “differences” to be observed at local levels. 2. Hierarchical management: This describes the scopes of responsibilities and authority of bank branches over the sources and use of credit funds under unified state plans. The head office alone occupied the top tier, the second

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tier comprised the branches of specialized banks and the PBC, and at the third tier were institutions governed by the main and branch offices of specialized banks. 3. Pegging deposits to loans: The idea of “credit difference” was, as mentioned, to link the amounts of deposits and loans. Where deposits exceeded loans, the difference was called a “deposit surplus”; vice versa, it was known as a “loan surplus.” Any deposit surpluses had to be turned over to the head office, and the head office would cover all loan surpluses. 4. Contracting credit differences: Where there was a “deposit surplus” at the time of assessment, this amount must be maintained during the contract period, while where a “loan surplus” was the case, the amount must not be exceeded during the contract period. Therefore, within the credit difference plans, banks having accumulated deposits that exceeded the minimum could issue more loans, while banks failing to attract enough deposits and recover enough debts would have to cut lending. In other words, the “deposit surplus” of a region equaled the quantum that bank branches of that region would turn over to branches of the next higher level, while the “loan surplus” of a region the funds that branches of that region would receive from their superior branches. At a provincial level, the generation and use of regional income would never correspond; for example, there would always be discrepancies between the revenue delivered to the central government and central appropriations as well as the net inflow and outflow of materials, and the credit difference provided a general reflection of these gaps. In terms of money supply, a credit difference signified either the net input or net recovery of money. The intricate relationships among regional currency in circulation, material inflow and outflow, and fiscal funds can be written as:1

Regional credit

(+) = Regional currency in circulation (+) (--) (--) + Regional material

Outflow (+) Inflow (--)

+ Net fiscal

Appropriations (+) Delivery to state (--)

To balance deposits and loans at a national level, the PBC head office determined the total permissible credit difference for individual regions, allowing provinciallevel major branches and county-level branches discretion as to how to manage their credit plans provided that they did not violate the central credit difference contracting plan and short- and medium-term equipment loan target. There were

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two types of contracts: “major contracts” (da baogan 大包干), total contracting of deposits and loans as in Guangdong and Fujian; and “minor contracts” (xiao baogan 小包干), partial contracting of deposits and loans as in other provincial regions. Guangdong and Fujian were given special treatment in accordance with government policy, in order to keep pace with the reform in economic structure in the two provinces. Under the “major contracts,” the contracted credit difference would remain unchanged for three years once ascertained, and the bank branches could make their own arrangements about short- and medium-term equipment loans within the limits. They could extend additional loans if deposits were sumptuous so long as they could guarantee sufficient funds for savings withdrawal, working capital, and acquisition of agricultural sidelines. For the “minor contracts,” the credit difference was assessed on an annual basis, and excess deposits could only be used to issue working capital loans as permitted by government policy, but not short- and medium-term equipment loans. Leading groups were established at local levels to coordinate among departments within banks. Although the planning department took charge of the planning and delegation of funds, it was the credit department that would be most familiar with the actual loan demand, while the savings department played a supportive role in lending. Compared with credit plans, deposit plans were harder to devise. Local banks thus set up analytical systems to help track the incoming and usage of funds, working out patterns through monthly, seasonal, and annual overviews and inspections. To fulfil the contracted difference, local banks started to take more initiative to attract deposits and improve efficiency. In a way, credit difference contracting allowed funds to be shifted between projects and bank branches, regions which were short of funds to be compensated, and regions with ample funds to extend more loans within a coordinated framework.

Institutional Backgrounds From the Economic Reform in 1979 onwards, the economic regime started to transition towards a planned commodity system. The practice of “unified control over deposits and loans” (tong cun tong dai 統存統貸) became increasingly incongruous with the new economic structure, which demanded the development of a new credit funds management system. At the same time, in the area of financial development, the PBC-dominant monobank system began to shatter, paving the way for more power delegation in handling credit funds.

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Economic regime The planned regime under which the central government governed all economic activities by instructions meant that the supply and demand sides were not connected by the market and resource allocation was determined by artificial rules. As the inherent limitations of centralized planning in information collection and incentive provision inevitably led to economic inefficiency and goods shortages, the Chinese leaders pinpointed power devolution and relinquishment of profits in favor of SOEs as the principal direction of economic reform. The major rural program was the household responsibility system, while in urban areas, a series of initiatives were launched to streamline bureaucratic structures in SOE management, allow SOEs to retain part of their profits, especially the increased profits, and expand SOEs’ autonomy in determining prices, allocating wages and bonuses, and utilizing capital. The devolution of financial power to SOEs necessitated the extension of corresponding autonomy in lending decisions to commercial banks, which held more immediate information over borrowers. Were the central bank to hold fast to decisions on credit size and structure, efficiency would be doomed. In the shift towards a commodity regime, the economy became increasingly monetized, bringing new changes to credit relationships. As SOEs developed towards independent entities and other types of enterprises began to emerge, demand for loans increased, giving rise to credit forms other than state-bank credit — bank credit as equivalent to state credit under an economic system in which the state dominated both the supply and demand sides — such as commercial credit and personal credit. Even the rural economy was moving away from a natural economy, its trends of commodification and monetization recognized by the approval of the Agricultural Bank of China as the first bank to split off from the PBC. While state-owned banks remained an important source of financing, extending loans on behalf of the state, the state could no longer represent both the supply and demand sides, which rendered the management of credit funds through central plans impractical. A credit funds management system allowing more flexibility and autonomy was necessary. At the same time, power devolution and decentralization reshuffled national income distribution. The slippage in government revenue and increase in government expenditure resulted in a fiscal deficit, while the share of enterprise and personal income grew, causing an expansion in the proportion of private deposits against that of government deposits in state-owned banks. SOE and personal savings thus became a more feasible source of funds for supporting SOEs, and state-owned banks started to take the place of fiscal authorities in extending financial support to SOEs according to the state’s preferences.2

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It was with these two factors in mind that the reforms of credit funds management beginning in 1979 revolved around incentivizing savings and granting more autonomy in lending decisions to state-owned banks, and credit difference contracting was the first initiative.

Financial regime A financial regime is derived from the real economy, which determines its nature, structure, and efficiency. It is but one of the many systems under a state’s overarching economic policy. From 1949 to 1978, the banking system was highly centralized and unified with the PBC doubling as central bank and commercial bank, singlehandedly commanding money and loan issuance. There was no autonomy in the financial structure. Basic financial activities, mainly money lending, passively followed state production plans. Deposits taken at local levels were centralized, while loans could only be issued within a prescribed loan limit and designated scope. There was no financial market to speak of, as all credit activities were centralized by the PBC and the government was the de facto supplier and demander; therefore interest and exchange rates played no regulatory functions, and money was no more than a tool for allocating resources according to state plans. The credit difference contracting system was introduced to relax the centralization of credit funds in order to meet new financing demand arising from the transition towards a commodity economy, which encouraged enterprise and individual production and consumption decision making based on the principle of optimality. As it was a transitional period, the system had yet to be totally marketized. The PBC still unified the preparation of credit plans albeit permitting flexibility in loan issuance provided that deposits surpassed the designated minimum, and the newly established specialized banks were still linked with the PBC in capital settlement through an interbranch (lianhang 聯行) system.

Credit Funds Management before 1978: Unified Control over Deposits and Loans Prior to 1978, the PBC was at the same time the state financial regulatory authority and a state bank operating financial services, monopolizing the functions of the central bank and commercial banks. Asset-liability management took the form of unified consolidated credit plans under which deposits and loans were separately managed at the national level (quan dai fenli, tong cun tong dai 存貸分離，統存統貸). Conforming to the highly centralized planned economic system, the management

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of credit funds had to be governed by central plans. Not until the economic regime was reformed would corresponding changes be introduced to the credit funds management system. Before the implementation of credit funds contracting, the credit funds management system had evolved in three stages within the planned economic framework.

Establishment To unify financial and economic policy, the State Council issued at the beginning of 1950 the Decision on the Practice of Cash Management in State Organs, designating the PBC as the state’s cash control authority responsible for formulating consolidated cash plans. The PBC thereby took charge to establish the state treasury, centralize deposits, and flexibly control funds, preliminarily unifying the state’s cash receipts and payments. In October of the same year, the PBC head office set out to devise the bank’s receipt and payment plan in accordance with the State Council’s Measures for Formulating the Money Receipt and Payment Plan. In September 1952, managers of the PBC’s major regional branches adopted the Draft Measures of the People’s Bank of China for Formulating Consolidated Credit Plans, which provided for details such as the procedures of the formulation and approval of credit plans, system of target management, and system of inspection. The first set of measures on credit funds management thus came into shape.

Reinforcement The 1st Five-Year Plan commenced in 1953, requiring further strengthening of planned management and centralized leadership over credit funds. During this period, the method of “financial netting credit funds management” (caiwu shouzhi yacha xindai jihua 財務收支軋差信貨計劃) — basically determining the credit limit for an enterprise based on the difference between payments and receipts in its financial plan — was in place for a time, as was the practice of hierarchical separate account management of central industrial and commercial enterprises by competent government departments and banks. In general, all deposits taken by the PBC were placed at the disposal of the head office, which would delegate loans according to the centrally planned target. Strict controls were imposed on the deployment and quantum of loan funds, with unified control over deposits and loans forming the foundation of credit funds management.

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Fluctuation During the age of exorbitant growth over the 2nd Five-Year Plan period, a bout of decentralization took place in fiscal funds management, as in other areas of governance. Apart from the central government’s deposits and the loans of central enterprises which remained within the scope of authority of the PBC head office, the management of all deposits and loans was devolved entirely to local branches; for agricultural loans, credit differences became the only means of control. The PBC went as far as to publicize the economically irrational slogan, “Supply whenever funds are needed. Provide wherever funds are asked for. Give however much funds are demanded.” (甚麼時候需要，甚麼時候供應；哪裏要，哪裏給；要多 少，給多少。) To redress the consequences, in March 1962 the State Council issued the Decision on Strengthening the Centralization of Banking Management and Strictly Controlling Money Issuance. In February 1963 the PBC’s Provisions on Several Issues Concerning Credit Plan Management ensued, centralizing the money issuing power and bringing hierarchical separate account management under centralized leadership, with the aim of emphasizing planning and more stringent management. Back then, dual management over the formulation and approval of credit plans by competent departments and banks continued. Later, the PBC found this practice too rigid and decided in April 1965 to slightly expand local banks’ power in managing credit plans. However, the Cultural Revolution soon shook the ground of credit funds management; therefore in 1972, the central bank implemented the new Measures for Credit and Cash Plan Management to reinstitute controls. Generally speaking, the unified control of deposits and loans was founded on the PBC’s centralized governance and financial management structures. Under this framework, branch banks were obligated to transfer all deposits to branches of the next higher level, eventually the head office which held the central deployment of funds. The head office then set a total loan ceiling, with targets for branches of each level approved and devolved along the top-down hierarchy. Local branches must strive to attain the deposit targets and not lend beyond the loan limit without approval. Central plans were largely mandatory instructions directly imposed and adjusted by administrative means. During this period, the PBC was the only legitimate credit creator; alternative forms of credit were absent. Enterprises took out loans according to their own approved plans. Local banks had no autonomy, a credit market was nonexistent, and interest rates had no substantial influence on the cost of funds. This highly centralized credit funds management system was flaw ridden, but the three

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decades of experience, with all the identifiable weaknesses, proved to provide the impetus for reforms after 1978.

Debates about the Credit Difference Contracting System After its implementation, there were three streams of opinion regarding the credit difference contracting system within the banking industry: those who supported it as a resolution to existing problems in credit plan management; those who opposed it for causing the PBC to lose its guiding and controlling role over loans; those who held it as a more advanced yet imperfect system. Soon, the PBC would reform its credit funds management system based on the experience of credit difference contracting.

Support The supporting opinion heralded the credit difference contracting system for affording local banks autonomy, which had the following advantages: First, by linking loans to deposits, it incentivized local banks to attract deposits. In the past, having no power of disposition over funds, local banks had no incentive to expand deposits. They could simply apply for additional credit funds in case of shortages, making loans generally larger than deposits. The new system transferred to local banks some power of disposing of their intake and hence the associated obligation of taking deposits. Second, expansion of local banks’ autonomy in utilizing funds resulted in more flexibility in credit funds usage. The control of credit funds under the system of unified control over deposits and loans was as rigid as to set limits by loan type, such that funds for industrial loans could not be transferred to commercial loans, for example. Such distinctions might not reflect realistic needs, and would often lead to the stagnation or waste of funds. The provision for flexible use of funds under selfbalance in credit difference contracting was more realistic and allowed more timely support for production and commodity circulation. This enabled banks to issue more diverse loans than the umbrella “industrial” and “commercial” categories, such as to individually owned businesses, tourism, and culture, education, and healthcare services, in turn providing added impetus for taking deposits. Third, the new system improved the business standards of banks. Bank branches under the old system, which could only follow instructions, were functionally more “cashiers” than banks. They issued loans to any party which met the eligibility requirements of the central credit policy without business concerns, as they could

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always rely on the central bank for fresh cash. Credit under credit difference contracting became more complex, which forced banks to start minding their own balance sheets. As a result, management systems such as position reporting, information accumulation, and registration of large deposit holders were basically established, with banks learning about changes in the sources and utilization of funds. The credit difference contracting system also fostered interdepartmental collaboration within a bank.

Oppose The opposing opinion cautioned that money and credit would get out of hand with the lifting of the loan ceiling. As loans had to be issued through cash or deposits, they would affect the currency in circulation. While the credit difference contracting system could control loans on the basis of deposit growth, four types of deposit growth could not be counted on as a sound basis for loan issuance. First were deposits caused by an excess distribution of national income, in which part of the growth was not insured against a material increase, as these savings were formed by yet-to-realized purchasing power. Second were deposits from the PBC head office’s overdraft from the Ministry of Finance in the face of funds shortages after it relinquished deposits from local banks. While local banks indeed had sumptuous deposits on which to base in making loans, the failure to account for the PBC head office’s needs led to an increase in money issuance. Third was the deposit growth directly contributed by loans. As the PBC was the money issuer as well as moneylender, the case was not necessarily “more deposits, more loans” but the contrary. Associated with this was the problem of derivative deposits, where loans were credited to borrowers’ deposit accounts. Fourth were funds not covered by the credit difference contracting system, which might be drawn into projects prescribed by the system as deposits.

Support while calling for further reforms The third opinion argued that credit difference contracting would not lead to an uncontrollable expansion of loan size and money in circulation as long as the central bank did not increase money and loan issuance. It also believed that the industry’s loan policy and principles which stressed a correspondence between money and its material basis would be able to constrain loan issuance. As far as derivative deposits were concerned, this opinion held, the problem was not imminent as the majority of bank accounts were combined accounts of deposits and loans.

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Moreover, there would not be duplicate loans because of the requirement for a material basis in borrowing. The concerns of this stream of opinion were not that the credit difference system was too relaxed, but rather it was not radical enough. To begin with, it criticized the hierarchy in contracting as lacking flexibility. As the loan quota was pegged with the deposit intake per administrative division, the flow of funds was regionally segmented. The lower the banks in the hierarchy, the less credit funds they could get hold of. It was also harder for lower-level banks to control the credit difference, which impeded them from extending loans even when they held enough deposits. Another limitation of the system was the frequent reassessment of the credit difference, which took place annually for the “minor contracts” implemented nationwide. This added to the concerns of local banks and paralyzed them from making long-term plans. An aspect that could dissuade deposit taking was that banks could also maintain self-balance by taking less deposits and issuing less loans. Moreover, determining a branch bank’s credit plan based on its share of the region’s deposit-over-loan difference at the end of the previous year committed banks with large deposits in the past year to increasing deposits a great deal in the coming year. The difficulty deterred incentive for taking deposits. In reflection of the utilization rate of cash use, the PBC head office also assessed a midyear difference, which was more generous than the difference by the end of the year. But the assessment of both differences was not scientific. The expanded midyear difference tended to be difficult to offset towards the end of the year, making it hard for banks to issue short- and medium-term loans after midyear. As for the year-end assessment, it only considered the accounts of the year-end day, leaving room for banks to play around account figures of that day alone. In this way, the credit difference could be reduced to naught. The use of credit differences as the yardstick for credit funds management was not ideal also because the connection between the size of the credit difference and the actual profits from lending was loose. None of the economic indices set to evaluate banks’ performance was related to credit difference contracting. Nor was there any tie between employees’ economic gains and the credit difference. Last and most importantly, the credit difference contracting system did not fundamentally alter the system of central funds supply. Specialized banks still shared an interbranch with the PBC, which allowed them to continuously obtain funds from the PBC. When the credit difference was surpassed, local bank branches could apply for additional grants from their superior branch, while head offices of specialized banks could borrow from the PBC.

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Example Cases of Local Credit Difference Contracting For a general grasp of the actual implementation of credit difference contracting at the local level, a few typical cases from local PBC branches, all except one in Zhejiang, are quoted below.

Pingyang County branch The Pingyang County branch carried out the program by setting up a five-person operations management group comprising the branch’s manager and heads of the planning, credit, accounting, and savings departments to lead the implementation of credit difference contracting in April 1980. According to its own report, the duties of the group were to examine and approve the submitted annual and seasonal credit plans; determine the monthly targets for the credit plans of each department according to the balance plan of the next-higher-level branch and shift funds around in the course of execution; and inspect and analyze the execution process of the plans and propose improvement measures for problems discovered. Each department was charged with a specific area of responsibility: fiscal deposits for the accounting department; urban deposits for the savings department; deposits from government departments other than the fiscal authority, and other organizations and groups for the planning department; and the preparation, execution, and inspection of enterprise loan plans for the industrial and commercial credit department. The planning department also oversaw progress reporting, the overall implementation of the system, and the daily operation of the management group. Accountability was ensured by an organization structure with all departments reporting to the management group, which in turn had to be responsible for the bank’s business performance and the plans they approved. 3

Shaoxing County branch The Shaoxing County branch opted to keep track of changes in deposits by periodic investigations and set loan periods and terms based on seasonal credit plans submitted by enterprises. A year into implementation, the bank evaluated: Changes in deposits were rather hard to grasp, the plans of which turned out to be less precise than the credit plans. However, as long as we strengthened investigation and study, constantly analyzing the changes, it was still possible to devise good plans. We have set up large depositors’ registration

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books which we analyzed every five days. Among them, there were 90 industrial parties, 282 commercial parties, and 83 government department and organization parties. Although these parties only made up 25% of total depositors, their deposits accounted for 70% to 80% of total deposits. Understanding the reasons for the increase or decrease of and development trends of these deposits allowed us to grasp the basic trends of movement of all deposits, which provided the basis for creating our plans. Comparatively, loan plans were more accurately observed as it was an “active service” for the bank. While deposit plans had an accuracy of 88%, the accuracy of loan plans was 96%.4

Hangzhou branch The Hangzhou branch reported improvements in deposit intake. Noting the rapid development of urban collective enterprises and growth of extrabudgetary funds from unions and Party organizations, it encouraged the opening of new deposit accounts. In 1980 and 1981, 1,935 accounts were opened, among which 545 came from collective industrial and commercial enterprises and 898 unions, Party organizations, and agencies in residential areas. In terms of deposit amounts, there was an increase of CNY41,700, or 51%, over the previous year in 1980, and then CNY34,300, or 28%, in 1981.5

Huangpu District office It is also worth looking at the hurdles faced by the Huangpu District office of the PBC in Shanghai, the more developed municipality neighboring Zhejiang. The branch was critical of the stringency in the pairing of deposits and loans, which obstructed the making of lending decisions. Zhou Jingdong from the bank described how the credit difference quota had precariously fluctuated with deposits: For example, one day in February, deposits at the Huangpu Regional Office suddenly fell, with the submitted deposit funds falling to merely CNY800,000 above the minimum target, and given the present practice of combined deposit-and-loan accounts for commercial loans, this mark could possibly be broken at any time. Therefore, for a moment, the entire credit department was held in great tension, controlling industrial loans and temporary commercial loans while applying for an extra quota from the

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main branch. None could predict that the deposits would increase again on the next day — only then could everyone breathe a sigh of relief. After the twists and turns, everyone had barely recovered from the lingering anxiety. Who would dare to pursue “more deposits and more loans” then?6

Beyond Credit Difference Contracting Credit difference contracting was one form of credit funds management installed briefly from 1979 to 1985, but China’s credit funds management system had been continuously evolving since the establishment of New China. This evolution could, in a nutshell, be described as a transition from a “capital supply system” under the planned regime to a “capital exchange system” under the market regime.7 As discussed, the credit funds management system was characterized by unified control over deposits and loans before 1978. After 1978, credit difference contracting rose in response to the needs of economic reform, marking the beginning of reforming credit funds management in line with the market regime. However, as a transitional measure per se, it would eventually be replaced. Finally, as the financial system became more established, the PBC formally relinquished all control over the loan sizes of commercial banks in 1998, announcing a new system based on asset-liability ratio and risk management, hence the slogan “state plans as guidance, self-balancing, asset-liability ratio management, and indirect regulation” (jihua zhidu, zi qiu pingheng, bili guanli, jianjie tiaokong 計劃指導，自求平衡，比例管 理，間接調控). This could in short be summarized as the system of “loans based on deposits” (shi dai shi cun 實貸實存).

1984–1993: Loans based on deposits As the roles of central bank and commercial bank were inherently conflicting, with the advancement of the financial reform, the State Council settled on the Decision on the People’s Bank of China to Exercise Only the Functions of the Central Bank in September 1983. Accordingly, the PBC was to relinquish the functions of taking deposits and issuing loans, which would be transferred to specialized banks with an industry-based division of labor. By 1984, the four major state banks had been totally split from the PBC, and the PBC could focus on its role as central bank. Meanwhile, having reviewed the operations of the specialized banks, the PBC decided to make adjustments to the credit difference contracting system and implement transitional measures. In October, it issued the Trial Measures for Credit Funds Management, putting forward a system characterized by “unified planning,

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differentiation of funds, loans based on deposits, and mutual financing” (tongyi jihua, huafen zijin, shi dai shi cun, xianghu rongtong 統一計劃，劃分資金，實貸實 存，相互融通) which would take effect on January 1985. “Unified planning” suggested that credit funds of specialized banks must be governed by the state’s consolidated credit plan, with the PBC head office overseeing the overall balance and determining these banks’ credit funds plans and their plans of borrowing from the PBC. The “funds” in “differentiation of funds” referred to the specialized banks’ self-owned funds and credit funds. The PBC would assess the quanta of the two types of funds that the specialized banks would need and extend corresponding grants to the banks’ head offices as working capital, allowing them to operate autonomously with independent accounting. “Loans based on deposits” described a landmark change in the cash flow between the PBC and specialized banks: instead of having PBC branches impose strict deposit and loan targets on branches of the next lower level, provincial-level PBC branches would lend a lump sum of funds to provincial-level specialized banks, for them to allocate to their subordinate branches in deposit accounts with the PBC. The result was the delimitation of loan capacity by available deposits rather than an overarching ceiling. Finally, “mutual financing” was to allow interbank lending, and hence the flexibility to maneuver funds across banks of the same administrative division. By defining a debtor-creditor relationship between the central bank and the specialized banks, this new system distinguished by “deposits based on loans” established the independence of specialized banks and instituted an initial reserve requirement as would befit the slowly maturing market system. This was a significant reform in credit funds management in many facets. First, the split of credit plans and credit funds forced specialized banks to manage funds wisely to fulfil the credit plans instead of squandering effortlessly obtained funds. Second, limiting loans by deposits helped cut off banks’ reliance on the “big rice pot” of the central bank. Third, it marked the beginning of controlling credit and money issuance by managing the monetary base, which was an important means of macrofinancial regulation. Fourth, interbank lending permitted the sourcing of funds from the market, thus limiting excessive money issuance caused by banks’ requests of “relending” from the central bank upon exhaustion of their primary share of credit funds while other banks might have idle funds. The system of “loans based on deposits” was yet imperfect. Funds management was still too centralized, as specialized banks were still subject to the central bank’s centralized funds supply and loan size control. But the greatest problem with the system was it did not really enable the central bank to control money supply as intended: China’s enterprise and banking structures, dominated by SOEs and state-owned banks, respectively, faced rather soft constraints, with local

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governments pursuing superficial expansion of investment scale and economic growth, sometimes even interfering in local banks’ lending decisions. It became the norm for specialized banks and local PBC branches to request expansion of their loan sizes, which contributed to the so-called “reversed monetary expansion mechanism” (dao bi jizhi 倒逼機制). This explained why the PBC modified the system again in 1989, gradually implementing a “two-way control” (shuangxiang kongzhi 雙向控制) on credit funds and loan size which required specialized banks to keep their growth of loans within a defined scope. Therefore at the heart of the system of “loans based on deposits” was the continued use of an overarching loan ceiling to limit the money multiplier effect and regulate cash flows. With the rapid development of nonbank financial institutions after 1991, a lot of funds came to be circulated outside the banking system. Simply controlling loan size and cash input no longer suffice as operational targets of monetary policy for macro-regulation. The PBC gradually embraced monetary-base-related operational targets, seeking to control not only loan size and cash input but also money supply.

1994–1997: Asset-liability ratio management Starting from 1994, the banking system became more sophisticated, with differentiation between commercial banks and policy banks. The central bank was surrounded by state-owned commercial banks, which formed the main body, and other commercial banks alongside policy banks. 1994 was the year in which the PBC founded its macro-regulatory system on the basis of the landmark documents Decision of the CPC Central Committee on Some Issues Concerning the Establishment of a Socialist Market Economic Structure and the Decision of the State Council on the Reform of the Financial Structure. In credit funds management, the system was reformed to gradually realize “aggregates control, asset-liability ratio management, categorized guidance, and market financing” (zongliang kongzhi, bili guanli, fenlei zhidao, shichang rongtong 總量控制，比例管理，分類指導，市場融通). The PBC’s management of monetary credit aggregates started to shift from loan size control to the diverse means of credit planning, relending, rediscount, open market operation, reserve ratio, central bank rate, asset-liability ratio, and loan ceiling. It also sought to monitor the security and liquidity of the credit funds of financial institutions by such indices as capital adequacy ratio, loan-deposit ratio, medium- and long-term loan ratio, asset liquidity ratio, and reserve ratio. In 1996, it formally made money supply a monetary policy target. In December 1997, the PBC issued the Notice on Improving the Management of Loan Sizes of State-Owned Commercial Banks, announcing the lifting of loan limits on

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state-owned commercial banks and the framework of asset-liability ratio and risk management. With the policy of “state plans as guidance, self-balancing, assetliability ratio management, and indirect regulation,” lending decisions of all apart from the three policy banks were no longer subject to specific limits; rather, the PBC would provide “guiding” — as opposed “instructional” — plans and policies that indirectly “guided” the allocation of credit funds. Thus commenced a new phase in which state-owned banks were freed from quota limits and switched to control their asset-liability ratio. They, as commercial banks, gained operational autonomy, keeping their own balance. The PBC completely abandoned loan size as the immediate and operational target of monetary policy and resorted to control money supply and commercial banks’ cash positions through multiple monetary policy tools, thereby performing macroeconomic regulation. Direct control over credit funds management by the central bank faded into history.

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Chapter

Full Loan Financing

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Introduction Of all the reforms that China implemented under the banner of “Reform and Opening Up” in the first three decades of reform, the most tumultuous one was arguably that of SOEs, as back then the working capital of these enterprises was solely granted by the state in the form of government-backed bank loans. It may sound inconceivable today that an enterprise would have no inherent source of capital to provide even for its daily production and capital flows, let alone secure a hold or expand on the market, but under the highly centralized planned economy of those days, it seemed only sensible that enterprises living on state capital would have to turn their profits over to the state, which would then profit from the enlarged capital. The fact was, however, the state did not gain much from the SOEs, since the majority of them were operating at a loss. The state instead had to bear their losses, but due to limited state revenue, it did not have the capacity to satisfy their liquidity demand. This vicious circle precisely reflects a big flaw of the planned economic system: SOEs lacked an incentive mechanism, and therefore employees had no urge to develop new products, product quality was low, sales were unsatisfactory, and a large inventory was accumulated. This was the background in which liquidity needs of SOEs came to be financed fully by working capital loans from the PBC — called “quan’e xindai” 全額信貸 — as the state, entangled in shortages of funds, was unable to shoulder its expected roles of large-scale investment and macroeconomic regulation. By this policy, starting from the beginning of the Reform and Opening Up period, the central bank provided for the working capital of SOEs upon the authorities’ assessments, and the prior practice of “separate supply and separate management” (fenbie gongying, fenkou guanli 分別供應，分口管理) by the Ministry of Finance and state banks was superseded.

Historical Background Early changes in the financing of SOEs’ working capital After the founding of the People’s Republic of China, the method of financing SOEs’ working capital underwent several adjustments. The so-called “separate supply and separate account management” method dominated the early days of the First Five-Year Plan period, when a prescribed amount of working capital (ding’e zijin 定額資金) was determined as that which would be necessary for an enterprise’s production and sales. Of this, 85% was supplied by fiscal appropriation, while the

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remaining 15% a mandatory bank loan, and if the actual demand of an enterprise exceeded the prescribed amount, this would be met by additional bank loans. As assessments were made in light of the maximum liquidity need of the enterprise’s operations, this practice meant that other than during periods of peak demand, there would always be idle capital, which runs contrary to the principles of speeding up capital flows and strengthening economic accounting. The first change was prompted by the advice of Soviet experts to Deng Xiaoping, the then premier, in February 1954. It was suggested that all working capital needed for the usual operational activities of SOEs should be paid by state funds, and this should be defined as the minimum need from production and turnover only, while the settlement funds, along with seasonal funds and other funds in excess of the prescribed amount, should be classified as interim funds and covered by bank loans. Along this line, towards the end of the year, the State Council adopted a report that urged the cancellation of the mandatory loan in favor of loans for interim funds, and the PBC soon settled on leaving the prescribed capital of state-owned industrial and commercial enterprises, and also part of the capital tied up in inventory, to the state, so that bank loans would only provide for seasonal, transitional, and interim needs in excess of the prescribed capital. When the Great Leap Forward policy pumped up demand for production and working capital, however, the State Council resolved in December 1958 to transfer the task of managing SOEs’ working capital to the PBC alone, as part of the central government’s decentralization policy which devolved much of the management powers over industrial enterprises, commerce, and financial resources to the local administrations, thereby expanding SOEs’ power. In 1959, specific regulations on the management of SOEs’ working capital were promulgated, shedding the distinction between “prescribed capital” and “excess capital” and placing all such capital under the centralized supply and management of the PBC. Henceforth, what had been state appropriations were replaced with loans from the central bank at a unified rate, and these had to be used solely for the turnover of working capital, and not capital construction or other purposes. Unfortunately, this reform made way for economic chaos, with the prohibition on capital construction going unheeded and the balance in the national economy severely upset, causing a dearth of daily commodities. Between 1958 and 1960, money issuance surged by CNY4.3 billion, CNY1.8 billion above the First FiveYear Plan period, bringing the currency in circulation to a peak of CNY9.59 billion by the end of 1960, a massive 81.6% increase above the 1957 level. The anomalous expansion was of course not a natural economic development, but a trick to mask the real fiscal deficit so as to sustain the phony “surplus” from SOE operations. Eventually this ended in a reversion to administrative centralization. The year

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1961 saw a return of the classification of “prescribed” and “excess” working capital. Industrial and transportation enterprises first had their prescribed quota assessed and then received 80% of that from the fiscal authorities through their superior competent department for their regular operations, while the remaining 20% was appropriated by the fiscal authorities to the PBC, which would extend loans within that quota to enterprises.1 Excess capital needs remained to be supported by bank loans. The reform of full loan financing for working capital at the beginning of the Reform and Opening Up period was introduced on this basis.

Problems of separate supply and management In the decades leading up to the reform in 1979, the working capital of SOEs was, in theory, severally supplied and managed by the Ministry of Finance and the PBC. The faults of this system were manifested in four aspects: First, the design of “separate management” was practically unworkable. The assessment of the prescribed working capital alone required the cooperation of various agencies, and unless under highly sophisticated management systems, an enterprise would not be able to keep its working capital within the prescribed limit. In fact, those who had been involved in the few instances of “assessments” knew best that the attempt to keep working capital under an assessed amount was exercised more in form than in practice, as capital needs from production and sales inevitably vary with demand and any attempts to set a strict quota out of an estimate is bound to be removed from reality. Moreover, such quotas were often beyond the affordability of the local treasuries; therefore responsibilities were broken down but the funds were never fully appropriated. Second, increases in state appropriations failed to keep pace with production demand. They were made incrementally posterior to reports of funds shortages, meaning a constant time lapse between the appropriated capital and the present demand. The case was often that after a few expansions in production in keeping with the goals of the Four Modernizations adopted into the Reform and Opening Up era, the prescribed working capital remained at the level of the 1960s. Changes in production and sales were so rapid that they could hardly be kept up with even if the quotas were reviewed annually, let alone that in reality the intervals were as wide as five to six years due to manpower, time, and technical limitations. SOEs in desperate need of working capital then resorted to bank loans, leading to the skyrocketing of long-term debts which were occupied in daily operation and could not be paid before long. Third, separate management encouraged the shedding of responsibilities. Fiscal authorities and the central bank often passed the buck to each other when requests

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for working capital were made, the latter accusing the former of not granting sufficient funds while the former insisting that the quotas had been maximized, subjecting SOEs to laborious arguments with both parties at every assessment. Despite fierce squabbling over the accounting of the “minimum” demand, SOEs had no choice but to submit to the decisions of the fiscal authorities and the bank which held the purse strings. Fourth, there was no economic accountability for SOEs on the utilization of their prescribed working capital, and so SOEs and their employees had no incentive to make the best use of their capital. This was the argument of Quan, Tang, Li, and Zhang for a switch to full loan financing.2 There had always been cautions against hyperinflation triggered by an unbearable burden on the central bank,3 but there was hope that full loan financing would at least serve to regulate the economy by an economic means.4 In fact, as the catchphrase “dead quotas, flexible appropriations” (si ding’e, huo bokuan 死 定額，活撥款) reveals, the prescribed quota had become largely nominal and underappropriation the norm. The appropriations that SOEs obtained were meager to the state that 80% to 90% of their working capital had been financed by bank loans already before any policy change was instituted. In a way, the full loan financing policy was implemented based on an accomplished fact.

Implementation of Full Loan Financing From the late 1970s to the early 1980s, state finances were stricken with revenue plunges from grave economic inefficiency with inordinate costs on industrial production, transportation, and commercial circulation. On the eve of the inception of the Reform and Opening Up policy, state revenue recorded negative real growth. In 1978, the fiscal system was the first target of rectification, with various forms of quotas imposed on most local governments. But even so, growth in state revenue still lagged economic growth, and the burden of the escalating demand for working capital from SOEs was unbearable for the state. The need to reform the complacent culture of “eating from the same big rice pot” in SOEs became increasingly pressing. The full loan financing policy was enforced by two important State Council papers in 1979 and 1983. The 1979 paper, issued on July 13, was one of the five pilot documents promulgated to reform the whole system of state-owned industrial enterprises by leveraging the moral and material incentives of responsibility, power, and profit. Titled Provisional Provisions on the Implementation of Full Loans for Working Capital in State-Own Industrial Enterprises, it first pinpointed the problems with the practice of separate supply and management, and then provided for a

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gradual shift towards the full supply of working capital by the PBC in the form of loans to state-owned industrial and transportation enterprises, including those under departments of material supply, in order to enhance operations and management, reduce accumulation of stock, and hasten capital flows. The directive also stipulated the interest rates to be applied for specific loan types and the scope of application of the working capital loans. The Ministry of Finance was to allocate to the PBC an appropriate sum for use as prescribed working capital loans to stateowned industrial enterprises at a low monthly rate of 0.21%, while loans in excess of the prescribed quota would be issued at a higher rate of 0.42%; a double rate of 0.84% would be charged for “overstock loans” — costs incurred from excess raw materials as well as finished goods inventories due to poor management. Differential interest rates were adopted to induce more effective cost management. The provisional provisions were first tested out in the same pilot SOEs which were granted extended power by the documents Several Provisions on the Enlargement of the Decision-Making Power of State-Own Enterprises in Operations and Management and Provisions on the Retention of Profits by State-Own Enterprises. After years of experimentation, the State Council formally approved the PBC’s Report on the Centralized Management of the Working Capital of State-Own Enterprises on June 25, 1983, resolving that all working capital of these enterprises would thereafter be managed by the PBC alone. The PBC was authorized to formulate its own management system for working capital, manage state-appropriated working capital, assess the quotas schemes of SOEs’ working capital, and examine SOEs’ effectiveness in utilizing their working capital. The report pointed out the importance of the centralized management of working capital: first, this was necessary for the effective management of funds under the change in financing sources of working capital; second, strengthening the responsibility of the bank would expand the potential of sourcing funds; third, the monitoring of the bank would encourage SOEs to observe the principle of frugality, benefiting the Economic Reform that was underway. Recommendations were also made for specific methods for centralized management. The two papers laid down the backbone of the practice of full loan financing, and the sanction of the 1983 PBC paper marked the extension of this practice to all SOEs. The new policy corresponded with the goals set forth in the Sixth National People’s Congress on June 6 to June 21, 1983, of increasing fiscal revenue and boosting economic efficiency by attuning economic systems to the economic laws. It did not get rid of state-appropriated working capital altogether, but retained it as SOEs’ self-owned capital under the centralized management of the PBC and suspended further increases of such funds. In terms of the assessment of the prescribed working capital quota, for industrial enterprises, the old breakdown

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of reserves, production, and finished goods gave way to a standard set above the average rate of utilized working capital to sales income; for Class I and II wholesale commercial enterprises charged with the procurement of agricultural and industrial products, the quota was set against a target inventory turnover rate considering their purchase and sales scheme, with deposits and loans managed under separate accounts. As regards interest rates, a flat but no longer low rate applied to all loans taken out within the prescribed amounts, while excess loans were issued at either a higher rate, or a floating rate based on the state-designated target for expediting working capital turnover. Differential rates were set for different types of industries, enterprises, and products to provide support for specific industries. The reform also included a new system for SOEs to replenish their self-owned working capital.

Effectiveness and Assessment of the Reform In a way, the full loan financing reform was necessitated by the economic conditions of its time. The Reform and Opening Up era was preceded by more than a decade of political turmoil which plunged the economy onto the verge of collapse. SOEs had been suffering great losses with inventory accumulation, and being accustomed to the culture of “eating from the same big rice pot,” had low incentive to optimize production. State revenue had been sliding, hardly coping with the liquidity needs of these enterprises; to improve economic value added, proposals were made to centralize capital on certain enterprises. As the central bank had already been financing most of the SOEs’ working capital and the state’s pocket was shallow, it seemed intuitive to institute a shift of power and responsibility while, taking the lesson of the 1959 disaster, making some provisions for increased SOE accountability. Still, the 1979 pilot document provoked vehement discussion among academics and bankers as soon as it was issued. Early debates revolved around the legitimacy of the reform per se, stemming from concerns over the risk of triggering hyperinflation, the effectiveness of the interest rate tool as a lever for inducing prudent use of capital, and the crippling of SOEs’ autonomy and the treasury’s fiscal power. It turned out that although hyperinflation was arrested by further reforms and policy changes, as far as the two goals of boosting SOE efficiency and relieving the state’s fiscal burden are concerned, the outcomes of the reform were far from satisfactory. In retrospect, some of the early concerns were more valid than the others, but the gist of the problem lied ultimately in the transitioning economic and financial systems which had yet to allow market mechanisms to hold.

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For the SOEs, the full loan financing policy was flawed by two fundamental errors. First, it confused investment with loaning and the investor with the creditor. Technically, transferring the financing of working capital to bank loans was no difference from a boss’s withdrawing the basic capital and demanding that his operator depend on loans instead. Worse still, as state businesses, SOEs continued to belong to their boss, that is the state, to whom they were obligated to turn profits; SOEs had to repay debts with the limited profits they were permitted to keep, while the “boss” held the mass of the profits without being held accountable for any losses. This relates to the second mistake: the failure to make room for SOEs’ repayment. Leaving aside those enterprises that had particularly high investment risks, even the more profitable enterprises would not have much profit remained after turning in the 55% profit tax and certain percentages of adjustment tax. Before 1985, SOEs had to pay a further 50% to their superior department out of the sustaining fixed asset depreciation funds. Such heavy tax burdens and profit delivery meant that profit accumulation was basically impossible. Many SOEs could not repay the principal, while others could not pay off even the interest and were forced to roll over it by borrowing more. It was with the concern of overburdening the bank that the 1983 reform added the provision for self-owned capital, to form a development fund, as compared to the pilot scheme in 1979, in hopes of guaranteeing a balance between deposits and loans as well as fixed asset investment and working capital. This shows consideration for SOEs’ need for working capital for turnover, and recognition of the fact that a portion of an enterprise’s working capital, growing alongside production expansion, would necessarily be tied up: if this part of capital too were to be supplied by bank loans, then the principal would be to the bank a de facto perpetual loss, which would alter the nature of credit funds and disturb the principles of lending. According to the PBC, this provision would not only break the “big rice pot,” wean SOEs from irresponsible reliance on the bank, and foster prudent use of funds, but also avert repeating the error of 1959, when the SOE sector put all their eggs in fixed asset investment and the bank was left in the lurch of hefty working capital burdens.5 The requirement of parallel growth in fixed asset investment and working capital seems self-explanatory, but if paying off debts was a problem for China’s tax-burdened SOEs, accumulation of self-owned capital would visibly be more so. Opponents of the interest rate lever had dismissed it as an unreasonable burden on SOEs, believing the prescribed quotas to reflect their minimum liquidity needs. Theoretically, it is the responsibility of each firm to raise sufficient working capital to support its daily operation, rather than maintaining the same production capacity

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despite low liquidity; it was only an ease with state subvention that had permitted SOEs to keep running at a loss over a long time without any sense of alarm. Under a market economy, a commercial bank would always assess a firm’s capacity before extending loans and determining the loan terms with it. Restraint by tools such as interest rates should be legitimate. However, in China’s case, the policy rates in the full loan financing reform did not have much success in exercising restraint. To begin with, they were formulated within a low fixed interest rate policy, and so were too weak to deter borrowing. An even more fundamental factor was yet the continuation of SOE bureaucracy. The requirement to replenish self-owned capital was not only unrealistic but also nonbinding. SOEs failing to replenish their working capital had a free hand to “squeeze” the bank further regardless of the interest rate; the greater an SOE’s losses, the bigger its debt. As Li and Zhang note, to tackle the shortage of SOEs’ working capital, expanding the sources would be as important as managing the use of funds. Working capital could only be enlarged by profit-backed business expansion, and only when managers were provided with economic incentives would they strive to optimize the use of working capital. A reform that simply changed the method of supplying working capital would not guarantee capital supply or boost SOE efficiency. The massive closure of inefficient SOEs in the late 1990s showed that isolated reforms as such could not get to the root of the inefficiency problem, which was only solved gradually as marketization advanced and systems were refined accordingly.6 For the PBC, the charge of SOEs’ working capital supply was overwhelming. The ultra-high economic growth from 1985 onwards was sustained by enormous fixed asset investments and capital construction that often exceeded the state budget, and the working capital associated with these projects was all financed by bank loans. Rather than losing its power to the central bank, the treasury went on to “squeeze” it through SOEs, which accumulated huge mutual debts beyond the bank’s control. Countless nonperforming loans were taken out to cover losses, interenterprise debts, and the costs of other kinds of unregulated behavior.7 Eventually, the microeconomic gaming among SOEs, the treasury, the central bank, and competent departments was to have profound impact on macroeconomic balances between the issuance and recovery of loans in the pool of credit funds, between fiscal funds and credit funds, and between fixed asset investment and working capital. Looking at credit funds as an example, most of the bank’s funds were tied up in gold, foreign exchange, fiscal overdrafts and loans to the government, bad debts in agricultural loans, and overstocking of industrial and commercial inventories, with little left for turnover. Given the financial shortages of the government at that time, SOEs would have nowhere to turn to if the bank’s lending capacity was shrunk.

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In 1989, a policy to control the economic aggregates and adjust the economic structure was promulgated, as a result of which the PBC tightened the monetary base. The general shortage of working capital led to a slippage in production, upsetting the wider economic activities. In the face of SOEs’ demand, the bank exhausted its means to open new sources of funds, which still fell short of demand and in fact perpetuated a vicious circle of overdependence and shortages. The working capital that SOEs needed for production depended solely on the limited idle funds the bank sourced from redistribution of national income. This put the bank in a dilemma where increasing loan issuance would easily trigger hyperinflation while contracting the monetary base would cause hazards for SOEs and in turn expose the country to economic and financial chaos. The full loan financing policy created more problems with working capital than solved them. In fact, the lending decisions of the PBC and other state banks were always subject to the intervention of local governments. With government patronage, plenty of underperforming, inefficient, and impoverished SOEs continued to live on what were named “stability and solidarity loans” (anding tuanjie daikuan 安定 團結貸款), paying employees’ wages by loans. State banks were hijacked by debtstricken SOEs, a huge sum of loans turning into bad debts and the quality of its financial assets increasingly compromised. The precarious dependence of SOEs on state banks was only terminated by the joint stock reform following the Asian Financial Crisis of 1997, which forced SOEs with no profitability to stop or halve production and lay off workers. These crises had long existed in the SOE system and had only been temporarily veiled by full loan financing. In the end, the bad debts generated from full loan financing were the government’s to bear. Some opponents of the full loan financing reform had warned against interfering with SOEs’ internal operation, but throughout the implementation of this policy, the advantageous position of SOEs remained untouched. One may instead question the desirability of “autonomy” unchecked by internal financial constraints, with prodigal spending sustained by free supply of state capital. Holding SOEs accountable for their spending was a judicious move, but until the SOE system was fully reformed alongside the development of a mature financial system that supports modern financial institutions, the relationship among the government, SOEs, and the banking sector could hardly be redressed. The full loan financing reform was a valuable lesson for the more comprehensive SOE reforms in the 1990s.

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Further Implications China implemented a full loan financing policy twice, first in the late 1950s and then the late 1970s. In both instances, it hoped to improve the inefficiency of SOEs’ use of funds by reforming the supply system of working capital. While both reforms did not reach their intended goals, they were valuable experiences for the reforms of SOEs and the financial system in the ensuing days. One of the root problems of the SOEs which were deeply enmeshed in the economic and financial systems was the mismatch of powers, responsibilities, and benefits. The 1983 full loan financing reform was implemented hand in hand with a policy to expand SOEs’ autonomy in operations and management. Despite the attempt to create an incentive system by the interest rate lever, SOEs were not pressured by economic consequences. They could spend the limited development funds they managed to amass on fixed asset investment without qualms, and in the event of a loss, offset it by state appropriations or bank loans. In the transition from the planned economy to the market economy, state planning abated, while market mechanisms were slow to take shape, opening a vacuum where SOEs were neither regulated by the state nor constrained by the market. In addition to profit delivery, the financial plight of SOEs had to be ascribed to irresponsible spending, as manifested in rash capital expansion, sometimes for flaunting in competition with their counterparts, depletion of retained profits without providing for reserves, and short-term actions. Subjecting SOEs to market control would be the foundation for the efficient use of bank loans. The importance of perfecting the financial system was particularly shown by the embarrassment that befell the PBC. It was a lack of autonomy that prevented it from approving loans according to the principle of economic efficiency and the interest rate lever from facilitating the survival of the fittest. Subordinate to the Ministry of Finance and running commercial services at the same time, the PBC lacked the awareness and power of an independent economic entity. In fact, the state policy of mandatory bank loans for working capital was contrary to market principles from the outset. Further injuring the autonomy of bank credit was government intervention when local SOEs were short of funds, which deprived banks of even the weapons of loan terms and restrictions on which the reform was supposedly depend. It was realized that the interest rate tool would only be effective when exercised by a bank that is free to pursue profit maximization and so selects clients, drafts lending terms, and determines the lending scope according to profitability — and knowledge was finally turned into action in the post-1997 joint stock reform on state-owned banks.

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Chapter

Eating from Separate Stoves

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Term Definition “Eating from separate stoves” (fen zao chifan 分灶吃飯) describes the budget decentralization policy implemented in China from 1980 to 1993. In this period, the fiscal relations between the central and local governments were prescribed by self-responsibility “contracts” (chengbao 承包) delineating the fiscal scopes of both levels of government and demanding that local governments maintain their own budget balance. This practice was sandwiched between the system of “unified control over revenues and expenditures” (tong shou tong zhi 統收統支) and the taxsharing system (fen shui zhi 分稅制). The policy of “eating from separate stoves” was enforced in three stages, the first of which ran from 1980 to 1984, under the slogan “division of revenue and expenditure responsibilities and hierarchical contracting” (huafen shouzhi, fenji baogan 劃分收支，分級包干); the second 1985 to 1987, labeled “division of tax types, assessment of revenue and expenditure responsibilities, and hierarchical contracting” (huafen shuizhong, heding shouzhi, fenji baogan 劃分稅種，核定收支， 分級包干); and the third 1987 to 1993, generalized as a “multiform contracting system” (duo zhong xingshi baogan zhi 多種形式包干制).

Historical Background Pre-1979 evolution of the fiscal system The question of central-local fiscal relations had been high on the economic agenda since the founding of New China. From 1950 to 1979, the central government launched repeated initiatives to improve local governments’ management of finances. From the policy summary given in Table 12.1, we can observe a trend of development from high centralization to centrally directed hierarchical management. The fiscal policy from 1950 and 1979 was in line with the highly centralized philosophy under the planned economy. Based on the umbrella principle of “unified control over revenues and expenditures,” central-local fiscal relations evolved in the following stages: 1. 1950: Eager to stabilize a newly unified country yet to recover from production stoppages, high unemployment, and hyperinflation in the aftermath of civil war, the new Chinese regime adopted a centralized control of the budget, beginning the policy of “unified control over revenues and expenditures.”

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Table 12.1

Budget management reforms, 1950–1994

General policy

Implementation Policy slogans/details period

Unified control over fiscal revenues and expenditures

1950

High centralization and unified control over revenues and expenditures

1951–1957

Division of revenue and expenditure responsibilities and hierarchal management

1958

Expenditures based on revenues with constancy over 5 years

1959–1970

Decentralization of revenue and expenditure responsibilities, planned contracting, regional adjustment, apportionment based on totals, and annual reassessment

1971–1973

Prescribed revenue and expenditure responsibilities, contracting of revenues and expenditures, guaranteed delivery (or grants for the deficit), retention of profits, and annual reassignment

1974–1975

Profit retention based on prescribed percentages, additional provisions for the sharing of excess revenues, and contracting expenditure responsibilities

1976–1979

Prescribed revenue and expenditure responsibilities, pegging of revenues and expenditures, apportionment based on totals, reassessment per year / pegging of revenues and expenditures, and apportionment based on revenue growth (pilot scheme)

1980–1985

Division of revenue and expenditure responsibilities and hierarchical contracting

1985–1987

Division of tax types, assessment of revenue and expenditure responsibilities, and hierarchical contracting

1988–1993

Multiform contracting system

1994–present

Tax-sharing system

Eating from separate stoves

Tax-sharing system

Note: Policy changes were frequent between 1950 and 1979, leading to diverse subdivisions

among academics. The subdivision here is based on Li, ed, A Graphical Explanation of China’s Intergovernmental Fiscal Relations.

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2. 1951–1957: The weakness of the centralized system in motivating local governments and the administrative burden of overly centralized planning began to manifest after a year of implementation. Adjustments were made in 1951, 1953, and 1954, but the overall spirit was to divide fiscal responsibilities between the central and local governments based on the administrative hierarchy having guaranteed sufficient funds for major state projects, so as to provide local governments with a regular source of revenue and financial incentives. 3. 1958: Fiscal decentralization was adopted following the policy of economic decentralization. In the past, the central government would, on an annual basis, ascertain local expenditures before allocating to local governments a proportional number of revenue items and fixing the percentage share of profits to be retained by them. The 1958 policy lengthened the assessment interval to five years, aiming to give local governments the free rein to determine their spending based on revenue within the period. However, the policy was aborted a year later due to government scams and fiscal frauds. 4. 1959–1970: A more nuanced approach to decentralization was employed to redress the 1958 chaos, as demonstrated by the lengthy slogan “Decentralization of revenue and expenditure responsibilities, planned contracting, regional adjustment, apportionment based on totals, and annual reassessment” (Shouzhi xiafang, jihua baogan, diqu tiaoji, zong’e fencheng, yi nian yi bian 收支下放，計劃包干，地區調劑，總額分成，一年 一變). In a nutshell, this was to take back some of the financial incentives alongside the devolution of fiscal responsibilities by returning to annual reassessment in order to align local budgets with state plans. During the Great Leap Forward period from 1959 to 1960, a greater emphasis was placed on expanding local fiscal powers, while the ensuing national economic readjustment during 1961 to 1964 brought back a higher degree of centralization. Overall, with “apportionment based on totals,” the percentage of revenue retention was assigned based on the share of local expenditure in local revenue. 5. 1971–1973: This other long slogan, “prescribed revenue and expenditure responsibilities, contracting of revenues and expenditures, guaranteed delivery (or grants for the deficit), retention of profits, and annual reassignment” (ding shou ding zhi, shou zhi baogan, baozheng shangjiao [huo cha’e butie], jieyu liuyong, yi nian yi ding 定收定支，收支包干，保證上繳 [或 差額補貼]，結餘留用，一年一定) can be simplified as a fiscal contractual

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responsibility policy. This reform expanded the scope of local fiscal responsibilities, while at the same time setting an exact quota of revenue to be turned over to the central government, exceeding which could be retained by local governments, thereby raising their incentive to enhance financial management. 6. 1974–1975: The national economy upset by the Cultural Revolution and state revenue unstable, the Ministry of Finance proposed fixing the percentages for profit retention, making additional provisions for the sharing of excess revenues, and setting expenditure targets to ensure sufficient funds for local spending. However, the removal of the linkage between revenues and expenditures undermined local governments’ incentive to boost revenues and strive for a balanced budget. 7. 1976–1979: In response to the disadvantage of having prescribed revenue and expenditure targets, the practice of “pegging of revenues and expenditures” and “apportionment based on totals,” assessed at annual intervals was added on top of “prescribed revenue and expenditure responsibilities” (ding shou ding zhi, shouzhi guagou, zong’e fencheng, yi nian yi bian 定收定支，收支掛鈎，總額分成，一年一變). As the annual review of revenue shares provoked adverse competition among governments, a pilot scheme of “pegging of revenues and expenditures” with “apportionment based on revenue growth” (shouzhi guagou, zengshou fencheng 收支掛鈎， 增收分成) was introduced in selected provincial-level districts, to channel attention towards local revenue growth.

Fiscal pressure on the eve of “eating from separate stoves” Starting from 1972, China gradually reopened diplomatic relations with the United States, Japan, and Europe. To adjust the heavy industry–dominated economic structure, it started supporting light industry, petrochemistry, and certain agricultural supporting industries by introducing advanced foreign equipment, which quickly engendered an immense CNY10 billion deficit by 1974. Notwithstanding this, development projects continued. In 1977 and 1978, the Chinese government announced further plans to attract foreign investment with some one hundred massive projects reminiscent of the 154 counterparts under the First Five-Year Plan of 1952, and the immediate fiscal consequence was a CNY17 billion deficit in 1978, accounting for 20% of state revenue. The fiscal situation was aggravated by military expenses from the 1979 Sino-Vietnamese War, which pushed the year’s deficit past the 18 billion mark. The deficit hike in the two years heightened China’s fiscal pressure. Abiding

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by an absolute debt-free philosophy under the influence of ultra-leftism, and also lacking overdraft facilities, the central government resorted to issuing an addition of CNY40 billion in currency. It also launched three reforms which were then criticized as attempts on the part of the Ministry of Finance to “shed burdens.” The first of these was the split of the fiscal and banking systems, or more concretely, the policy of “loans for appropriations” that transferred the financing of SOE investment to government-backed bank loans and thereby reduce fiscal expenditure on capital construction. Second was the widely covered rural household responsibility system that supplanted the inefficient people’s communes. “Eating from separate stoves” was the last of these efforts, implemented to increase local governments’ incentive in financial management as the central government could no longer afford the local expenses. As a result of the last policy, local fiscal authorities were established along administrative divisions.

Development of Fiscal Budget Management during the “Eating from Separate Stoves” Period Following the Third Plenary Session of the 11th Central Committee of the CPC in 1978 which set down the focus of modernization, the Party’s Central Economic Work Conference put forward the guiding principle of “readjustment, reform, rectification, and improvement” in April 1979 and identified fiscal management as the first area of gradual but fundamental reform of economic institutions. Introduced in 1980, the “eating from separate stoves” reform underwent three stages of development.

“Division of revenue and expenditure responsibilities and hierarchical contracting,” 1980–1985 The fiscal scopes of the central and local governments were clearly delineated in recognition of the subordinate relations of the two levels of government: profits from SOEs under the central government, customs revenue, and other central revenues went to the central government, while profits from SOEs under local governments, salt tax, industrial and commercial income tax, and other local revenues belonged to local governments; the central government bore expenditures on central capital construction investment, working capital of central SOEs, national defense, and other national-level affairs, while local governments were responsible for expenses on local capital construction, working capital of local SOEs, local administration, and other local-level affairs. There was a shift towards “assignment of percentage

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shares in state totals and proportional contracting” (zong’e fencheng, bili baogan 總額 分成，比例包干) in the later days. While decentralization had been in place prior to 1980, the new policy marked the turning point from “eating” from the same “stove” — a central fiscal budget — to separate “stoves” — independent central and local budgets, with each government responsible for their own budget balance. Expenditures were no longer devolved from the central government, and the percentage shares of responsibilities and subsidy quotas were to remain constant over five years.

“Division of tax types, assessment of revenue and expenditure responsibilities, and hierarchical contracting,” 1985–1987 In 1984, the second phase of the “tax-for-profit” (li gai shui 利改稅) reform for SOEs was accomplished. The change from profit delivery to taxation reshuffled the relationships between state and enterprises as well as central and local fiscal authorities, making it imperative to reform the fiscal system again. This was endorsed and detailed in the Decision on Reform of the Economic Structure adopted by the Third Plenary Session of the 12th Central Committee of the CPC in October 1984. Tax revenue division was adjusted according to the tax types classified in the second phase of the “tax-for-profit” reform, the details of which are listed in Table 12.2. Table 12.2 Division of tax revenues between central and local governments, 1985–1987 Central government regular revenues

Product tax, VAT, 70% of business tax (from SOEs under Ministry of Petroleum Industry, Ministry of Electric Power, China Petrochemical Corporation, and China National Nonferrous Metals Corporation); income and adjustment taxes from central SOEs; industrial and commercial taxes, income tax, and mining royalty from offshore oil enterprises, foreign invested enterprises, and Chinese-foreign joint ventures; duties and industrial and commercial tax levied by Customs; business tax from railway, civil aviation, and postal and telecommunications departments as well as head offices of banks and insurance companies; revenue of military industries run by central government and enterprises with responsibility contracts with central government; subsidies for losses of foreign-invested enterprises run by central government and excess procurement and price increases of grain, cotton, and oil; special tax on oil burning; revenue from treasury securities; state energy and transportation construction funds

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Table 12.2

(Cont’d)

Local government regular revenues

Product tax, VAT, 73% of business tax (from SOEs under Ministry of Petroleum Industry, Ministry of Electric Power, China Petrochemical Corporation, and China National Nonferrous Metals Corporation); income and adjustment taxes from local SOEs; income tax from collective enterprises; agricultural tax; vehicle and vessel license tax; urban property tax; livestock transaction tax; deed tax; revenue from local SOEs in fulfilment of profit quotas; losses of grain and supply and marketing enterprises run by local governments; surcharges on default tax and tax underpayment or evasion penalties

Revenues shared between central and local governments

Product tax, VAT, business tax other than that from SOEs under Ministry of Petroleum Industry, Ministry of Electric Power, China Petrochemical Corporation, and China National Nonferrous Metals Corporation, or railway, civil aviation, and postal and telecommunications departments, or head offices of banks and insurance companies; business and income taxes from foreigninvested enterprises and Sino-foreign joint ventures excluding offshore oil enterprises; personal income tax; resource tax; construction tax; salt tax; bonus tax on SOEs

Based on the above scopes of revenue and expenditure responsibilities, provincial-level districts whose regular revenue exceeded regular expenditure were required to turn part of their revenue to the central government in a prescribed quantum, while those with regular expenditure exceeding regular revenue were allocated a portion of the revenue shared between the two levels of government; excess regular expenditure that the whole of the shared revenue was unable to cover was met by an additional grant from the central government. Once fixed, the revenue shares, size of revenue delivery, and subsidies were to remain unchanged for five years, during which local governments would be responsible for their own budgeting. Like revenues, expenditures were assigned along the line of the division of government responsibilities. Major areas of central expenditures included national defense, diplomacy, national-level education, science, culture, and public health affairs, and national administration, whereas major areas of local expenditures included local economic development, local-level education, science, culture, and public health affairs, and local administration.

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“Multiform contracting system,” 1988–1993 When the 1985 reform proved to be too comfortable for local governments to be effective in motivating local revenue increases, leading to a plunge in the central government’s share in total revenue, the State Council promulgated the new directive Decision on Measures for the Implementation of Local Fiscal Contracting, which was to take effect in 1988, specifying the forms of contracting for 37 districts including not only provinces, autonomous regions, and direct-controlled municipalities but also the so-called “separately listed cities in the state plan,”1 except Guangzhou and Xi’an which were to follow the plans for Guangdong and Shaanxi. These included: 1. Incremental revenue contracting (shouru dizeng baogan 收入遞增包干): A rate of revenue increase, together with the proportions of revenue retention and delivery, was determined according to the revenue growth in the past years with the final revenue and reasonable fiscal resources at the end of 1987 as the base. The part of revenue lying within the rate of increase was shared between the central and local governments in the prescribed proportions of retention and delivery; revenue in excess of the rate of increase remained with the local government, but the local government would have to make up for any amount short of this rate to meet the delivery quota. This applied to 10 districts, namely, Beijing, Hebei, Liaoning, Shenyang, Harbin, Jiangsu, Zhejiang, Ningbo, Henan, and Chongqing. 2. Apportionment based on totals: Proportions of revenue retention and delivery were set according to the share of expenditure in revenue in the final accounts of the past two years. Three districts, namely, Tianjin, Shanxi, and Anhui, were assigned this method. 3. Apportionment based on totals and revenue growth: On top of method 2, an additional share of revenue was apportioned to the local government according to its revenue growth over the previous year. Another three districts, namely, Dalian, Qingdao, and Wuhan followed this method. 4. Incremental delivery quota contracting (shangjie dizeng baogan 上解額遞增 包干): The delivery quota was increased annually at a certain percentage with the revenue delivery in 1987 as the base. This was implemented in two districts: Guangdong and Hunan. 5. Prescribed quota delivery (ding’e shangjie 定額上解): A delivery quota was fixed considering the assessed fiscal surplus. There were three districts assigned this method: Shanghai, Shandong, and Heilongjiang. 6. Prescribed subsidies (ding’e buzhu 定額補助): A subsidy was prescribed

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considering the assessed fiscal deficit. This applied to 16 districts: Jilin, Jiangxi, Fujian, Shaanxi, Gansu, Hainan, Inner Mongolia, Guangxi, Guizhou, Yunnan, Tibet, Qinghai, Ningxia, Xinjiang, Hubei, and Sichuan. Hubei and Sichuan would have belonged to group 5, but fiscal deficits were estimated for them with Wuhan and Chongqing set apart as “separately listed cities in the state plan.” The deficit subsidies for these two provinces were provided separately by a reduced part of the two cities’ revenues which would otherwise have been submitted to the central government.

Theoretical Discussion Nature of central-local taxing contracts While theoretically arrangements of “eating from separate stoves” provided for the apportionment of revenue and expenditure responsibilities, in effect this was a question of allocation of powers related to fiscal revenue. As a large part of government revenue comes from taxation, the nature of fiscal agreements under this framework can be understood by analyzing the intergovernmental allocation of taxing powers, which involve legislation, levying, and revenue retention. In China legislative power has been concentrated in the hands of the central government, making it perhaps more valuable to look into the allocation of tax levying power and revenues between the central and local governments. It is possible to classify four common kinds of “taxing contracts” between the central and local governments: 1. Prescribed quota contract: All revenues are left at the disposal of the local government upon its fulfilment of the revenue quota prescribed by the central government on an annual basis. Let T be the total revenue and T0 be the prescribed quota, then the tax revenues for the central and local government will be T0 and T–T0, respectively. In theory, prescribed quota contracts can also be implemented in reverse, that is, to have the local government retain only the prescribed quota and turn over everything else to the central government. However, this practice provides too little incentive to local governments to be of practical value. 2. Revenue-sharing contract: A percentage of tax revenues is set apart for the local government, while the remaining portion goes to the central government. Let α be the share of the local government, then the tax revenues obtained by the central and local governments will be (1–α)

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T and αT. Revenue-sharing contracts typically take the form of revenue sharing in the same tax, as in the allocation of income tax, corporate income tax, and VAT revenues in Germany among the federal, state, and municipal governments. 3. Tax-sharing contract: A more fundamental tax-sharing system than revenue-sharing contracts. The central and local governments each possess full powers in levying some taxes and owning the revenues, rendering revenue allocation unnecessary. Sometimes certain tax types are assigned entirely to the local government, usually minor ones like property tax, land tax, and service charges. Other times the central and local governments simultaneously impose the same kind of tax at different rates or on different items, without overlapping authority. Sales taxes in the United States, which are levied by the federal government and state governments, as well as local governments which are devolved the power to do so by state governments, are an example. 4. Levying agency contract: The central government delegates power to the local government to levy taxes on its behalf only; in other words all revenues belong to the central government. Thus, tax revenues are shared between the two levels of government in the first two types of contracts. With T, α, and T0 as tax revenue, percentage share of revenue, and tax quota, respectively, the above four types of contracts can be expressed mathematically on the same basis. Accordingly, the share of the local government, TL, will be αT – T0, and that of the central government, TC, will be (1–α)T + T0. The values of α and T0 in the four types of contracts are displayed in Table 12.3. Table 12.3

Comparison of central-local taxing contracts Percentage share and delivery quota

Levying party

Prescribed quota

α = 1, T0 > 0

Local government

Revenuesharing

0 < α < 1, T0 = 0

Local or central government

Tax-sharing

α = 1, T0 = 0

Levying agency

Local and central governments

Prescribed quota to central government, the rest to local government Shared between central and local governments by agreed percentages To central or local government by tax type

α = 0, T0 = 0

Local government

All to central government

Contract type

Revenue allocation

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Incentive systems under different types of taxing contracts Under the prescribed quota contract For the local government, the merit of this type of contract is its residual claim to collected revenues upon fulfilling the delivery quota, while the disadvantage is that it will have to bear the risk of revenue shortages on its own, at economic downturn, for example. For the central government, the contracting cost is necessarily high as setting prescribed quotas will either deprive it of a revenue increase in times of economic growth or compel it to bargain with local governments for quota revisions from time to time.

Under the revenue-sharing contract It gives the local government part of the residual claim to collected revenues while subjecting it to part of the risks in tax collection. Thus, compared with the prescribed quota contract, it may encourage the local government to shirk taxation responsibility. The central government, too, shares part of the residual claim and part of the taxation risk, and will have to bear the cost of monitoring local governments.

Under the tax-sharing contract By allocating to the central and local governments full powers in levying taxes and owning the corresponding revenues, this type of contract renders it unnecessary for the central government to provide additional financial incentives to and deliberately supervise local governments. The greatest weakness of this system is the high administrative costs incurred from the need to establish double taxing agents. There will be a time cost in the communication and coordination between central and local tax bureaus.

Under the levying agency contract The marginal tax revenue of the local government is completely independent of its marginal cost of effort, making this contract type the least incentivizing of all. In reality, this practice is now rather obsolete, although governments may have their tax bureau levy certain fees and charges for other government agencies. China’s local tax administrations have levied for other departments the cultural undertaking construction fee and the water resources fund.

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For comparison’s sake, the efficiency of the four types of contracts can be summarized as follows: • For incentivizing local governments: tax-sharing contract > prescribed quota contract > revenue-sharing contract > levying agency contract • For incentivizing the central government: tax levying contract > tax-sharing contract > revenue-sharing contract > prescribed quota contract • Cost of monitoring local governments: revenue-sharing contract > prescribed quota contract > tax-sharing contract > levying agency contract • Cost of bargaining with local governments: revenue-sharing contract = taxsharing contract = levying agency contract > prescribed quota contract This provides a basis for comparing the efficiency of the fiscal arrangements in the “eating from separate stoves” period. Next, it will be necessary to identify the contract types to which the Chinese budget management policies of different periods belonged.

Contract types under different budget management systems in China “Unified control over revenues and expenditures” period, 1949–1979 “Unified control over revenues and expenditures” was itself a form of levying agency contract. However, during this period, the budget management system was adjusted multiple times to increase financial incentives for local governments. The practice of “apportionment based on totals” implemented between 1959 and 1970, then from 1976 to 1979, and its variant of “profit retention based on prescribed percentages, additional provisions for the sharing of excess revenues, and contracting expenditure responsibilities” in 1974 and 1975 were revenue-sharing contracts.

“Eating from separate stoves” period, 1980–1993 The revenue contracting systems continued to change frequently, but overall the dominant contract types were the revenue-sharing and prescribed quota contracts. Regarding the six systems of 1988, “apportionment based on totals” and “apportionment based on totals and revenue growth” were revenue-sharing contracts, “incremental revenue contracting,” “prescribed quota delivery,” and “prescribed subsidies” were prescribed quota contracts, and “incremental delivery quota contracting” was a mix of both, with a prescribed quota forming the base

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and revenue-sharing observed in the increment.

Post-1994 tax-sharing system The tax-sharing reform in 1994 was a major revamp of central and local government allocation policy, with which taxes that were deemed easy to manage and essential for macroeconomic regulation were designated as central taxes or shared taxes, while those suitable for local administration local taxes. This kind of division basically manifested the spirit of the tax-sharing contract, although a handful of shared taxes involved revenue-sharing contracts. The central government avoided its disadvantage in information gathering compared with local governments by designating the more manageable taxes as central. In 2002 another reform was implemented within this system, to share the revenues of individual and enterprise income taxes, which had belonged solely to local governments, between the central and local governments. This initiative obviously represented a shift to revenue sharing in income tax, and it was introduced as a fiscal centralization effort. Table 12.4 Period

Taxing contract types from 1988

Fiscal system

Contract types

1988–1994 Fiscal contracting Revenue-sharing: apportionment

based on totals; apportionment

based on totals and revenue growth

Prescribed quota:

Revenue sharing

revenue

quota:

incremental

contracting;

prescribed quota delivery;

prescribed

+ prescribed incremental

delivery quota contracting

subsidies (i.e.,

negative quota) 1994–2001 Tax-sharing

Revenue-sharing:

Tax-sharing:

Securities

VAT and securities

VAT (75 : 25);

transaction tax (50 : 50)

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all taxes except transaction tax

—

Eating from Separate Stoves

Table 12.4 Period

(Cont’d) Fiscal system

After 2002 Tax-sharing

Contract types Revenue-sharing:

Tax-sharing:

Securities

VAT, securities

VAT (75 : 25);

transaction tax (97 : 3);

Corporate income

all taxes except

—

transaction tax,

and income tax

tax (growth 60 : 40); Individual income

tax (growth 60 : 40) Note: Ratios in brackets represent the shares of the central government to local governments. The division of income tax revenues after 2002 applied only to the growth over the 2001 revenues, apart from which remained with local governments.

Efficiency of the “eating from different stoves” system Efficiency gains Under “unified control over revenues and expenditures” prior to 1980, local governments did not at all benefit from their tax collection efforts, and there was little motivation to control expenditure due to soft budget constraints. With annual assessment of revenues and expenditures, central and local fiscal relations were typically strained by cycles of quarrels over targets at the year’s start, quota increases in midyear, and underassignment at the year’s end. More importantly, the supervision of local governments’ taxing efforts was costly and in fact not cost effective: the central government’s appointment of on-site supervisors to factories and tax commissioners was unable to arrest the sliding of productivity of and tax revenues from SOEs.2 As a residual claimant, the central government could hardly counter the dishonesty of SOEs because of its lack of necessary information and also the lack of monitoring incentive on the part of the commissioned supervisors (agents), who were not the real residual claimants.3 The case was often the collusion between the supervisor and the supervised in deceiving the central government, which lied in a passive position. The policy of “eating from separate stoves” clarified the delineation of powers between the central and local governments and drastically transformed the budget

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structure, division of fiscal powers, and allocation of financial resources. It could increase the motivation of local governments to maximize revenue and minimize expenditure in the following aspects. First, the same “stove” that was the central government was split into some 20 local “stoves,” ending the practice of “eating from the same big rice pot.” Second, the allocation of financial resources changed from the assignment of every single budgetary item to larger targets taking into account the state plans and local capacity, allowing for more local flexibility to adjust spending as the situation demanded. Third, the assessment interval of revenue shares and subsidies was lengthened from one year to five year, which was more desirable for the formulation and execution of long-term plans. Fourth, the unification of fiscal powers and responsibilities by requiring local governments to oversee their own budgets urged them to be more circumspect in their spending. By separating state planning from local fiscal management, and assigning fiscal scopes according to the responsibilities of individual government departments, departments would have the power and responsibility to allocate resources to their subordinate enterprises or agencies.

Efficiency losses Given China’s political centralization, its central government enjoyed absolute control over local governments in the arrangement of taxing contracts, and local governments had limited bargaining power. This might not necessarily bring about the lowering of contracting costs, however. On the contrary, the possibility of violating the local government’s will might prevent the contract from achieving a Pareto improvement; friction might arise from local governments’ effort to maximize profit, inducing greater costs in both maintaining and altering a contract. These problems were revealed in the frequent changes in budget management systems during the period. Not wanting to hurt local incentive by increasing its own revenue share on the one hand and yet desiring to benefit from the revenue growth over time on the other, the central government repeatedly manipulated its authority to alter the existing contracts, sometimes even breaching them, and force local governments to renegotiate new contracts. The new systems in 1980, 1985, and 1988 were big adjustments in short intervals. Such frequent changes can be viewed positively as the central government’s determination to optimize the allocation of resource distribution powers, but they also reflected its inability to find a relatively efficient and stable framework to balance centralization and decentralization and tackle the financial relations between the central and local governments, and the state and enterprises.4 Guo discusses in detail the negative repercussions of the budget management

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systems that were imposed by the central government’s compulsory, discretionary power during the period. The first was the triggering of opportunistic behavior, which increased transaction and negotiation costs while undermining efficiency of resource allocation and utilization. The reliance of the central government on reported information, coupled with the discrepancy in utility functions and preferences between the central and local governments, made it vulnerable to guile, especially when state plans deviated significantly from the goals of local governments and enterprises. Such means as slacking, procrastination, relaxed management, and bargaining to circumvent state instructions led to efficiency losses and compromised the effect of macroeconomic regulation. The second problem was the injury to the trust between the central and local governments. Apart from the sense of instability created by frequent changes per se, the mechanism of bilateral negotiations between the central government and individual local governments — rather than the more transparent practice of multilateral negotiations — contributed to the feeling of injustice among local governments, causing both better off and worse off governments to feel deprived. The impression that resources would be allocated to those in want also drove money to rent-seeking activities, causing waste of financial resources. The third problem was the hike in supervisory costs despite the theoretical advantage of revenue sharing. The dual role of local governments as tax collector and taxpayer motivated them to maximize not only tax collection, but also the retention of tax revenues for their own disposal.5 In 1958, for example, the selfresponsible extrabudgetary funds of local governments swelled for the first time with an explosion of infrastructure projects under the devolution of fiscal/ economic plan management, and enterprise management powers. While revenue sharing provided financial incentives, local governments were inevitably motivated to pursue regional rather than national interest. The worst scenario was when the central government attempted to tighten control by altering the contracts or shortening contract terms, which ultimately harmed stability, ruined trust, and increased administrative costs.6 Ultimately, local opportunism was to act negatively on the economic structure. As local governments were driven by economic interest to patronize industries that would bring instant high tax revenues, chances of important but floundering “bottleneck industries” were doomed, undermining diversity in regional economic structures. Also, local government–directed interregional competition, which resulted in blind capacity expansion and regional protectionism, hindered the formation of a unified market and ran counter to the effective use of resources, the separation of SOE and government management, and the principle of fair competition.

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Economic Effects The fiscal contracting system of 1988 was an interim measure to break reliance on the single “stove.” However, with the passage of time, its negative effects began to surface. Rather than rapid growth, there was in fact a shrink in the growth rate of fiscal revenue compared to that of GDP. As discussed, the incentive systems of different taxing contracts would affect the size of total fiscal revenue. From 1978 to 1994, the growth in total tax revenue was much slower than GDP growth, and the average growth elasticity of tax revenue (tax revenue growth / GDP growth) from 1986 to 1992, after the 1985 “tax-for-profit” reform, was a mere 0.43 (see Fig. 12.1). Fig. 12.1

Fiscal revenue growth and GDP growth

0.20 0.15 0.10 0.05 0.00 1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

-0.10

1978

-0.05

Year

GDP growth Fiscal revenue growth

Apart from the policy to devolve power and relinquish profits to SOEs, in light of the taxing contracts under “eating from separate stove,” the revenuesharing contract also played a part in the meager growth. As we shall see, the efficiency of the revenue-sharing contract in motivating revenue growth paled in comparison with the tax-sharing contract which was adopted after 1994. Even with the implementation of annual “fiscal taxation inspections” from 1985 and efforts to strengthen supervision and penalization, the distance between the central government and local authorities hampered the effectiveness of such efforts. Beyond 1994, starting from when the tax-sharing system made the central and local governments responsible for their own taxation, however, annual tax revenue growth more than doubled from 7.2% between 1986 and 1992 to 18.4% between 1995 and 2008.

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The reforms on the distribution of fiscal powers also had profound impact on the concentration of fiscal revenue. The nature of the taxing contracts adopted by the reforms of 1985 and 1988 directly caused a fall in the central government’s revenue share. Directed towards the economically developed areas of Guangdong, Hunan, Beijing, Shanghai, Shandong, and Heilongjiang, the 1985 reform was yet largely based on the prescribed quota contract, meaning that the central government would not benefit much from revenue growth, and its share in total revenue would necessarily go downhill. Worse still, the central government had to subsidize 16 less advanced areas. It was this dire strait that pushed the central government to launch the differential schemes of 1988, hoping that “incremental delivery quota contracting” and “incremental revenue contracting” would expand its share of revenue while maximizing local governments’ motivation. This arrangement had the short-lived effect of lifting the central government’s revenue share in the first two years of implementation, but was otherwise unable to turn the tide of decline (see Table 12.2). To use Shanghai, which was designated a model of “prescribed quota delivery” with incremental revenue sharing, as an example, its fiscal revenue throughout the five years under this scheme was maintained between CNY16.5 billion and CNY16.5 billion with no recognizable growth. Revenue growth was controlled to keep down the central government’s share in the increase. Central and local government revenue shares

Fig. 12.2 100

%

80 60 40

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

10

1986

20 Year

Local share Central share

The turning point came only in 1994 thanks to clear delineation of taxing powers under the tax-sharing contract. With the central and local governments each levying their own taxes within their own scope except for a few shared taxes,

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the revenue shares of the two levels of government remained stable from 1994 to 2001, and the income tax revenue division reform in 2002 even slightly expanded the central share.

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13

Chapter

Food First, Construction Second

MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 2

The slogan “Food first, Construction Second” (yi yao chifan, er yao jianshe 一要吃飯， 二要建設) was taken from a speech by late statesmen Chen Yun which was made in a senior meeting of the CPC in 1981. The sentence in full reads: “We are a population of a billion, making it necessary to have all-round planning and rational allocation as regards how much to give the workers and farmers, and how much to go into construction (jianshe) every year; food (chifan) must come first, and construction should come second.”1 Chen pointed out as early as the 1960s: “Now we face the problem of how to consolidate and develop the fruits of the revolution, and the key lies in the settlement of the lives of over 600 million people and truly striving for their welfare.”2 He had also noted the tension between economic construction and people’s livelihoods and drawn attention to the importance of striking a reasonable balance: Both economic construction and people’s livelihoods have to be taken care of — they have to be balanced. It appears that for a long time, this balance will be a rather tight balance. To be bountiful both in construction and people’s livelihoods — I see that this would be rather difficult. We only have this amount of farmland, but our population is large. What we eat and what we wear all depend on it. If we do not undertake construction, unemployment and semi-unemployment will remain as they are, social purchasing power will still be low, and commodity supply will of course be not tight for the time being. But it is impossible not to undertake construction. If we undertake construction and increase employment, a portion of the rural population will move into cities. People will eat more, wear more, and use more, social purchasing power will be raised, and commodity supply will become tight.3 It is clear, then, that chifan refers to people’s livelihoods and welfare, while jianshe investment on production;4 the slogan prioritizes people’s livelihoods over economic construction. The question of priorities regarding people’s livelihoods and economic construction embodies China’s outlook on development in different periods. Zhao and Zhang break down the history of New China by development outlook into three phases: 1949 to 1978, as characterized by economic growth–oriented development; 1979 to 1994, economic development–oriented development; and post-1995, socioeconomic progress–oriented development.5 From the major features of these three periods of development as summarized in Table 13.1, we can see that before 1995, China had focused on catching up with the Western nations and therefore placed growth and development at the top of its national agenda. In the 1980s, there began to be a realistic recognition of the importance of people’s livelihoods

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as the foundation of economic development, although it was not until 1995 that priorities were significantly reversed. Table 13.1

Changes in China’s outlook on development since 1949

First-generation

Second- generation

Third-generation outlook:

growth–oriented

economic

oriented development

outlook: economic

outlook:

socioeconomic progress–

development (1949– development–oriented (post-1995) 1978) Goal Index

Industrialization Industrial and

Channel

added Growth first

Focus Method

Heavy industry External-oriented

agricultural value

development

(1979–1994) Four Modernizations GNP

Human development Green national product

Growth first,

Development first

supplementary Industry External-oriented and

National economy and society Internal-oriented and

accumulation and

and consumption

development

Form

and extensive Accumulation first

Regional

Balanced

Trend Scope

production relations Up Catching up Catching up Economic Economic

approach development Drive Revolution of

extensive Simultaneous consumption Unbalanced

development Reform and Opening

encompassing social

intensive Simultaneous accumulation

Coordinated development Well-rounded development of society Peaceful development Economic, social, human, ecological

Source: Zhao and Zhang, “Historical Interactions between the Concept of Development and the Development Model since the Founding of New China,” 24.

Analytical Framework The question of choice between investment on production and people’s livelihoods is not exclusive to planned economies or China. Advanced market economies, too, diverge over which to prioritize. In comparative institutional analyses, institutions

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leaning towards the two ends have been classified as “production regimes” and “welfare regimes.” Soskice defines a production regime as “the organization of production through markets and market-related institutions,” suggesting that “it analyzes the ways in which the microagents of capitalist systems — companies, customers, employees, owners of capital — organize and structure their interrelationships, within a framework of incentives and constraints or ‘rules of the game’ set by a range of market-related institutions within which the microagents are embedded.” He identifies the four most important institutions of such a framework: the financial system, the industrial relations system, the education and training system, and the intercompany system.6 In their study of developed market economies, Hall and Soskice distinguish between “liberal market economies” and “coordinated market economies” by institutional structure.7 Coordinated market economies are characterized by strong powerful union organization, a concentrated wage bargaining system, corporatist policy-making, and an emphasis on the role of the state in the market, which can be represented by Germany and Japan. In coordinated market economies, firms tend to depend more on nonmarket relationships in negotiations; hence the production regime is driven more by “strategic interaction among firms and other actors” than “demand and supply conditions in competitive markets” as in liberal market economies.8 This “joint regulation of labor markets,” summarizes Thelen, “is embedded in other institutional arrangements that have taken employers further in orienting their competitive strategies around high-quality, high valueadded production that depends on a high degree of stability and cooperation with labor.”9 In other words, firms in coordinated market economies need high-skilled workers, a need that develops into an internal labor market with a high-wage structure and a high-skilled workforce, lending an important role to the dual vocational training system and all-round on-the-job training. Despite strong overarching union structures, Thelen observes a trend of renegotiation of collective bargaining relations from central union–directed national-level bargaining to plant-level bargaining between workplace representatives and employers.10 According to Ebbinghaus, since workplace and union representatives will bargain for social plans in the case of mass dismissal, in times of economic recession that compels restructuring, a firm may strategically “uphold its tenure commitment and maintain social peace at the workplace level” by providing early retirement or reduced hours options in order to avoid mass layoffs of prime-aged workers.11 Ebbinghaus also argues in terms of financial system that employment stability and corporate welfare benefits are guaranteed by stable ties between firms and banks.12 Liberal market economies are, on the contrary, regimes with relatively weak unions, a nonconcentrated wage bargaining system, a lack of corporatist policy-

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making, high female employment rate, and low government intervention.13 The United Kingdom and the United States are prototypes of this regime. Firms in liberal market economies, Hall and Soskice note, coordinate activities “primarily via hierarchies and competitive market arrangements,” leading to market relationships founded on “exchange of goods or services in a context of competition and formal contracting,”14 and market prices determined by supply and demand. As Thelen shows, employers lacking coordinating capacities among themselves favor labor deregulation, and the weakening of unions give them larger initiative vis-à-vis unions and greater power in renegotiating work rules.15 Unlike coordinated market economies, liberal market economies are dominated by Fordist mass production firms which demand lower skills from workers, who are thus more susceptible to layoffs under market fluctuations as employers are less committed to employment tenure.16 Relying on “capital markets that impose short-term horizons and on antitrust polies that foster competitive interfirm relations,” listed companies in liberal market economies are likely to downsize employment and sell off units in the face of economic pressure, and firms often boost profit by creating economies of scale through mergers and acquisitions, subjecting employees to a new parent company that may not honor the original pension commitments of the acquired company.17 The concept of welfare regime is closely related to the development and expansion of welfare states in the West. While welfare states have the common goals of protecting individuals against economic risks brought by unemployment, illnesses, old age, and occupational hazards, there are differences in the choice of institutional setup for achieving similar goals. Esping-Andersen’s innovative study in 1990 organizes discussion around the concept of “welfare-state regimes,” looking beyond the construction of social-amelioration policies to how the policies influence employment and the general social structure, and thereby exhibit the interwoven legal and organization systems between state and economy.18 Examining the phenomenon that is commonly discussed as the “welfare state crisis” later, Esping-Andersen stresses that the “sum-total of societal welfare” derives from the combinations of the three institutions of labor markets, the family, and the state, not just specific welfare policies or plans.19 Welfare regimes have been classified into three types: the Nordic “social democratic,” the Continental European “conservative,” and the Anglo-Saxon “liberal” (see Table 13.2). Different social policy strategies (such as means testing, social insurance, and citizenship) entail political, social, and economic divergences, for example in labor markets, as Kolberg and Esping-Andersen demonstrate.20 Esping-Andersen and Korpi have similarly shown that different welfare strategies are underlain by different ideologies and values, which will in turn shape labor markets, social risks, and personal lives.21

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Table 13.2 Classification of welfare regimes Regime

Social democratic

Conservative

Liberal

Value orientation

Universalism

Employer-labor

Individualism

Policy goal(s)

Redistribution

coordination Safety and stability

Means

Provision of welfare

Mutually contributed

alleviation Means-tested

Level of

High

negotiations Medium

or insurance Low

Medium welfare

Low welfare and

transfer payment

expenses

and social services to all welfare via labor

decommodification Fiscal expenditure High welfare expenses, medium transfer

payment expenses

expenses, high

Poverty

social assistance

transfer payment

Fiscal revenue

High tax burden

expenses Medium tax burden

Low tax burden

Example countries

Sweden, Norway,

Germany, France,

U.S., U.K.,

Denmark

Italy

Canada

The above discussion reveals a parallel between production regimes and welfare regimes; that is to say, a production regime has to be supported by a corresponding welfare regime. Bernard and Boucher have compared the relationships of social democratic and liberal welfare regimes with their respective production regimes,22 which are presented in Fig. 13.1 and 13.2. Two points are clear: first, the welfare regime determines the long- and short-term productivity of the production regime; second, different combinations of fiscal and welfare regimes have to be matched by different social policies (on fiscal expenditure and tax revenue). It is evident from the social democratic model that high social expenditure raises both shortterm productivity — by increasing human capital and reducing workers’ burdens — and long-term productivity — by lengthening feasible work hours (such as by enabling women and parents to spend more time on work and equipping older people to keep on working through training). In the liberal model, however, low social expenditure engenders greater cross-class welfare differentials, and hence an uneven distribution of short-term productivity and the unwillingness and inability of the low income to pay tax, which in turn restrict social expenditure.

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Fig. 13.1 Relationships between welfare, production, and fiscal regimes in social democratic regimes Social investment (mainly via public provision of productivity-enhancing services) Care for family members (children, elderly, the sick) Education, training, and life-long learning Healthcare and rehabilitation

Short-term productivity (output/hour): equal distribution, generally high

Long term productivity (output/lifespan): equal distribution, general high

Institutional competitiveness built on societal investment High fiscal capacity (many can afford public service taxes)

Thus, as illustrated in Fig. 13.3, the production, welfare, and fiscal regimes in a market economy are interdependent. The production regime restricts the fiscal regime in that the economic resources needed in fiscal activities are derived from the value added in production, and different production regimes (government-/ market-driven, internal-/external-oriented, extensive/intensive) determine the major sources of revenue. In relation to the welfare regime, the production regime influences it through the maturity of the financial market, which demarcates the feasible social insurance arrangements, and the degree to which it emphasizes skills and welcomes female workers, which affect the level of support to be given to workers and families. The fiscal regime, through the size of revenue, limits the pool of money that can go into welfare expenses in the welfare regime. Yet in the other way round, the welfare regime can also select the sizes and forms of fiscal revenue and expenditure for the sake of “social protection.” Finally, by advancing human wellbeing and the protection of the natural environment, the welfare regime lays the foundation for sustaining and expanding reproduction. The public goods provided by the fiscal regime, as well as the tax burdens it places on firms, likewise, have a great impact on the maintenance and expansion of reproduction.

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Fig. 13.3

Interrelations between the production, welfare, and fiscal regimes Fiscal regime

Restrains

Selects Reproduces

Restrains

Restrains Production regime

Reproduces

Welfare regime

Although production and welfare regimes are concepts coined by scholars studying capitalist market economies, they are not necessarily inapplicable to planned or transitional economies. Production and welfare creation are arguably issues facing all economic regimes. As far as China is concerned, the changes in the production regime during the transition towards the market economy have caught the lion’s share of attention due to its direct bearing on the country’s rapid economic growth; however, the corresponding changes to the welfare and fiscal regimes should not be neglected. Were these changes suited to the principle of “food first, construction second”?

Institutional Changes The relationship between “food” and “construction” since the founding of New China can be analyzed based on the above framework. The main components of the production regime are the financial system, labor relations, the education and training system, and interfirm relations. Regarding the welfare regime, the four aspects of interest are care for family members, education, healthcare, and housing. For the fiscal regime, fiscal revenue, fiscal expenditure, the fiscal budget, and intergovernmental fiscal relations will be studied. Table 13.3 shows the parallel changes in the three regimes before 2002.

122

Production regime

Planned economy: • Funds allocated according to state plans, mainly executed through fiscal authorities • Labor relations under government’s unified control according to administrative hierarchy • Training mainly provided by enterprises’ internal training (apprenticeship system) and state-run vocational education institutes • Enterprises developed relationships according to administrative hierarchy and state plans

“Dual track” economy • Funds allocated along administrative hierarchy, mainly executed by banks, with a waning role of fiscal authorities • Labor relations becoming less administrative with the beginning of employment contracts • Indirect training mainly through encouraging participation of governmentrun vocational qualification exams

Period

1953– 1978

1979– 1992

Enterprise- and family-oriented: • Care for family members mainly by family, with market playing an increasing role • Education mainly provided by state, with increasing fees • Healthcare tending towards market provision • Housing becoming less a benefit and more a commodity

State-, enterprise-, and familyoriented: • Care for family members mainly by family, with some financial aid and facilities from enterprises • Education mainly provided by state for free or at a low cost • Healthcare protection mainly provided by enterprises in cities and collective medical system in villages • Housing provided by enterprises as employment benefit

Welfare regime

Table 13.3 Parallel changes in China’s production, welfare, and fiscal regimes

“Dual track” production: • Fiscal revenue mainly from taxes and fees • Fiscal expenditure with economic construction expenses greatly reduced and educational, cultural, and administrative expenses surging • Budget balance emphasized • Intergovernmental relations regulated by full contractual responsibility

Planned production: • Fiscal revenue mainly from SOE revenues • Fiscal expenditure mainly spent on production • Budget balance emphasized • Intergovernmental relations regulated by unified control of revenues and expenditures

Fiscal regime

Food First, Construction Second

123

124

1993– 2002

Period

Table 13.3

Interfirm relations characterized by dual elements of planned and market economies

Nascent stage of market economy: • Funds allocated mainly by commercial banks and supplemented by direct finance • Labor relations mainly governed by market contracts, with employers taking the lead and limited protection for workers • Training dependent on the enterprise

•

Production regime

Family-oriented: • Care for family members by family as well as market services, with social insurance playing only a limited role • Formal education mainly provided by state, with emergence of private education • Healthcare mainly dependent on market • Housing mainly provided by market

Welfare regime

Market production: • Fiscal revenue mainly from taxes, with proportionally large extrabudgetary revenues • Fiscal expenditure mainly spent on purchases, with increase in transfer payments • Economic regulation emphasized in budget planning • Intergovernmental relations characterized by tax hierarchy

Fiscal regime

(Cont’d)

MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 2

Food First, Construction Second

The three stages in the table are divided based on changes in the production regime. From 1953 to 1978, a Socialist planned economic regime was gradually established. Despite the frequency of political campaigns, the planned economic system remained steadfast, laying down the backdrop to the economic transition in the ensuing period. The years 1979 to 1978 were a period of experimentation with market-oriented reforms. With an incremental approach, a market sector was developed alongside its existing state-owned counterpart, giving birth to the household responsibility system, collective township and village enterprises (TVEs), individual operations, and foreign-invested enterprises, so that the stateowned and non-state-owned sectors ran on a “dual track” that characterized the period. The Economic Reform entered a mature stage in 1993 to 2002, as the pricing and supply of major commodities became basically market driven, and the public sector, which included TVEs, increasingly shrank in share and significance in the economy.23 Privatization in the welfare regime and decentralization in the fiscal regime were performed to suit this trajectory of change.

The three regimes under the planned economy In the planned economic era, the production regime was dominated by the state. In rural areas, the primary production unit was the “production brigade” (shengchan dadui 生產大隊), while the urban counterpart was the state-owned enterprise. These production units were simultaneously components of the production and welfare regimes, fulfilling state production plans while affording benefits, including services and facilities on healthcare, education, elderly care, and raising of children, to members of the units, forming some kind of “enterprise-run society.” Fiscal appropriations to these public units were used for production as well as welfare provision. However, marred by an impetuous “catchup” strategy, fiscal redistribution showed disproportionate favor to heavy industry at the expense of light industry, cities over villages, and production over welfare and benefit. Being discriminatory, this fiscal regime was bound to be rejected by the disadvantaged sectors (agriculture, villages, and households) and must be implemented by intense micro-control under highly concentrated administration, which would paradoxically weaken fiscal functions. To look at the expenditure side, the fiscal regime was unable to truly penetrate the production regime as all the human and material resources were allocated by state plans. For example, although fiscal revenue was the source of capital for fixed asset acquisition and upgrading, SOEs would not be able to utilize the funds unless authorized by state plans; therefore the availability of capital was not the determining factor for SOEs’ activities in relation to fixed assets. The fiscal function

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in welfare provision was not given much play, either, for family and individual welfare was provided in the forms of physical assets or services, such as schools and hospitals, by scattered production units and local agencies. Similarly, from the angle of revenue, benefit-deducted SOE profits took up the mass of fiscal revenue, meaning that fiscal redistribution which would otherwise be performed between the production and welfare regimes was completed in the production unit already under the planned economy. The weakened redistributive function of the fiscal regime in turn crippled local governments’ fiscal functions. Under unified control of revenues and expenditures, the central government saw local governments more as executors in revenue collection and spending than agencies with autonomous decision-making power. Despite Mao’s pinpointing of central-local government relations as one of the five most important relationships in his 1956 report On the Ten Major Relationships, the central government was generally not disposed to turn state revenue into financial incentives for local governments. The several trials of decentralization during the Great Leap Forward and the Cultural Revolution were attempted without hard budget constraints and doomed to provoke irrational expansion of local projects regardless of economic benefits, eventually forcing intergovernmental fiscal relations to revert to centralization. Central planning of economic resources also reduced the government’s fiscal extractive capacity. Studies on state capacity usually take extractive capacity as the foundation of other dimensions of capacity, but in a planned economy, it is political penetration capacity enabled by a one-party system that is most fundamental.24 Acting on the leadership of local Party committees in various production units along the administrative hierarchy, the central government could directly impose its intents on urban industrial plants and rural farms, and thereby complete resource allocation within the production units. This very demand of the planned economy on political penetration capacity made it essential to increase the number of administrative levels. Even back in imperial times, the dynastic governments ever since the Song dynasty (AD 960–1279) had always refrained from extending imperial power beyond the county level, holding county-level governments as the lowest level of local government. The central government in the planned economic era of New China, however, not only established administrations down to the level of people’s communes, but also directly controlled village production via production brigades. From the People’s Commune Movement in 1958 onwards, towns and townships were disposed of and merged into large “communes” charged with the powers and responsibilities of former town and township governments, while agricultural cooperatives were renamed “production brigades,” signifying the unification of

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political and production organizations. Party branches were established within the production brigades, which not only handled Party affairs, but also implemented tasks associated with plans handed down by superior Party organizations. In order to ensure the smooth communication of instructions, the more concrete control the central government wished to grasp, the shorter distances between governments it would need. In order words, this, again, necessitated the addition of administrative layers and local government responsibilities. Eventually, the weakened redistributive function of the fiscal regime and the expansion of local administration structure led to a mismatch between governments’ budgetary revenues/expenditures and functions. Budgetary revenues only accounted for a part of all revenues associated with government functions. As the line between government departments and SOEs was blurred, superior competent departments of SOEs managed to direct the generation of budgetary revenue and utilization of budgetary expenditure on behalf of the central ministries and commissions, as constituents of the vertical execution of central planning. In sum, between 1953 and 1978, intergovernmental fiscal relations were characterized by a high degree of concentration of fiscal power in the central government, with financial incentives playing a negligible role in affecting local officials’ choices of action. The increase of administrative levels and local government functions directly created more fiscal levels but lowered the importance of conventional fiscal revenues in total government revenue.

The three regimes at the beginning of the Reform and Opening Up era During 1979 to 1992, the Reform and Opening Up policy was still wavering between amelioration of the planned economic system or a full migration to the market system, hence the so-called “dual track” policy accommodating both economic regimes. Its implication on the production regime was the relaxation of the decision-making power over SOE and rural household production: SOEs were permitted to produce goods for market transactions upon fulfilling the state quotas, while rural households were, under rural land contracts, granted the freedom to grow their own produce after turning over the public grain. With this, bank loans rose to the new financing needs of profit-oriented production. According to He’s breakdown of enterprises’ financing sources in 1978, 1990, and 1995, the main source of enterprises’ capital gradually shifted from fiscal appropriations to bank loans (see Table 13.4).25 Increasingly over time, the strengthening of the market mechanism spurred enterprises to pursue efficiency. The job security of “iron rice bowls” was gradually superseded by employment contracts to deter sloth, while to lower costs, enterprises began to withdraw from welfare provision that had no direct connection with production. 127

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Table 13.4

Source

Changes in China’s financing structure after Reform and Opening Up

Year

1978

Fiscal appropriations

70.1%

1990

1995

15.1%

2.5%

8.6%

10.1%

Bank loans

27.7%

64.5%

Market

2.2%

11.8%

Internal

0

71.0% 16.4%

Source: He, “A Brief Discussion of China’s Enterprise Financing Mechanisms,” 46.

Within the welfare regime, a complementary structural adjustment was underway. On the one hand, the growth in the overall efficiency of production units raised the money income of their employees; on the other hand, the reduction in benefits lowered their income in kind. The latter change increased the uncertainty in future consumption expectations, triggering a precipitous rise in savings. Modigliani and Cao’s study, as illustrated in Fig. 13.4, shows a large increase in China’s per capita income since 1978, which was yet outpaced by the growth in household savings ratio.26 Fig. 13.4

0.40 0.35 0.30

China’s household savings ratio and per capita income, 1953–2000 CNY 700

Household savings ratio

600

Per capita income in 1950 CNY

500

0.25 0.20

400

0.15

300

0.10

200

0.05

100

1998

1993

1988

1983

1978

1973

1968

1963

1953

-0.05

1958

0.00

0 Year

Source: Modigliani and Cao, “The Chinese Saving Puzzle and the Life-Cycle Hypothesis,” 146.

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The increased household savings were injected into production through the banking system, thus tilting the balance between the production and welfare regimes towards production. In this period, the fiscal regime had not tried to redress the balance by effective redistribution. Despite the drop in fiscal expenditure on economic construction and rise in cultural and educational expenses, the continuous slippage in the share of fiscal expenditure in GDP caused cultural and educational expenses to fall in reality, from 4.37% in GDP in 1980 to 3.94% in GDP in 1990 (see Table 13.5). Table 13.5 Changes in China’s fiscal expenditure structure (%) Year

Economic construction expenditure in fiscal expenditure

Cultural and Administrative Fiscal expenditure educational expenditure in in GDP expenditure in fiscal expenditure fiscal expenditure

1980 58.2

16.2

6.1

27.0

1985 56.3

20.4

8.5

22.2

1989 45.7

23.7

13.7

16.6

1990 44.4

23.9

13.4

16.5

Source: Computed based on data in Finance Yearbook of China 2006.

The reduced portion of fiscal appropriations on economic construction was totally covered by an increase in loans issued by state-owned banks. As Fig. 13.5 shows, when economic construction expenditure swelled from CNY46.62 billion to CNY71.90 billion between 1976 and 1978, there was no such item as “fixed asset investment loans” in state-owned banks, but starting from 1979, fixed asset investment loans kept growing year after year, finally overtaking the economic construction expenditure by 1987 (CNY128.68 billion compared with CNY115.35 billion). State banks had replaced fiscal authorities as chief providers of capital for economic construction.

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Fig. 13.5 Fiscal economic construction expenditure and fixed asset investment loans by state-owned banks in China, 1976–1999

2,200 2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 0

1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

CNY1 billion

% 65 60 55 50 45 40 35 30 25 20 15 10 5 0 Year

Fiscal economic construction expenditure Fixed asset investment bank loans Fiscal economic construction expenditure in total fiscal expenditure Fixed asset investment bank loans in total bank loans Source: Han, “Efficient Institution and Restriction of Administrative Powers,” 19.

After two stages of the “tax-for-profit” reform, the item of “SOE profits” had been removed from the fiscal balance sheet, existing in a new form as enterprise income tax. And this was no mere change in name, for the tax rate was lowered to 33% from the hundred-percent delivery of profits in the past. The burden on SOEs was drastically reduced, yet given the huge financial demand of the government, coupled with the adoption of a predominantly indirect tax system, the tax burden was inevitably shifted towards the end consumers, that is, the people. Simultaneous with the changes in the fiscal structure were adjustments in intergovernmental fiscal relations in favor of the institutional transformation of the production regime. In the past, the top-down fiscal system embedded in the Party organization under the planned economic regime had bound local governments and production units into joint administrative entities, and political penetration was achieved at the expense of economic efficiency. With the introduction of the Reform and Opening Up policy, extraction capacity was developed to remedy the low level of social support. Political administration was split from SOE management, with the SOE’s leadership reformed from collective leadership by Party committees to a factory manager responsibility system (changzhang fuze zhi 廠長負責制). At the same time, fiscal contracting systems connected local government revenue to local

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SOEs’ business performances, thereby transforming the joint administrative entities into mutually restraining joint benefit entities. This kind of intergovernmental fiscal relations thus tied the fiscal activities of local governments with the reform of the production regime. Compared with the gradual marketization reform on the state-owned sector, the non-state-owned sector, especially TVEs, represented an even more vigorous drive for privatization. The people’s commune system was shattered following the implementation of the household responsibility system, and the 1982 constitution amendments prescribed township (xiang 鄉) and towns (zhen 鎮) as the lowest levels of government, breaking the vertical leadership of town and township governments over villagers committees. Like the higher levels of local government, town and township governments saw local SOEs as their major source of revenue under fiscal contract arrangements; however, the limitation in public economic resources at their administrative level incited a unique enthusiasm for developing collectively oriented TVEs. Cao, Qian, and Weingast have demonstrated that hard budget constraints played a role in pushing Chinese local governments towards SOE reform.27 Although township and town governments did not supervise SOEs, it was for this reason, compounded with their relatively weaker power in interfering with bank loan issuance, that they were subject to harder budget constraints than local governments of higher levels and thus were more enthusiastic in fostering TVE efficiency. By 1993, TVEs which had only sprung up since the 1980s had assumed a 30% share of China’s gross industrial output. The drastic growth of TVEs in this period can be seen in Table 13.6. Table 13.6 Development of TVEs in China, 1978–1993 Year Value added (CNY1 billion) Growth rate (%) 1978 20.9 — 1979 22.8 9.09 1980 28.5 25.00 1981 32.1 12.63 1982 37.4 16.51 1983 40.8 9.09 1984 63.3 55.15 1985 77.2 21.96 1986 87.3 13.08 1987 141.6 62.20 1988 174.2 23.02 1989 208.3 19.57 1990 250.4 20.21 1991 297.2 18.69 1992 448.5 50.91 1993 800.7 78.53 Source: Chen et al., Chinese Rural Institutional Changes over 60 Years.

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As local governments’ fiscal power came to be established by fiscal contracting, the share of total fiscal (budgetary) revenue in GDP and the central government’s revenue in GDP dwindled. Despite the apparent illusion of decreased resource extractive capacity, this was not true. The fact was that back in the planned economic era, local government revenues from administrative responsibilities had not been included in the budget and therefore not considered “fiscal revenues.” With the devolution of power over SOEs to local governments following the start of the Reform and Opening Up era, control of central ministries and commissions over local government departments greatly loosened, and extrabudgetary and extra-establishment revenues of local administrative departments not subject to delivery to the central government, which would only assign and adjust delivery percentages of budgetary revenues, surged. The decline of local governments’ enthusiasm in boosting budgetary revenue, then, is clearly ascribed to the fact that they could retain nonbudgetary revenues in full. Table 13.7 exhibits the hike in extrabudgetary revenue, while Table 13.8 estimates the size of extra-establishment revenue by deducting from the total government expenditure as calculated by national income accounting budgetary and extrabudgetary revenues. The sum of extrabudgetary and extra-establishment revenues exceeded budgetary revenue a great deal. Another reason that accounts for the low shares of central and budgetary revenues in GDP is the central government’s dearth of information in negotiating its revenue share, whose growth constantly lagged that of economic growth as a result. Simply put, the low share of budgetary revenue in GDP reflects not so much a fall in the government’s extractive capacity as institutional loopholes in intergovernmental fiscal relations: we can see from Tables 13.7 and 13.8 that the share of total government revenue (fiscal budgetary + extrabudgetary + extraestablishment) in GDP was maintained stably at around 36% from 1988 to 2002. Intended as financial incentives for reforming inefficient SOEs, the devolution of SOEs to local governments during the “dual track” regime of 1978 to 1992 had the unexpected effect of turning TVEs into a major component of the national economy, thereby empowering town and township governments which had a dominant influence over TVEs in intergovernmental fiscal relations. Against the wish of the central government, local governments focused their efforts on amassing extrabudgetary and extra-establishment revenues instead of responding to the limited inducement of the fiscal contracting systems to increase budgetary revenue. Total budgetary revenue thus decreased, as did the central government’s revenue share.

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Table 13.7 Budgetary and extrabudgetary revenues in China, 1978–1992

Year 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992

Budgetary revenue Total (CNY1 Share in billion) GDP (%) 113.22 31.1 114.63 28.2 115.99 25.5 117.57 24.0 121.23 22.9 136.70 22.9 164.27 22.8 200.48 22.2 212.20 20.7 219.94 18.2 235.72 15.7 266.49 15.7 293.71 15.7 314.95 14.5 348.34 12.9

Extrabudgetary revenue Total (CNY1 Share in billion) GDP (%) 34.71 9.6 45.29 11.1 55.74 12.3 60.11 12.3 80.27 15.1 96.77 16.2 118.85 16.5 153.00 17.0 173.73 16.9 202.88 16.8 236.08 15.7 265.88 15.6 270.86 14.5 324.33 14.9 385.49 14.3

Extrabudgetary revenue in budgetary revenue (%) 30.7 39.5 48.1 51.1 66.2 70.8 72.3 76.3 81.9 92.2 100.1 99.8 92.2 102.9 110.7

Source: Xie, ed., A 60-Year Review of China’s Public Finance.

Table 13.8 Year 1988 1989 1990 1991 1992

Extra-establishment revenue in China, 1988–1992 Total (CNY1 billion) 83.17 86.09 105.10 149.08 218.69

Share in GDP (%) 5.5 5.1 5.6 6.9 8.1

Source: Computed based on Yang and Hu, “Theoretical Study and Empirical Analysis of Government Nontax Charges.”

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The three regimes after initial migration to the market regime After 1992, the market orientation of economic reform was fully confirmed, with the diminution of planned elements and aggrandizement of market elements in the production regime becoming irreversible trends. One of the landmark events of this change was the mass bankruptcy and restructuring of SOEs. First was the adoption of the Decision on Several Issues Concerning the Establishment of a Socialist Market Economic System by the Third Plenary Session of the 14th CPC Central Committee in 1993, which provided for enterprises’ ownership of all legal person property rights from investments of all sources, including the state, and their independent operation and self-financing responsibility as legal persons. Then there was the recognition of “grasping the large and releasing the small” (zhua da fang xiao 抓大放小) — concentrating support on large SOEs and selling off or closing down small and medium-sized ones — as the leading strategy of SOE reform in the Fifth Plenary Session of the 14th CPC Central Committee in 1995, after which the number of SOEs went downhill. As Fig. 13.6 shows, the number of state-owned and state holding enterprises went down from 1.33 billion in 1992 to 41,110 in 2002. As demonstrated earlier, TVEs expanded remarkably in the early days of the slashing of SOEs, but these rural enterprises had been mired in inherent problems such as ownership ambiguity, funds shortages, technological backwardness, and, especially, overreliance on town and township governments in organization and management, resource acquisition, and market development. As the market matured and competition intensified, the resources that town and township governments could offer them began to reduce, and in fact governmental intervention began to be felt as a hindrance rather than a help to TVEs’ development. Therefore TVEs started to reorganize into other forms of business after 1997, and their growth rate could no longer be sustained (see Table 13.9). The plunge in the number of collective enterprises between 1997 and 1998 in Fig. 13.6 reflected a sharp reduction of TVEs. The increase in market elements was evident in the rapid growth of the nonpublic sector. In addition to providing for SOEs’ legal person rights, the 1993 Decision also pledged to create favorable conditions for the equal participation in market competition of enterprises of all kinds of ownership. In 1997 President Jiang Zemin’s report at the 15th National Congress of the CPC reads: “The nonpublic sector is an important component part of China’s socialist market economy. We should continue to encourage and guide the non-public sector comprising self-employed and private businesses to facilitate its sound development.”28 This was incorporated into the constitution by the amendment adopted by the Third

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Session of the Ninth National People’s Congress in 1999, which states, “The nonpublic sectors of the economy such as the individual and private sectors of the economy, operating within the limits prescribed by law, constitute an important component of the socialist market economy”; “The State protects the lawful rights and interests of the individual and private sectors of the economy, and exercises guidance, supervision and control over the individual and the private sectors of the economy.”29 The position was emphasized again in Jiang Zemin’s report at the 16th National Congress of the CPC in 2002: “it is necessary to encourage, support and guide the development of the non-public sectors of the economy.”30 The growth of the nonpublic sector is illustrated by the line for “other enterprises” in Fig. 13.6. Although there was a dip in 1998 due to the Asian Financial Crisis, the upward trend resumed after that.

Table 13.9 Development of TVEs in China, 1992–2007 Year 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Value added (CNY1 billion) 448.5 800.7 1,092.8 1,459.5 1,765.9 1,891.4 2,218.6 2,488.3 2,715.6 2,935.6 3,238.6 3,668.6 4,181.5 5,053.4 5,795.5 6,926.0

Growth rate (%) 50.91 78.53 36.48 33.56 20.99 7.11 17.3 12.21 9.13 8.1 10.32 13.28 13.98 20.85 13.83 20.13

Source: Chen et al., Chinese Rural Institutional Changes over 60 Years.

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Fig. 13.6

Number of industrial enterprises in China by ownership, 1999–2002 State-owned enterprises Collective enterprises Other enterprises

700,000 600,000 500,000 400,000 300,000 200,000 100,000 0

1992

1993

1994

1995

1996

1997

1998

Source: China Industry Economy Statistical Yearbook 2006.

1999

2000

2001

2002

Year

The diversification of enterprise types and the rise of the nonpublic sector should have dictated matching changes in the financing structure. However, as Table 13.10 shows, bank loans remained dominant in enterprises’ financing sources, while direct finance merely contributed a small part. Table 13.10 Sizes of bank loans, treasury bonds, and enterprises’ direct financing in China (CNY1 billion) Year

Bank loan increase

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

633.54 721.66 933.98 1,068.33 1,071.25 1,149.09 1,084.64 1,334.66 1,243.94 1,897.92

Treasury securities issuance 381.31 1,137.55 1,510.86 1,847.77 2,411.79 3,808.77 4,015.00 4,657.00 4,884.00 5,934.30

Funds raised from domestic stock market (A and B shares) 314.54 138.05 118.86 341.53 933.82 803.57 897.39 1,541.02 1,182.13 779.75

Enterprise bond issuance 235.84 161.75 300.80 268.92 255.23 147.89 158.20 83.00 147.00 325.00

Source: People’s Bank of China and Chinese Securities Regulatory Commission, quoted in Li and Long, “Reflections on Perfecting the Financing Structures of Our Enterprises,” 35.

Among the bank loans, the nonpublic sector assumed as little as about 20% of the funds (see Table 13.11), meaning that the inefficient state-owned sector, made

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up mostly by heavily loss-making SOEs, benefited from most of the increased loans, whereas the booming non-state-owned sector received minimal support from the main financing channel. The banking system and the financing structure at large were far from efficient in funds allocation. However, as in the case of coordinated market economies, bank-based capital also occupied a central importance in the welfare regime, being the backbone of welfare provision through firms. Thus, the fact that SOEs would be ousted by the market within a short time without the support of bank loans would paradoxically bring too big an immediate shock to employment that society could possibly bear. While the financing structure did hold back privatization, it allowed privatization to proceed at a relatively affordable pace. Table 13.11 Loan share of China’s non-state-owned sector, 1985–2000 (%) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Loan share 19.16 19.18 20.17 20.19 18.18 12.16 18.16 25.13 24.18 26.12 25.19 Source: Zhang, Financial Intermediaries and State-Owned Banks during Economic Transformation.

But still, the welfare functions of the production regime would continuously diminish with the advancement of privatization. The mass bankruptcy and restructuring of SOEs and collectively owned enterprises caused a large number of employees to be laid off or retire early, thereby breaking the connection between enterprises and welfare provision. Table 13.11 shows that the size of the urban workforce at its lowest point in 2003 was 44.16 million below the peak in 1995, while the SOE workforce began to shrink starting from 1996, with the most drastic decrease in 1998. Within a decade, the workforce of SOEs and collective enterprises slumped by 77.84 million, among whom 75.34 million were employees. On the other hand, private enterprises began to hire idle rural workers on a large scale, giving rise to a wave of migrant workers. But remaining part of the “agricultural” population, these workers were not protected by the basic welfare benefits enjoyed by urban citizens: for the time being, the government, being short of budgetary revenue, prioritized efficiency over equity, economic construction over welfare provision, and baking a big “cake” over fair cake-cutting, so caring for the elderly and children, education, healthcare, and housing were left to the responsibility of the family. The deterioration of income distribution under rapid economic growth was arguably the outcome of the failure to make new institutional arrangements after the tie between the production and welfare regimes was cut off.

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Table 13.12 China’s urban employment figures, 1992–2006 (10,000 persons) Year

Collective enterprise workforce Size Difference Size Difference Size Difference Size Difference Size Difference 1992 17,241 264 14,792 284 10,889 225 10,889 225 3,621 –7 1993 17,585 344 14,849 57 10,920 31 10,920 31 3,393 –228 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Total workforce

18,413 19,093 19,815 20,207 20,678 21,014 21,274 23,940 24,780 25,639 26,476 27,331 28,310

828 680 722 392 471 336 1,160 2,666 840 859 837 855 979

Total employees

14,849 14,908 14,845 14,668 12,377 11,773 11,259 10,792 10,558 10,492 10,576 10,850 11,161

0 59 –63 –177 –2,291 –604 –514 –467 –234 –66 84 358 311

SOE workforce

10,890 10,955 10,949 10,766 8,809 8,336 7,878 7,409 6,924 6,621 6,438 6,232 —

–30 65 –6 –183 –1,957 27 –458 –469 –485 –303 –183 –206 —

SOE employees

11,214 11,261 11,244 11,044 9,058 8,572 8,102 7,640 7,163 6,876 6,710 6,488 —

294 47 –17 –200 –1,986 –486 –470 –462 –477 –287 –166 –222 —

3,285 3,147 3,016 2,883 1,963 1,712 1,499 1,291 1,122 1,000 897 810 —

–108 –138 –131 –133 –920 –62 –213 –208 –169 –122 –103 –87 —

Source: Wang, “Review of China’s Ten-Year Social Security Development.”

Note: Figures of “workforce” include both employers and employees. “Difference” is that compared with the previous year.

To infer from the theoretical discussion in the previous section, a highly privatized welfare regime permitting great welfare inequality would restrict short- and long-term productivity. This explains why liberal economies still devote considerable resources to transfer payments to alleviate the harm of privatization to welfare creation. The trend towards welfare privatization in China could be likened to liberal economies. Large transfer payments, however, require a high fiscal capacity, especially from tax revenue and bond issuance, which China had yet to develop. The expansion of extractive capacity would take time, so would the amelioration of the composition of fiscal expenditure. As regards budgetary revenue, the share of tax revenue in GDP started to turn up, as did the proportion of direct taxes in total tax revenue, from 11% and 23.9% in 1994 to 16.8% and 33.8% in 2002, respectively. Despite the improvement, however, China’s tax burden in terms of percentage of GDP in 2002 was still low internationally, compared with not only developed economies like the United States (29.6%), the United Kingdom (37.4%), Japan (27.1%), and Australia (31.5%) but also

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transition economies like Korea (26.1%), Mexico (18.5%), and Hungary (39.1%) in the same year. The root cause was the low share of direct taxes, particularly income tax, which made up only 21.5% of tax revenue in 2000, compared with 28.8% of Korea, 27.3% of Mexico, and 24.3% of Hungary,31 coupled with the absence of social security tax. Such small tax revenue was apparently insufficient to support an effective increase in social spending or improve income distribution. Nor did treasury securities issuance bring any significant breakthrough to the welfare regime. There was a recognizable expansion in the scale of bond financing between 1992 and 2002, with two major events of issuance: of CNY800 billion longterm treasury bonds for construction under proactive fiscal policy from 1998 to 2003, and CNY270 billion special treasury bonds to recapitalize the state-owned commercial banks in 1998. However, as seen, these bonds were meant to finance the production, not the welfare, regime. In budgetary expenditure, welfare spending was not only not expanded but in fact cut back, showing signs of government withdrawal of welfare commitments. To begin with, social security spending, including pension insurance, was sidelined as but an extrabudgetary item. The handful of budgetary welfare-related expenses — social welfare relief, compensation for veterans, ex-servicemen, and their dependents, and disaster relief — were rather minor, and they actually waned in proportion after the 1994 tax reform enlarged the overall fiscal accounts, falling from 1.3% in budgetary expenditure in 1992 to 1.06% in 2002. As for education, notwithstanding the proposed target of raising budgetary educational expenditure to 4% of GDP by the end of the 20th century in the State Council’s 1994 Outline for Education Reform and Development of China, it had not been met by 2002; on the contrary, the budgetary share of the country’s educational expenses dropped from 84.05% in 1992 to 63.21% in 2002. Regarding healthcare, as remarks Wang, the individual healthcare burden hiked from less than 23% of public health expenditure in 1980 to over 60% during 2000 to 2002, making the Chinese healthcare system one of the most privatized in the world (comparing developed country average 27%, transition country average 30%, least developed country average 40.7%, and other developing country average 42.8%).32 Finally, in the area of housing, the State Council’s Decision on Deepening the Urban Housing Reform of 1994, which prescribed a new urban housing system as befitted the Socialist market economy, paved the way for the commercialization of housing and put an end to the housing allocation system. Although a Housing Provident Fund was then developed, this drop in the bucket failed to insure the people against soaring home prices. The intergovernmental division of fiscal powers played a decisive role in the quick advances of privatization in the production and welfare regimes during this decade. Over the years 1978 to 1992, the use of financial incentives had made

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intergovernmental fiscal relations a leading factor in local government action. As privatization in the production regime, be it through the “grasping the large and releasing the small” SOE policy or the restructuring of TVEs, would inevitably deprive local governments of major revenue sources, had there not been any compensatory incentives, it would hardly win the enthusiasm of local governments. The 1994 tax-sharing reform was introduced to provide alternative incentives. By making VAT, the most important source of tax revenue, a shared tax, without altering the nature of the tax-sharing agreement between the central and local governments, the central government’s share in tax revenue was improved while local governments were incentivized by heightened benefit expectations in local economic growth (not just publicly owned enterprises) to promote privatization. At the same time, the pursuit of economic growth drove local governments, which bore 70% to 80% of total government expenditure, to favor expedient projects for short-term benefits and inevitably neglect welfare spending, opening the door for the privatization of welfare provision. The influence of privatization varied among levels of local government. At the beginning of the Reform and Opening Up era, county and township government– directed TVEs had the upper hand in competing with provincial government– directed SOEs. However, as privatization progressed, TVEs lost their edge to the even more privatized private enterprises, implying the loss of an importance revenue source on the part of county and township governments. For provinciallevel governments, however, having disposed of the burden of loss-making SOEs, they managed to gain an added economic advantage by tapping into the existing industrial foundation and their influence on bank credit. Coupled with the highly centralized political administration and functionaries, which allowed provincial-level governments to increase revenue and minimize costs by the strategy of “centralizing fiscal powers and devolving administrative (expenditure) responsibilities” (caiquan shangshou, shiquan xiayi 財權上收、事權下移), county and township governments typically fell into the plight of “feeding finance” (chifan caizheng 吃飯財政) — living on a hand-to-mouth budget that could do little beyond settling the payroll, let alone developing the local economy or providing welfare services. The 1994 tax-sharing reform intended to, in addition to raising the GDP share of budgetary revenue and central government revenue, dampen local governments’ enthusiasm in amassing extrabudgetary and extra-establishment revenues through affording them stable tax revenue sources, thereby regulating government revenue. However, because the central government failed to reduce local governments’ expenditure responsibilities while increasing its own share in total budgetary revenue (from 22% in 1993 to round 50% in 1994), the reform had

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the contrary effect of forcing local governments to resort to more extrabudgetary and extra-establishment sources, including the much criticized land transfer fee (tudi churang jin 土地出讓金). All in all, the intergovernmental fiscal relations under the market regime between 1992 and 2002 saw a correction of the low share of overall budgetary revenue and central government revenue by the tax-sharing reform of 1994, with a further use of financial incentives to motivate local economic growth. The effect of the reform yet varied across government levels: the lower in the administrative hierarchy, the greater the fiscal plight. Contrary to being an effective restraint on nontax revenues, the tax-sharing reform actually intensified intergovernmental fiscal competition, making extrabudgetary and extra-establishment revenues no less important than before.

Conclusion Whether “food” or “construction” should come first was a question of national economic management under the planned regime, when the central government controlled the majority of economic resources, and then one of fiscal redistribution under increasing privatization in the course of market-oriented economic reform. The days before the introduction of the Reform and Opening Up policy were a period when “belts were tightened to undertake construction,” and the catch-up strategy lent more importance to the production regime than the welfare regime. By promoting privatization and decentralizing fiscal powers, the Economic Reform accentuated this imbalance. While the welfare regime was pegged with the production regime under the planned economy, privatization made profit-making the only goal of enterprises and thereby cut off the relationship between production units and welfare provision. The financial incentives of fiscal decentralization, too, drew local governments more towards economic construction as compared with welfare provision. But although the deterioration of social welfare provision was the combined effect of privatization and fiscal decentralization, it was not a necessary outcome. The profit orientation of firms is market normalcy, but the growth orientation of the government is more a feature of the planned economy. As privatization results in reduced enterprise-based benefits, it is not impossible to adjust financial incentives for local governments for the sake of motivating them to increase welfare provision, such as by strengthening the people’s right to examine and approve the budget, which would increase local governments’ sense of responsibility over lower-level governments. However, the fiscal decentralization efforts prior to 2002 ran contrary

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to this end. The progress in fiscal decentralization privatization, unfortunately, opened a gap between the production and welfare regimes. Rapid economic growth was achieved at the expense of income redistribution, compromising the quality of the growth as well as upsetting the macroeconomic equilibrium — a problem exposed in 1998 by insufficient internal demand. In the aftermath, the central government launched a series of social policies in attempts to restore equilibrium (see Table 13.13). The “scientific outlook on development” raised formally in 2003 denoted a fundamental shift in economic development principles, such that pure pursuit of growth gave way to coordinated development, drawing attention to the possible drawbacks of growth. The relative importance of the production and welfare regimes was thus reversed at the policy level, and the old slogan “food first, construction second” finally crystalized, at least, as a guiding principle of national economic development. Table 13.13 China’s social policies launched after 1998 Year

Policy

1999

Western Development Program

2002

Urban subsistence allowance

2003

Start of support for the “Three Rural Issues”; rural tax-for-fee reform; plans to

2004

Agricultural tax reduction; start of “three agricultural subsidies”— quality seed

build rural new-style cooperative healthcare system

subsidy (liangzhong butie 良種補貼), direct subsidy for grain cultivation (liangshi zhijie butie 糧食直接補貼), and general subsidy for agricultural input (nongzi zonghe butie 農資綜合補貼)

2005

Partial abolition of agricultural tax

2006

Full abolition of agricultural tax; launch of general subsidy for agricultural input; waiving of tuition and miscellaneous fees of Western China rural compulsory education; pilot of urban low-cost housing

2007

Free compulsory education for all of rural China; full implementation of rural new-style cooperative healthcare system; full implementation of low-cost

housing; full implementation of rural health insurance; start of urban national health insurance 2008

Labor Contract Law

2009

Adoption of healthcare reform plan

2010

Home price controls

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14

Chapter

Tax for Profit

MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 2

Term Definition “Tax for profit” (li gai shui 利改稅) was a reform addresing the treatment of profits earned by SOEs. As the term suggests, it was to levy an income tax on SOEs at a specified rate instead of requiring their delivery of total profits. By substituting income tax for profit delivery, the reform fixed the relationship between the state and SOEs by law and provided the basis for SOEs’ autonomous operations and self-financing responsibility as truly independent economic entities. With this, employees’ benefits were linked with enterprises’ production and operations. Egalitarianism was discarded so that the distinguished would be rewarded while the underachieving would be spurred on; the more one contributed, the more one would gain. The “tax-for-profit” reform was accompanied by a full-scale reform of the industrial and commercial tax system in response to the needs of the Reform and Opening Up era. A major reform in the taxation system since the founding of New China, it played a pivotal role in economic reform and development as a curcial initiative to tackle the profit distribution relationship between the state and SOEs.

Historical Background Changes in the profit distribution relationship between state and SOEs Before 1978: Total profit delivery Under the unified control over fiscal revenues and expenditures as directed by a highly centralized economic philosophy, almost all industrial and commercial enterprises were of state or “collective” (jiti 集體) ownership. The enterprises in those days were the loci of executing the state’s production plans for the national economy, having nearly zero autonomy in operations. The profits they realized, apart from a small portion they were permitted to retain, were centralized in the hands of the state via “profit delivery.” The funds they needed to sustain production had to be obtained by application along the administrative hierarchy, while losses were borne by the state. Practical problems such as what to produce, how much to produce, who to sell to, and how much to sell the goods for were all determined by state plans. Such heavy constraints dampened any enthusiasm in enterprise running, lulling SOEs into the complacency of eating from the “big rice pot” of the state and employees that of the SOE.

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1978–1982: Devolution of power and relinquishment of profits Breaking the “big rice pot” was the chief task in revitalizing the economy and reforming the SOEs. To free SOEs from the predicament of overcentralization and stifling control of production and operations, the government recognized expanding enterprises’ autonomy as a critical principle of SOE reform. In 1978, the State Council promulgated the Several Provisions on the Enlargement of the DecisionMaking Power of State-Owned Enterprises in Operations and Management, granting enterprises some rights in the planning, sales, use of funds, and utilization of employee benefit and bonus funds. The policy aimed to adjust the relationship between the state and SOEs so as to transform the latter from pure subordinates of government departments into relatively independent economic entities with considerable autonomy and profits. The pilot scheme of enlarging SOEs’ power commenced in Sichuan, where pilot enterprises were permitted to retain some profits, to be distributed to employees in the form of bonus, upon fulfilling the output increase targets at the end of the year. By the end of 1981, reform had been implemented in 50% of China’s SOEs, and they were afforded some rights to production planning, profit retention, use of funds, sales of goods in excess of target quotas, and personnel deployment. The pilot of profit relinquishment took place simultaneously, with total profit sharing substituting for profit retention within the target quota and planned profit sharing in 1980. The percentages of total profit sharing were fixed, assessed usually using the enterprise’s earnings in the year as the base, with consideration of enterprises’ needs for funds for development and production, collective benefits, and employee bonuses. Upon the establishment of these three funds, the state no longer shouldered related operating costs. The scopes of benefits and responsibilities of the state and SOEs were demarcated in hopes of ensuring SOEs’ benefits and their contributions to the state at the same time. The most conspicuous effect of the devolution of power and relinquishment of profits was that SOEs went a step closer to being independent commodity producers, which stimulated their internal drive for development and production. With retained profits, SOEs gained an initial capacity for expanding reproduction and reinvestment. As the government allowed them to spend 60% of the depreciation fund, the major overhaul fund, and most of their self-owned funds on equipment acquisition, technological upgrading, and production innovation, SOEs earned some economic power for independent development. These were microadjustments just yet, but they nonetheless provided valuable experience for a more thorough overhaul of the SOE system in the future. The devolution of power and relinquishment of profits to SOEs suffered from

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the defect of oversimplification, though. The relationship between government and SOEs continued to lack transparency, and it was practically difficult for the state to account for the revenue differences among enterprises. Moreover, it soon became clear, when SOEs’ earnings decreased but their own gains fell much less than the state’s, that a slight tweak of state-SOE relations along the line of administrative power division would not get to the root of the problem. SOEs must be assigned responsibilities while being granted power, or they would soon fall back to the old mentality. Profit retention could definitely incentivize SOEs, but as long as no provisions were made to hold them responsible for their losses, they would continue to eat from the “big rice pot” of the state since losses would at most affect profit retention and not incur any economic consequences. As far as power devolution is concerned, SOEs were hardly extricated from their status as subordinates of government departments. Administrative measures failed to establish them as self-financed autonomous commodity producers, exercising self-restraint, and making independent development plans. In fact, as full-fledged macroeconomic reform had yet to be developed and supportive measures were weak, some rights that the government planned to devolve to SOEs had been either retrieved before they were ever put into practice or intercepted by local governments. This led to the realization that government-SOE relations would have to be regulated by economic instruments, so that SOEs’ rights would be linked with responsibilities.

1983–1986: “Tax for profit” Soon, SOE funds became too scattered, leading to too little financial resources concentrated in the state. Therefore from 1983 onwards, the pilot “tax-for-profit” reform was implemented, while profit delivery continued to function. In October 1984, the Third Plenary Session of the 12th CPC Central Committee established the goals of SOE reform: “The enterprise should be truly made a relatively independent economic entity and should become a producer and operator of socialist commodity production that is independent and responsible for its own profit and loss and capable of transforming and developing itself and that acts as a legal person with certain rights and duties.”1 Further measures to substitute taxation for profit delivery were implemented in the same year.

Taxation system before the “tax-for-profit” reform The formulation of the taxation system from 1949 at the founding of the People’s Republic of China to 1978 was tortuous. On January 30, 1950, the Government

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Administration Council of the Central People’s Government promulgated the National Tax Policy Implementation Rules, naming 14 kinds of taxes to be levied throughout the nation, namely goods tax, industrial and commercial tax (including business tax and income tax), salt tax, customs duty, salary income tax, savings interest income tax, stamp tax, inheritance tax, transaction tax, slaughter tax, house property tax, land property tax, special consumption tax, and license use tax. In addition, there were taxes levied by local governments such as agricultural tax and animal husbandry tax. Some adjustments were made in the course of implementation. For example, the house property tax and land property tax were merged into a single urban property tax, the special consumption tax became part of the business tax and a new culture and entertainment tax, and a deed tax and tonnage tax were added. There was also the trial implementation of a commodity turnover tax and legislation of the agricultural tax at the national level, but the salary income tax and inheritance tax had not been levied. During 1950 to 1958, a compound tax system with numerous taxes and multiple times of collection was established based on the new state’s Socialist philosophy and the economic conditions at that time, laying a foundation for nation building and economic recovery. In 1958 came the first major tax reform since the founding of the Republic of China. This included the simplification of the industrial and commercial tax system, the trial implementation of a consolidated industrial and commercial tax, and even pilots of the “merge of taxation into profit delivery” (shui li he yi 稅利合一) in urban SOEs and “fiscal contracting” (caizheng baogan 財政包干) in the rural people’s communes. By then, there had been established a total of nine taxes in the Chinese industrial and commercial tax system: consolidated industrial and commercial tax, industrial and commercial income tax, salt tax, slaughter tax, and interest income tax (ceased in 1959), urban property tax, vehicle and vessel license tax, culture and entertainment tax (ceased in 1966), and livestock transaction tax (without unified national legislation). In 1962, a market transaction tax was introduced, but it was basically terminated after 1966. The second major tax reform took place in 1973, still revolving around the simplification of the industrial and commercial tax system. Seven taxes were levied at that time: industrial and commercial tax (including salt tax), industrial and commercial income tax, urban property tax, vehicle and vessel license tax, slaughter tax, consolidated industrial and commercial tax, and market transaction tax. SOEs were only levied a single industrial and commercial tax, while collective enterprises were levied the industrial and commercial income tax in addition to the industrial and commercial tax. The urban property tax, vehicle and vessel license tax, and slaughter tax were levied on individuals and a limited number of

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production units, and the consolidated industrial and commercial tax applied to external parties. Overall, the early tax regime was heavily affected by Leftist thought and Soviet economic and taxation theories, thus taking a course of simplification and denying the value of economic instruments. The result was the diminution of tax types and oversimplication of taxation, which shrunk the share of taxation in the economic arena and restricted the role of taxation in socioeconomic life.

Launch of the “tax-for-profit” reform At the nascent stage of the Reform and Opening Up period, many local governments had tried to implement quota-based profit delivery plans in the manner of the rural household responsibility system on SOEs; however, the effects were far from satisfactory, especially in terms of resolving the tension in the relationships between the state, the enterprise, and the individual. Therefore, the central government decided to kick off the reform of the urban economic structure with the critical area of taxation, which was fundamental to redressing the problem of “eating from the same big rice pot.”

Stage one After the Economic Reform was approved by the Third Plenary Session of the 11th CPC Central Committee in December 1978, the question of tax reform, especially SOE tax reform, was quickly brought to the center of attention. Answering the call of the National Taxation Work Conference of 1979, the Chinese tax reform was set to first establish a system to deal with taxes involving foreign parties. Measure included the promulgation of the Law of the People’s Republic of China on Sino-Foreign Equity Joint Ventures and the Individual Income Tax Law of the People’s Republic of China in 1980, and the Income Tax Law of the People’s Republic of China Concerning Foreign Enterprises in 1981, as well as the confirmation of the continuation of the Draft Regulations of the People’s Republic of China on the Consolidated Industrial and Commercial Tax adopted by the Standing Committee of the National People’s Congress in 1958 for turnover taxes, and the Provisional Regulations Concerning Urban Real Estate Tax and the Provisional Regulations Concerning Vehicle and Vessel Tax promulgated by the State Council in 1951. At the same time, investigation and pilots on the domestic side were also embarked on. The pilot scheme can roughly be divided in two periods: the first period started from 1979 and took place in some of the SOEs in Guanghua County, Hubei; Liuzhou City, Guangxi; Shanghai; and Sichuan, mainly concerning income

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tax on SOEs, while the second period saw an extension of pilot areas from the fourth quarter of 1980 onwards. On July 31, 1980, the Leading Group of Financial and Economic Affairs convened a meeting, listening to the report of Minister of Finance Wang Bingqian on his conception of the reform of the industrial and commercial tax system. After the adjournment of the meeting, the Ministry of Finance submitted the report Conception Concerning the Reform of the Industrial and Commercial Tax System, which pointed out the major problem of the existing system: oversimplification, with only one tax on SOEs and two taxes on collective enterprises, confining the scope of activity of taxation in the economic arena. It also noted that the tax rates on certain goods had not been adjusted for a long time and thus were unable to keep pace with the present economic conditions. The guiding principles for the reform would be to follow the policy of “readjustment, reform, rectification, and improvement,” rationally adjust the economic interests of various parties, properly handle the interest relations between the state, the enterprise, and the individual, and give full play to the functions of taxation in order to foster national economic development. In accordance with the instructions of the State Council, especially the demands raised at its executive meeting, the Ministry of Finance and the State Commission for Restructuring the Economic System dispatched joint-investigation teams to Shanghai, Tianjin, and Jinan between December 1982 and January 1983, to conduct investigations and estimates on 6,691 state-owned industrial, transportation, and commercial enterprises. Concluding the lessons from the pilots and the investigation results, the Ministry of Finance formulated the Draft Trial Measures for the Substitution of Taxation for Profit Delivery in State-Owned Enterprises, and reported it to the State Council on February 25, 1983. Three days later, the State Council approved the report of the draft measures and authorized the Ministry of Finance to convene a conference for the “tax-for-profit” reform, studying revisions of the draft and formulating concrete steps. The Fifth Plenary Session of the Fifth National People’s Congress in November 1982 affirmed the experience from the “tax-for-profit” pilots. The meeting laid down the direction of substituting tax payment for profit delivery, which was to be implemented in steps. For large and medium-sized SOEs, the reform would be carried out in two stages over three years, during which the “tax-for-profit” transition would be accelerated without significantly affecting the prices. From March 17 to 29, 1983, the scheduled National Tax-for-Profit Work Conference was convened. The State Council’s instructions and documents were communicated and delivered, revisions on the Draft Measures for Shifting from the Profit-Delivery System to the Taxation System were discussed, and concrete provisions for levying income tax and the handling of enterprise finances were deliberated. On April 12,

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the Ministry of Finance submitted to the State Council the Report on the National Tax-for-Profit Work Conference, along with the revised Draft Measures for Shifting from the Profit-Delivery System to the Taxation System for approval. The draft measures were approved on April 24, recognizing that the first stage of the “taxfor-profit” reform had started from January 1 of the same year, and stipulating that the income tax would be levied on all SOEs nationwide from June 1.

Stage two In September and October 1983, the Ministry of Finance and the State Commission for Restructuring the Economic System again sent joint-investigation teams, this time to Shanghai, Hubei, Sichuan, and Shaanxi, to prepare for the second stage of the “tax-for-profit” reform and verify the feasibility of the second-stage plan. The National Work Conference for the Second Stage of the Tax-for-Profit Reform, convened in Beijing from June 22 to July 7, 1984, revised the various draft regulations on taxation and draft measures on financial accounting submitted by the Ministry of Finance. The general guidelines for the second stage of reform, as given by Wang Bingqian, were: apart from further regulating the distributional relationship between the state and the enterprise so as to fundamentally resolve the problem of enterprises eating from the “big rice pot” of the state, to guarantee the stable growth of state revenue while affording SOEs considerable financial power and autonomy in operations, management, and development, and to utilize taxation as a lever to realize the state’s reward and constraint policies, and temper the tension brought by irrational prices for the benefit of national economic readjustment and reform. The policy of “tax for profit” was confirmed as an unalterable path. On September 7, 1984, the State Council submitted to the Standing Committee of the National People’s Congress the “Motion on Authorizing the State Council to Reform the Industrial and Commercial Tax System and Issue Relevant Draft Tax Regulations,” which was adopted on September 18 by a decision that authorized the State Council to implement the “tax-for-profit” reform on SOEs and draft relevant regulations for trial implementation. On the same day, the State Council issued the Notice on the Approval and Transmission of the Report of the Ministry of Finance on the Implementation of the Second Stage of Substitution of Taxation for Profit Delivery in StateOwned Enterprises, as well as promulgated the Draft Regulations of the People’s Republic of China on the State-Owned Enterprise Income Tax and the Measures of Collection of the State-Owned Enterprise Adjustment Tax, announcing that the Trial Measures on the Second Stage of Substitution of Taxation for Profit Delivery in StateOwned Enterprises would take effect on October 1, 1984. A tax which gave the state a direct hand in the allocation of enterprise profits, the enterprise business tax was

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a core tax in the “tax-for-profit” reform. It had been established in the first stage of the reform, and in the second stage, some adjustments were made in the details, with tax regulations by the State Council supplanting the Ministry of Finance’s provisional measures.

Reform Details Stage one As mentioned, measures for the first stage of the “tax-for-profit” reform took effect on January 1, 1983, with the collection of taxes beginning on the following June 1. The main provisions were given in the Measures for the Substitution of Taxation for Profit Delivery in State-Owned Enterprises. Differentiated measures were devised for different types of enterprises, which were distinguished in five groups: 1. Profit-making large and medium-sized enterprises (including financial and insurance institutions) were to be levied an income tax rate of 55%. Part of the after-tax profit would be delivered to the state, while part of it, as designated by the state, would be retained by the enterprise. The part to be delivered to the state could take the forms of incremental contracting delivery, fixed percentage delivery, adjustment tax,2 and fixed quota contracting delivery.3 Enterprises with an after-tax profit smaller than the state-designated level of profit retention could be freed from profit delivery, but the state would not lower the income tax rate. For enterprises which fell significantly short of the designated profit-retention level, however, the income tax rate might be lowered within a certain period. Calculations of the level of delivery would in principle be based on the final accounts of 1982, but where the profit retention level had been unreasonable or profits had been retained twice, adjustments were to be made. The base of calculations, amount of delivery, and methods of assessment were to remain unchanged for three years. 2. Profit-making small enterprises were to be taxed at eight-tier progressive rates. Apart from those enjoying relatively large profits, which might be charged a contracting fee or be required to deliver a fixed amount of profits, all others would not be required to submit further profits after the income tax. They were to be responsible for their own profits and losses and would not receive state appropriations anymore. A small enterprise was defined as an industrial enterprise with fixed assets not exceeding CNY15 billion in original cost and an annual profit not exceeding CNY2

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billion, or a commercial or retail enterprise with a staff size not exceeding 30 and an annual profit not exceeding CNY30,000 or CNY50,000, all in 1982. Provincial-level governments were given the discretion to make slight adjustments based on this standard, however. 3. Commercial guesthouses, hostels, hotels, and catering companies were to be levied a 15% income tax. No additional state appropriation would be granted thereafter, and after-tax losses were to be handled by local departments of commerce. For catering companies in Beijing, Tianjin, and Shanghai, the Ministry of Commerce could gather a considerable amount of funds from their after-tax profits to assist with those in remote and more difficult areas. 4. Supply and marketing cooperatives above the county level were to pay the income tax at eight-tier progressive rates in units of county companies or cooperatives, and receive no more state appropriation. Apart from specific commodities prescribed by the state, the state would not extend any more price subsidies. Those having a relatively large after-tax profit were to deliver part of it, after deducting the storehouse building funds, simple construction fees, and administrative fees originally supported by state appropriations, as well as the replenishing working capital, production support funds, enterprise funds, and employee bonus funds originally paid through the retained profit, to the Ministry of Finance at an assessed base. Those whose after-tax profit did not attain a reasonable level could, upon approval, have the income tax rate reduced for a certain period. 5. Military enterprises, postal and telecommunications enterprises, grain enterprises, foreign-invested enterprises, agricultural and animal husbandry enterprises, and enterprises involved in labor reform would continue to deliver profits to the state as in the past. General provisions were given regarding SOEs’ finances and the government’s powers and responsibilities: 1. SOEs could, upon approval of the fiscal authority concerned, repaid a special project loan with the before-tax profit generated out of the designated project. To be eligible for a special project loan, however, the enterprise must commit 10% to 30% of self-owned funds in that project. 2. Concerning the subsidies for SOE losses, fixed quota or planned subsidies would continue to be extended to cover losses within the permits of state policy. Excess losses would not be covered, while earnings from reduced losses would be shared between the contractor (the supervisory department)

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3.

4.

5.

6.

7.

and the contractee (the enterprise). The subsidy amount would remain unchanged for three years. In case of losses due to poor management, the competent government department would demand the enterprise to implement rectification. Subsidies would be granted upon approval by the fiscal authority concerned within a specified period, beyond which no further subsidies would be given. Where a price adjustment or change of tax rates affected enterprises’ profits, except for cases of drastic changes where the State Council sanctioned the adjustment of the delivery quota, delivery percentage, or adjustment tax rate, no adjustment would be made. The after-tax profit was to be divided into five portions. 60% of it would contribute to new product testing, production development, and reserve funds, while 40% would go to employee benefit and employee bonus funds. The income taxes of SOEs would be managed by the tax authorities, while their finances and accounting the fiscal authorities. SOEs were to prepay the income tax and deliver profits according to the designated schedule, and late submissions would incur a 1‰ penalty per day to be paid from the retained profits. In case of failure to fulfil tax or profit delivery obligations despite repeated reminders, the tax and fiscal authorities would notify the bank and deduct the overdue amounts along with the late penalty from the enterprise’s deposit account. In case of disagreement about the quantum of the income tax, SOEs would have to pay as advised by the local tax authority before applying for review to the tax authority of the next higher level. Local SOEs dissatisfied with the review results could appeal to the provincial fiscal authority, while central SOEs could appeal to the Ministry of Finance. SOEs evading income tax or profit delivery were liable to a penalty of less than a double of the original quantum which would be paid from the retained profits, while the management and directly responsible parties of the enterprise were liable to administrative responsibility. Serious offenses or violations of the criminal code would be referred to the judicial authorities and held criminally responsible. After the implementation of the “tax-for-profit” reform, supervisory departments of enterprises could continue to concentrate part of the retained profits for expenses on such areas as technological refurbishment, expanding commercial networks, and simple construction works. The quantum would be determined by the competent department and reported to the fiscal authority. The income taxes paid by enterprises would be submitted to the central and local fiscal authorities. The central government would not adjust the

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base and revenue share for fiscal contracting of provinces, direct-controlled municipalities, and autonomous regions, which would find their own means to compensate county governments’ revenue losses due to the “taxfor-profit” reform. 8. Autonomous regions of ethnic minorities were in principle to follow the reform provisions. However, their governments, or the provincial governments concerned, could have the discretion to issue flexible rules. The state’s protection of ethnic enterprises would remain. The first stage of the “tax-for-profit” reform covered 107,145 state-owned industrial, transportation, and commercial enterprises, involving 92.7% of all profit-making enterprises. It basically attained the goal of the state gaining the majority share, enterprises a medium share, and individuals a small share. In 1983, the state held 61.8% of profits while enterprises retained 38.2%, of which 47.6% went to the production development fund, 17.4% the collective benefit fund, and 35% the employee bonus fund. However, at this stage, there was little diversity as far as tax type was concerned, limiting the effectiveness of tax in regulating the economy, while the models of after-tax profit sharing, on the contrary, varied as much as to perpetuate uncertainty in state-enterprise financial relations. For the majority of China’s SOEs, the “tax-for-profit” reform in effect consigned them to the double obligations of income tax and profit delivery, and the situation of small enterprises was even graver as the class intervals in the progressive tax for small enterprises were too close to be fair. A second stage of reform was thus launched.

Stage two The second stage of the “tax-for-profit” reform mainly reclassified all the profits SOEs would have to turn to the state into 11 taxes, thereby completing the full transition from the coexistence of taxation and profit delivery to taxation. The most important change was the substitution of a profit adjustment tax, the rate of which was assessed and determined individually by the fiscal authority and the supervisory government department, for profit delivery for large and mediumsized SOEs on top of the 55% income tax, with the allowance of a 70% reduction of the adjustment tax rate over increased profits. The reform provisions were laid down in the Notice on the Approval and Transmission of the Report of the Ministry of Finance on the Implementation of the Second Stage of Substitution of Taxation for Profit Delivery in State-Owned Enterprises:

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Tax types A complete overhaul of the industrial and commercial tax system, the second-stage reform broke down the existing industrial and commercial tax by target taxpayers into product tax, VAT, salt tax, and business tax, adjusted the arrangements for the income tax and adjustment tax, and established the resource tax, urban maintenance and construction tax, housing property tax, land use tax, and vehicle and vessel usage tax: 1. Product tax: SOEs in this group were required to pay the tax after selling off taxable products. From October 1, 1984, profits from cigarettes were subject to the product tax, and the subsidy for price increases in tobacco leaves and the nonprice subsidy for brand-name cigarettes were abolished. 2. VAT: SOEs in this group were required to pay the tax after selling off taxable products. The VAT was implemented to end double taxing while fostering professional synergized production for the purpose of optimizing the product structure. Exemptions in the calculation of the VAT were centrally determined by the state. 3. Salt tax: SOEs producing, selling, or importing salt were required to pay this tax when selling or importing salt. 4. Business tax: Applicable to SOEs in the sectors of commerce, material supply and marketing, transportation, construction and installation, finance and insurance, postal and telecommunications services, public utilities, publishing, entertainment, processing and repair, and other services, which were required to pay the tax after selling their products or receiving their business income. However, in reality, the tax was initially levied on the wholesale sectors of petroleum, transportation and electricity, and chemical industries only, and was temporarily postponed for other industries. 5. Resource tax: Applicable to SOEs in the exploitation of natural resources including crude oil, natural gas, coal, metal mineral products, and nonmetal mineral products, after the sale of products. However, the tax was initially levied on crude oil, natural gas, and coal only, and was temporarily postponed for other resources. Provisions were made for preferential tax reduction for mineral enterprises (including small coal kilns) which exploited resources in a reasonable scope and which the state deemed necessary to support. 6. Urban maintenance and construction tax: Applicable to all SOEs subject to the product tax, VAT, and business tax. 7. House property tax: Applicable to SOEs owning house property.

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8. Land use tax: Applicable to SOEs using state-owned land. 9. Vehicle and vessel usage tax: Applicable to SOEs owning and driving vehicles and vessels. 10. Income tax: Large and medium-sized SOEs were taxed at a fixed rate of 55%, while small enterprises were taxed at newly established eight-tier progressive rates. 11. Adjustment tax: Large and medium-sized SOEs were required to pay an additional adjustment tax at an assessed rate on top of the income tax. The urban maintenance and construction tax, house property tax, land use tax, and vehicle and vessel usage tax were temporarily postponed. Additionally, the existing slaughter tax, special tax on oil burning, agricultural tax, building construction tax, and bonus tax were levied according to original provisions.

Adjustment tax rate assessment for large and medium-sized SOEs In assessing the adjustment tax rates, the enterprise’s profit in 1983 was taken as the base. The rate was fixed based on the ratio of the base profit less the 55% income tax and the reasonable retained profit amount for 1983 over the base profit, after accounting for the newly introduced or adjusted product tax, VAT, business tax, and resource tax. In calculating the base profit of cigarette SOEs, it would be necessary to add the income from the cigarette price increase in 1983 and deduct the product tax levied on the increased cigarette price, the subsidy for the tobacco leaf price increase, and the nonprice subsidy for brand-name cigarettes. For SOEs jointly operated with other units, the base profit would be either enlarged by profits earned from the partner unit, or deducted by profits shared out to the partner unit. Large and medium-sized enterprises whose profits after the 55% income tax fell below the reasonable retained profit amount in 1983 would be exempted from the adjustment tax and upon approval, allowed a tax credit within a specific period. The exact adjustment tax rates and income tax credits were to be assessed and determined by the fiscal authority, tax authority, and competent authority supervising commercial enterprises. However, provincial-level authorities had to report their decisions to the Ministry of Finance for approval. The approved adjustment tax rates took effect in 1985. A 70% adjustment tax reduction would be made to the profit growth of the assessed year over the base year. The profit growth was considered in a fixed percentage which would remain unchanged for seven years once assessed. The reduction was not applicable to material supply and marketing or finance and insurance enterprises.

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Classification of small SOEs Small profit-making SOEs basically had to be responsible for their own profits and losses after the application of the new eight-tier progressive tax rates. No state appropriations would be granted. However, when assessing the base profit, the state could demand from enterprises with high after-tax profits an additional “contracted” quantum (chengbao fei 承包費), the provisions on which would be determined by provincial-level governments. Those whose after-tax profits were short of the reasonable retained profit level for 1983 could be allowed a tax credit within a certain period upon approval. The upper limits for the classification of small SOEs were relaxed so as to allow more SOEs to become self-financed. In Beijing, Tianjin, and Shanghai, a small industrial or transportation SOE was defined as one whose fixed assets did not exceed CNY4 million in original cost and whose annual profits did not exceed CNY400,000. In other regions, the two thresholds were lowered to CNY3 million and CNY300,000, respectively. The so-called “industrial and transportation” SOEs included urban public utility enterprises, commercially run industries, industries run by grain enterprises, fodder industries, and storage and transport enterprises. For retail shops with independent accounting to be considered small, the upper limits for Beijing, Tianjin, and Shanghai were annual profits of CNY200,000 and a staff of 60; for provincial capitals, seats of autonomous regions, and Chongqing, annual profits of CNY150,000 and a staff of 60; and for other cities, annual profits of CNY80,000 and a staff of 60. The criteria on annual profits were obligatory, but provincial-level governments had the discretion to decide whether to observe the limit on staff size. All commercially run agricultural and animal husbandry enterprises were classified as small.

Other types of enterprises The new eight-tier progressive income tax also applied to commercial guesthouses, hostels, hotels, and catering service providers. The increased income tax amount as compared to the first stage of the reform would be listed as a budgetary expenditure by the fiscal authority of the same level of government, to be appropriated to the competent department for networking, technological refurbishment, and assistance to key projects. Military enterprises, postal and telecommunications enterprises, civil aviation enterprises, foreign-invested enterprises, agricultural and animal husbandry enterprises, enterprises involved in labor reform, and a handful of enterprises

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approved for pilot implementation of incremental contracting of delivered profits were temporary exempted from the income and adjustment taxes, but were subject to other taxes. They continued to abide by the original regulations regarding the delivery of profits and funds occupation fees as well as itemization of expenses on employee benefits and bonuses.

Loss-making enterprises Subsidies, credits, and exemptions to loss-making or low-profit enterprises were governed as follows: First, permissible losses would be covered by planned subsidies. Excess losses would not be subsidized, while earnings from reduced losses would be shared between the contractor and the contractee. The subsidy quantum and percentage share could be reassessed on an annual or triennial basis. Second, for losses induced by poor management, the competent department would order the enterprise to resolve the loss within a period, during which a loss subsidy as assessed by the fiscal authority would be extended, excess losses would not be subsidized, and earnings from reduced losses would be shared between the contractor and the contractee. Beyond that period, no more subsidies would be granted. The tax provisions would apply to these enterprises again upon their turning of losses into profits at the end of the period. However, the loss subsidy for the same year would continue to be appropriated even if the enterprise managed to turn losses into profits before the end of the period, while profits made in the ensuring year would be treated in the same manner as reduced losses and shared between the contractor and contractee. Third, enterprises which were originally making profits in 1983 but would make insufficient profits for a reasonable retention level or make losses as a result of the adjusted tax rates or new taxes would for three years be allowed credits for product tax, VAT, and business tax. These enterprises could be treated as minimal profit enterprises and exempt from income and adjustment taxes. If in practice their profits exceeded the reasonable retention level, the profits would be shared between the state and the enterprise at a percentage share that would remain unchanged for three years.

Other general provisions After the implementation of the second stage of the reform, the stipulated provisions would not be adjusted for changes in prices and tax rates unless significant changes warranted the State Council’s special approval of the adjustment of the base profit

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or adjustment tax rate. Enterprises were required to judiciously allocate their retained profits for the setting up of new product testing, production development, reserve, employee benefit, and employee bonus funds. The share of the employee bonus fund in the retained profits would be negotiated by the Ministry of Finance with provinciallevel governments and enterprises’ superior departments, and then further assessed by lower-level departments. Enterprises would generally set apart 50% of the profits for production development, 20% for employees’ collective benefits, and 30% for employee bonuses. Enterprises’ superior departments could still concentrate part of the retained profits for major technological refurbishment, commercial network expansion, and facility building, but not the department’s own expenses. The portion to be concentrated could be either collected from the enterprise or obtained through a tax refund. For ethnic autonomous regions, credits and exemptions could be granted as tax incentives in areas that would affect local government revenue upon approval by the provincial or autonomous region government. The government of the Tibet Autonomous Region could have the discretion over how to implement the reform provisions. To accelerate the progress of opening up, the State Council later issued an additional document, titled Provisional Regulations on Reduction and Exemption of Enterprise Income Tax and Industrial and Commercial Consolidated Tax for Special Economic Zones and 14 Coastal Port Cities, which was transmitted by the Ministry of Finance on December 3, 1984, specifying the preferential treatment for Sino-foreign joint ventures started up by the economic and technology development zones in the Special Economic Zones of Shenzhen, Zhuhai, and Shantou, and the port cities of Guangzhou and Zhanjiang.

Assessment The gist of the “tax-for-profit” reform was to change the type of levy on SOE income from profit delivery to taxation, introducing income tax into the realm of SOE profit distribution so as to pave the way for full after-tax profit retention and eventually, totally self-financed SOEs. Starting in 1983, the first stage of reform brought large and medium-sized enterprises under the dual systems of profit delivery and taxation, while the second stage provided for the gradual transition from the dual system to complete substitution. The reform radically transformed the Chinese taxation system, adapting it for the planned Socialist commodity economy,

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which had positive effects on stabilizing fiscal revenue sources, macroeconomic regulation, fostering the process of reform and opening up, regulating state-SOE distribution relations, and propelling socioeconomic development. It also laid the foundation for future tax reforms. The two-stage reform established a compound industrial and commercial tax system with multiple taxes centering on turnover taxes and income tax, which was in line with the coexistence of diverse economic entities, methods of management, channels of goods circulation, and forms of resource distribution. Taxation covered most areas of reproduction and therefore had the potential to regulate social production on a larger scale. By unprecedentedly introducing taxes on SOEs, the “tax-for-profit” reform remodeled the distribution relationship between the state and SOEs. For the first time, SOEs were made income taxpayers as independent commodity producers. Profit distribution between the state and SOEs came to be defined by taxation, making tax revenue the chief source of state revenue. This had the merits of guaranteeing stable fiscal revenue growth while expanding SOEs’ financial independence, thereby providing the institutional basis for reforms to minimize governmental intervention in SOE management. The increase in tax revenue enhanced the functions of taxation as an instrument in regulating production, distribution, and consumption according to the state’s economic policy. Taxation also became the state’s tool for supervising and guiding microeconomic activities. Of the turnover taxes, the introduction of VAT prevented double taxation in the course of commodity circulation, thereby facilitating professional collaborative production. The adjustment of tax types and tax rates served to considerably regulate enterprises’ profit levels, so as to temper the adverse effects of unreasonable price levels and create an environment that permitted positive competition under fair tax burdens. While developing a more desirable tax system, the reform nonetheless gave rise to new problems. The income tax rate was exorbitantly high, placing a heavy tax burden on SOEs. Worse still, large and medium-sized SOEs were levied an additional adjustment tax, whose rate was subject to great uncertainty by the system of individual assessment. Moreover, the allowance for deductions on loan repayments was in effect a disguised form of repaying enterprise debts by fiscal funds, which indirectly encouraged enterprises to vie for loans, with banks being guaranteed loan recovery at the expense of state revenue. Eventually, a new reform was introduced in 1987, providing for profit delivery alongside taxation at new rates under a tax-plus-profit (li shui fenliu 利稅分流) system. Profit delivery would be reinstated, but only after taxation. Loan repayments would be excluded from tax deductions, and SOEs would deliver a share of their after-tax profits to the state according to their contracts.

160

Notes Chapter 8 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

National Bureau of Statistics of the People’s Republic of China, China Statistical Yearbook 1983, 241. Ibid., 149. Ibid., 244. National Bureau of Statistics of the People’s Republic of China, China Statistical Yearbook 1985, 18. National Bureau of Statistics of the People’s Republic of China, China Statistical Yearbook 1983, 323. Sun, Economic History of the People’s Republic of China (1949–Early 1990s), 178. “Premier Chou En-lai Reports on the Work of the Government,” Peking Review, 8(1) (1965), 7. National Bureau of Statistics of the People’s Republic of China, China Statistical Yearbook, 38. Sun, Economic History of the People’s Republic of China (1949– Early 1990s), 253. Ibid. Deng, “Excerpts From Talks Given in Wuchang, Shenzhen, Zhuhai and Shanghai,” January 18–February 21, 1992, in Selected Works of Deng Xiaoping, vol. 3, 361.

Chapter 9 1. 2. 3. 4. 5.

Jia and Bai, “Research on Sources of Government Revenue and Measures for Improvement in China.” Hu and Zhang, “There Is Great Potential to Raise the Tax Share in GDP.” Sheng, “Three Theoretical Issues about China’s Tax Cut.” Yang, “Study of Irrational Government Behaviors and Risks of the Banking Industry.” Li, Wang, and Liu, Assessment of the Regional Financial Ecological Environment in China (2006–2007).

Chapter 10 1. 2. 3. 4. 5. 6. 7.

Cai, “A Brief Discussion of the New Problems Arising from the Execution of the Credit Difference Contracting Plans,” 36. Zhang, Structure and Transformation of China’s Financial System. Management Group, Pingyang County Branch, People’s Bank of China, “How We Experimented with the Credit Difference Contracting Method,” 1. Shaoxing County Branch, People’s Bank of China, “Ways of Implementing Credit Difference Contracting,” 40. Planning Department, Hangzhou City Branch, People’s Bank of China, “Lessons and Suggestions on the Implementation of Credit Difference Contracting,” 8. Zhou, “Need for Studying and Improving the Credit Difference Contracting Method,” 12. Jiang, Institutional Change and Financial Development.

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Notes

Chapter 11 1. 2. 3. 4. 5. 6. 7.

Shang, Contemporary China: Money and Banking. Quan, “‘Full Loan Financing’: A “Must-Do” Reform”; Tang, “An Initial Discussion on Reform of Bank Loan Supervision”; Li and Zhang, “Reforming Enterprises’ Working Capital, Managing Bank Credit Funds.” Some opponents of the policy were Fu, “Opinions on the Issue of Full Loan Financing”; and Zhao, “Pros and Cons of Full Loan Financing.” Tang, “An Initial Discussion on Reform of Bank Loan Supervision.” Shen, “Several Questions on the Reform of the Working Capital Management System.” Li and Zhang, “Reforming Enterprises’ Working Capital, Managing Bank Credit Funds.” Li, “On Hardening the Constraint of Bank Loans on Enterprises.”

Chapter 12 1.

2. 3. 4. 5. 6.

i.e., jihua danlie shi 計劃單列市: major cities assigned separate economic state plans from those of the provinces to which they belonged, hence enjoying greater economic autonomy albeit remaining under provincial administration. This system was implemented in the mid-1950s, the mid-1930s, and after the 1980s, with as many as 14 such cities in 1993. In 1994 the number was reduced to 6, and in 1997 one of them, Chongqing was promoted to direct-controlled municipality. — Ed. Guo, “Efficiency of the Transformation of China’s Fiscal System (1949–1979),” 84. Zhang, The Theory of the Firm and the Reform of Chinese Enterprises. Guo, “Efficiency of the Transformation of China’s Fiscal System (1949–1979),” 84. Wang, The Bottom Line of Decentralization. Guo, “Efficiency of the Transformation of China’s Fiscal System (1949–1979),” 84.

Chapter 13 1. 2. 3. 4.

5. 6. 7. 8. 9.

162

CCCPC Party Literature Research Office, A Biography of Chen Yun, vol. 2, 1616. Chen, speech at a meeting of the Leading Group for Financial and Economic Affairs, March 7, 1962, in Chen Yun wenxuan, 1956–1985, 202. Chen, “Do a Good Job in Commercial Work,” (Zuo hao shangye gongzuo 做好商業工作), speech at an extended meeting of the Ministry of Commerce, November 19, 1956, in ibid., 30. Chifan literally means “eat rice,” while jianshe means “build,” and is often rendered “construction” (as in “economic construction” and “capital construction”) when used as a noun. It has a meaning close to “development.” — Ed. Zhao and Zhang, “Historical Interactions between the Concept of Development and the Development Model since the Founding of New China,” 24. Soskice, “Divergent Production Regimes: Coordinated and Uncoordinated Market Economies in the 1980s and 1990s,” 101–2. Hall and Soskice, “An Introduction to Varieties of Capitalism.” Ibid, 8. Thelen, “Varieties of Labor Politics in the Developed Democracies,” 73.

Notes

10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23.

24. 25. 26. 27. 28.

29.

30.

31. 32.

Thelen, “Varieties of Labor Politics in the Developed Democracies.” Ebbinghaus, Reforming Early Retirement in Europe, Japan and the USA, 32–33. Ibid, 195. See Huber and Stephens, Development and Crisis of the Welfare State: Parties and Policies in Global Markets. Hall and Soskice, “An Introduction to Varieties of Capitalism,” 8. Thelen, “Varieties of Labor Politics in the Developed Democracies.” Ebbinghaus, Reforming Early Retirement in Europe, Japan and the USA, 188. Ibid, 194–95. Esping-Andersen, The Three Worlds of Welfare Capitalism, 2. Esping-Andersen, Social Foundations of Postindustrial Economies, 4–5. Kolberg and Esping-Andersen, “Welfare States and Employment Regimes.” Esping-Andersen, The Three Worlds of Welfare Capitalism; Korpi, “Contentious Institutions: An Augmented Rational-Action Analysis of the Origins and Path Dependency of Welfare State Institutions.” Bernard and Boucher, “Institutional Competitiveness, Social Investment, and Welfare Regimes.” The three major types of enterprises back then, namely SOEs, collective enterprises (to which TVEs belonged), and private enterprises, are traditionally classified under the two systems of state-owned / non-state-owned sectors and public / private sectors. Only SOEs are state owned, but SOEs together with collective enterprises are referred to as the “public” sector. — Ed. See Chen, “State Capacity Study: the Perspectives of the State-centered Theory.” He, “A Brief Discussion of China’s Enterprise Financing Mechanisms,” 46. Modigliani and Cao, “The Chinese Saving Puzzle and the Life-Cycle Hypothesis,” 145–46. See Cao, Qian, and Weingast, “From Federalism, Chinese Style to Privatization, Chinese Style.” “Hold High the Great Banner of Deng Xiaoping Theory for an All-round Advancement of the Cause of Building Socialism With Chinese Characteristics Into the 21st Century,” report of Jiang Zemin at the 15th National Congress of the Communist Party of China, September 12, 1997, Beijing Review, under “The 15th National Congress,” http://fas.org/news/china/1997/970912-prc.htm (last modified March 25, 2011). “Amendment to the Constitution of the People’s Republic of China,” as translated in National People’s Congress of the People’s Republic of China, “Constitution and the Related Laws,” http://www.npc.gov.cn/ englishnpc/Law/2007-12/05/content_1381953.htm (accessed February 18, 2016). “Build a Well-off Society in an All-Round Way and Create a New Situation in Building Socialism with Chinese Characteristics,” report of Jiang Zemin at the 16th National Congress of the Communist Part of China, November 8, 2002, Xinhuanet, November 17, 2002, http://news.xinhuanet.com/english/2002-11/18/ content_632554.htm (accessed February 18, 2016). Research Team of Tax Science Research Institute, State Administration of Taxation, People’s Republic of China, “The Development and Prospects of Direct and Indirect Taxes in China,” 50. Wang, “Crises and Opportunities of China’s Public Health System.”

163

Notes

Chapter 14 1. 2.

3.

164

Decision of the Central Committee of the Communist Party of China on Reform of the Economic Structure, 10. Tax rate determined based on the share of delivered profits in realized profits (i.e., before-tax profits). This rate applied only to the portion of profits that was equivalent to the profit in the base year, while the rate for the growth amount would be reduced by 60%. Only applicable to mining enterprises.

Bibliography Chapter 7 Chinese materials:

CCCPC Literature Research Office, ed. Jianguo yilai zhongyao wenxian xuanbian 建國 以來重要文獻選編 [Selected Important Documents Since the Founding of New China]. Vol. 13–14. Beijing: Central Party Literature Press, 1996. CCCPC Literature Research Office, ed. San zhong quan hui yilai zhongyao wenxian xuanbian 三中全會以來重要文獻選編 [Selected Important Documents Since the Third Plenary Session of the 11th Central Committee of the Communist Party of China]. 2 vols. Beijing: People’s Publishing House, 1982. Deng Xiaoping 鄧小平. Deng Xiaoping Wenxuan 鄧小平文選 [Selected Works of Deng Xiaoping]. 3 vols. Beijing: People’s Publishing House, 1993. Liu Shucheng 劉樹成. “Lun you hao you kwai fazhan” 論又好又快發展 [On the Development with Better–Fast Growth]. Economic Research Journal 經濟研 究, (6) (2007): 4–13. Mao Zedong 毛澤東. Mao Zedong xuanji 毛澤東選集 [Selected Works of Mao Zedong]. Vols. 5 and 7. Beijing: People’s Publishing House, 1977, 1999. National Bureau of Statistics of the People’s Republic of China. Zhongguo tongji nianjian 中國統計年鑒 [China Statistical Yearbook]. Beijing: China Statistics Press, various years. Pei Yuanxiu 裴元秀, and Li Bingzhong 李秉忠. “Renzhen zongjie lishi jingyan gaohao guomin jingji tiaozheng: ‘Tiaozheng, gonggu, chongshi, tigao’ fangzhen de chubu yanjiu” 認真總結歷史經驗搞好國民經濟調整：「調整、鞏固、充 實、提高」方針的初步研究 [Do a Good Job of Economic Readjustment by Drawing Lessons from Historical Experience: A Preliminary Study of the Policy of “Readjustment, Consolidation, Enrichment, and Improvement”]. Social Science Research 社會科學研究, (2) (1981): 54–58, 73. Sun Dali 孫大力. “Liangci shishi jingji tiaozheng bazi fangzhen de bijiao” 兩次實 施經濟調整八字方針的比較 [Comparison between the Two Eight-Character Policies]. Research on Chinese Communist Party History 中共黨史研究, (3) (2003): 55–60. Sun Jian 孫健. Zhonghua renmin gongheguo jingji shi (1949–90 niandai chu) 中華人 民共和國經濟史（1949–90年代初） [Economic History of the People’s Republic of China (1949–Early 1990s)]. Beijing: China Renmin University Press, 1992. Sun Xuewen 孫學文. “Guomin jingji zai hongguan tiaokong zhong gaige qianjin (yi):

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Bibliography

‘Tiaozheng, gaige, zhengdun, tigao’ xin bazi fangzhen de shixing” 國民經 濟在宏觀調控中改革前進（一）——「調整、改革、整頓、提高」新八字 方針的實行 [China’s Economy Progresses in the Process of Macroeconomic Regulation and Control I: The Implementation of the New Eight-Character Policy of “Readjustment, Reform, Rectification, and Improvement”]. Corpus of Party History 黨史文匯, (9) (1999): 2–6. Wu Li 武力. Zhonghua renmin gongheguo jingji shi 中華人民共和國經濟史 [Economic History of the People’s Republic of China]. 2 vols. Beijing: China Economic Press 中國經濟出版社, 1999. Wu Li 武力, Xu Dihua 徐棣華, and Chen Donglin 陳東林. “Xin bazi fangzhen de tichu he shishi” 新八字方針的提出和實施 [The Proposal and Implementation of the New Eight-Character Policy]. World of Party History 黨史天地, (12) (1998): 25–30. Xie Duyang 謝渡揚. “Jin sinian de luzi shi zenme zou guolai de: Dui ‘tiaozheng, gaige, zhengdun, tigao’ fangzhen de tichu he guanche qingkuang de jianyao huigu” 近四年的路子是怎麼走過來的：對「調整，改革，整頓， 提高」方針的提出和貫徹情況的簡要回顧 [How Did China Come through the Past Four Years: A Brief Review of the Proposal and Implementation of the Policy of “Readjustment, Reform, Ratification, and Improvement”]. Macroeconomic Research 宏觀經濟研究, (33) (1983): 2–11. Zhang Zhaojun 張肇俊, and Tang Kun 湯堃. “Gongtong tichu ‘tiaozheng, gaige, zhengdun, tigao’ bazi fangzhen” 共同提出「調整、改革、整頓、提高」 八字方針 [Jointly Put Forward the Policy of “Readjustment, Reform, Rectification, and Improvement”]. World of Party History 黨史天地, (6) (2009): 70–71.

English materials:

Lin, Justin Yifu. “Collectivization and China’s Agricultural Crisis in 1959–1961.” Journal of Political Economy, 1990. “Premier Chou En-lai Reports on the Work of the Government.” Peking Review, 8(1) (1965): 6–20.

Chapter 8 Chinese materials:

Hu Angang 胡鞍鋼, and Zhang Yaoting 張堯庭. “Tigao shuishou zhan GDP bizhong dayouqianli” 提高稅收佔GDP比重大有潛力 [There Is Great Potential to Raise the Tax Share in GDP]. Public Finance Research 財政研究, (5) (1999): 11–14.

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Jia Kang 賈康, and Bai Jingming 白景明. “Zhongguo zhengfu shouru laiyuan jiqi wanshan duice yanjiu” 中國政府收入來源及其對策研究 [Research on Sources of Government Revenue and Measures for Improvement in China]. In Shui fei gaige yanjiu wenji 稅費改革研究文集 [A Collection of Research on Taxes and Fees Reform], edited by Jia Kang 賈康. Beijing: Economic Science Press, 2000. Li Yang 李揚, Wang Guogang 王國剛, and Liu Yihui 劉熠輝. Zhongguo diqu jinrong shengtai huanjing pingjia (2006–2007) 中國地區金融生態環境評價（2006– 2007） [Assessment of the Regional Financial Ecological Environment in China (2006–2007)]. Beijing: China Financial Publishing House, 2007. Sheng Hong 盛洪. “Youguan Zhongguo jianshui de saige lilun wenti” 有關中國 減稅的三個理論問題 [Three Theoretical Issues about China’s Tax Cut]. In Zhongguo shuizhi gaige 中國稅制改革 (China’s Taxation Reform), edited by Xu Dianqing 徐滇慶 and Li Jinyan 李金艷. Beijing: China Economic Press, 1997. Wang Guogang 王國剛. Jingru 21 shiji de Zhongguo jinrong 進入21世紀的中國金融 [China’s Finance in the 21st Century]. Beijing: Social Sciences Academic Press, 2000. Yang Chong 楊充. “Fei lixing zhengfu xingwei yu yinhang ye fengxian yanjiu” 非理 性政府行為與銀行業風險研究 [Study of Irrational Government Behaviors and Risks of the Banking Industry]. PhD diss., Southwestern University of Finance and Economics, 2006. Zhou Li 周立. “Gaige qijian Zhongguo guojia caizheng nengli he jinrong nengli de bianhua” 改革期間中國國家財政能力和金融能力的變化 [Changes in China’s Fiscal and Financial Capacity during Reforms]. Finance and Trade Economics 財貿經濟, (4) (2003): 44–51.

Chapter 9 Chinese materials:

Research Group of the People’s Construction Bank of China on Loans for Appropriations. “Ji jian touzi bo gai dai tuixing qingkuang diaocha” 基建投 資撥改貸推行情況調查 [Research Report on the Implementation of “Loans for Appropriations” for Capital Construction Investment]. Macroeconomic Research 宏觀經濟研究, (30) (1984): 25–28. Wang Tongsan 汪同三, ed. Zhongguo touzi tizhi gaige 30 nian yanjiu 中國投資體制 改革30年研究 [Research on the 30 Years of China’s Investment System Reform]. Beijing: Economy & Management Publishing House, 2008. Zeng Guojian 曾國堅. “Jiben jianshe touzi bokuan gai daikuan yu caizheng fenpei” 基本建設投資撥款改貸款與財政分配 [The Replacement of Fiscal

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Appropriations for Capital Construction Investment by Bank Loans and Fiscal Allocation]. Journal of Zhongnan University of Economics and Law 中南 財經政法大學學報, (5) (1985): 31–37.

Chapter 10 Chinese materials:

Cai Duoni 蔡多妮. “Qian tan xindai cha’e baogan jihua zai zhixing zhong chuxian de xin wenti” 淺談信貸差額包干計劃在執行中出現的新問題 [A Brief Discussion of the New Problems Arising from the Execution of the Credit Difference Contracting Plans]. South China Finance 南方金融, (2) (1983): 36–39, 49. Jiang Qiwu 江其務. Zhidu bianqian yu jinrong fazhan 制度變遷與金融發展 [Institutional Change and Financial Development]. Hangzhou: Zhejiang University Press, 2003. Management Group, Pingyang County Branch, People’s Bank of China. “Women shi zenyang shixing xindai cha’e baogan banfa de” 我們是怎樣試行信 貸差額包干辦法的 [How We Experimented with the Credit Difference Contracting Method]. Zhejiang Finance 浙江金融, (3) (1982): 1–4. Planning Department, Hangzhou City Branch, People’s Bank of China. “Guanyu shixing xinda cha’e baogan banfa de ji dian tihui yu jianyi” 關於實行信 貸差額包乾辦法的幾點體會與建議 [Lessons and Suggestions on the Implementation of Credit Difference Contracting]. Zhejiang Finance 浙江金 融, (2) (1982): 7–10. Shaoxing County Branch, People’s Bank of China. “Shixing xindai cha’e baogan de ji dian zuofa” 實行信貸差額包干的幾點做法 [Ways of Implementing Credit Difference Contracting]. China Finance 中國金融, (8) (1981): 40–41. Zhang Jie 張杰. Zhongguo jingrong zhidu de jiegou yu bianqian 中國金融制度的結構與 變遷 [Structure and Transformation of China’s Financial System]. Taiyuan: Shanxi Economic Press, 1998. Zhou Jingdong 周靜棟. “Xindai cha’e baogan banfa you yanjiu gaijin de biyao” 信貸差額包干辦法有研究改進的必要 [Need for Studying and Improving the Credit Difference Contracting Method]. Shanghai Finance 上海金融, (6) (1981): 12.

English material:

North, Douglass C. Structure and Change in Economic History. New York : Norton, 1981.

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Chapter 11 Chinese materials:

Fu Zhong 夫中. “Guanyu quan’e xindai wenti de taolun yijian” 關於全額信貸問題 的討論意見 [Opinions on the Issue of Full Loan Financing]. China Finance 中國金融, (8) (1979): 17–18. Li Jiayou 李嘉尤, and Zhang Xuan 張軒. “Gaige qiye liudong zijin tizhi, guan haoyinhang xindai zijin” 改革企業流動資金體制，管好銀行信貸資金 [Reforming Enterprises’ Working Capital, Managing Bank Credit Funds]. China Finance 中國金融, (5) (1990): 15–16. Li Xiaobi 李小筆. “Lun yinhua yinhang xindai dui qiye de yueshu” 論硬化銀行信貸 對企業的約束 [On Hardening the Constraint of Bank Loans on Enterprises]. Modern Economic Science 農村金融研究, (8) (1987): 37–42. Quan Jinxing 全勁興. “‘Quan’e xindai’ fei gao buke” 「全額信貸」非搞不可 [“Full Loan Financing”: A “Must-Do” Reform]. Journal of Financial Research 金融 研究動態, (23) (1979): 1–8. Shang Ming 尚明, ed. Dangdai Zhongguo de jinrong shiye 當代中國的金融事業 [Contemporary China: Money and Banking]. Beijing: China Social Sciences Press, 1989. Shen Shuigen 沈水根. “Guanyu liudong zijin guanli tizhi gaige de jig e wenti” 關 於流動資金管理體制改革的幾個問題 [Several Questions on the Reform of the Working Capital Management System]. Finance & Trade Economics 財貿 經濟, (9) (1983): 39–42. Tang Qinghong 湯慶洪. “Shi lun yinhang xindai jiandu fangshi de gaige: guanyushixing quan’e xindai de tantao 試論銀行信貸監督方式的改革 [An Initial Discussion on Reform of Bank Loan Supervision]. Journal of Financial Research 金融研究動態, (5) (1979): 1–13. ———. “Zai lun woguo xindai jiandu fangshi de gaige — Guanyu yinhang tongyi guanli liudong zijin wenti de tantao” 再論我國信貸監督方式的改革——關 於銀行統一管理流動資金問題的探討 [Revisiting the Reform of Bank Loan Supervision: A Discussion on Banks’ Unified Management of Working Capital]. Journal of Jinan University: Philosophy and Social Sciences Edition 暨 南大學學報：哲學社會科學版, (1) (1985): 3–10, 60. Zhang Dicheng 章迪誠, and Zhang Xingwu 張星伍. Zhongguo guoyou qiye gaige de zhengshi zhidu bianqian 中國國有企業改革的正式制度變遷 [Formal Institutional Changes in China’s SOE Reform]. Beijing: Economy & Management Publishing House, 2008. Zhao Dingfang 趙定方. “Shixing quan’e xindai libi de shangque” 實行全額信貸利 弊的商榷 [Pros and Cons of Full Loan Financing]. Modern Economic Science 當代經濟科學, (1) (1980): 47–49.

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Chapter 12 Chinese materials:

Bai Yanfeng 白彥鋒. Shui quan peizhi lun: Zhongguo shui quan zongxiang huafen wenti yanjiu 稅權配置論：中國稅權縱向劃分問題研究 [On the Allocation of Taxing Power: The Study of Vertical Division of China’s Taxing Power]. Beijing: China Financial and Economic Publishing House, 2006. Guo Canpeng 郭燦鵬. “Zhongguo caizheng tizhi (1949–1979) bianqian de xiaolü” 中國財政體制（1949–1979）變遷的效率 [Efficiency of the Transformation of China’s Fiscal System (1949–1979)]. Reform 改革, (2) (2001): 80–86. Li Ping 李萍, ed. Zhongguo zhengfu jian caizheng guanxi tujie 中國政府間財政關係圖 解 [A Graphical Explanation of China’s Intergovernmental Fiscal Relations]. Beijing: China Financial and Economic Publishing House, 2006. Lü Bingyang 呂冰洋, and Li Feng 李峰. “Zhongguo shuishou chao GPA zengzhang zhi mi de shizheng jieshi” 中國稅收超GDP增長之謎的實證解釋 [Positively Explaining the Riddle of Tax-Exceeding-GDP Growth]. Finance and Trade Economics 財貿經濟, (3) (2007): 29–36. Lü Bingyang 呂冰洋. “Zhengfu jian shuishou fen quan de penzhi xuanze he caizheng yingxiang” 政府間稅收分權的配置選擇和財政影響 [Allocation Choice and Fiscal Influence of Intergovernmental Tax Decentralization]. Economic Research Journal 經濟研究, (6) (2009): 16–27. Wang Shaoguang 王紹光. Fen quan de dixian 分權的底限 [The Bottom Line of Decentralization]. Beijing: China Planning Press, 1997. Zhang Weiying 張維迎. Qiye lilun yu Zhongguo qiye gaige 企業理論與中國企業改革 [The Theory of the Firm and the Reform of Chinese Enterprises]. Beijing: Peking University Press, 1999.

English materials:

Barzel, Yoram. Economic Analysis of Property Rights. Cambridge University Press, 1989. Cheung, Steven N. S. The Theory of Share Tenancy: With Special Application to Asian Agriculture and the First Phase of Taiwan Land Reform. Chicago: University of Chicago Press, 1969.

Chapter 13 Chinese materials:

CCCPC Party Literature Research Office. Chen Yun zhuan 陳雲傳 [A Biography of Chen Yun]. 2 vols. Beijing: Central Party Literature Press, 2005. Chen Xiwen, 陳錫文, Zhao Yang 趙陽, Chen Jianbo 陳劍波, and Luo Dan 羅丹.

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Zhongguo nongcun zhidu bianqian 60 nian 中國農村制度變遷60年 [Chinese Rural Institutional Changes over 60 Years]. Beijing: People’s Publishing House, 2009. Chen Yun 陳雲. Chen Yun wenxuan, 1956–1985 陳雲文選，一九五六—一九八五 年 [Selected Works of Chen Yun, 1956–1985]. Beijing: People’s Publishing House, 1995. Chen Chii-Ching 陳啟清. “Cong guojia zhongxin lun de guandian lun guojia nengli de jianjiu” 從國家中心論的觀點論國家能力的研究 [State Capacity Study: The Perspectives of the State-Centered Theory]. Journal of State and Society 國家與社會, (1) (2006): 31–80. Han Chaohua 韓朝華. “Mingxi chanquan yu guifan zhengfu” 明晰產權與規範政府 [Efficient Institution and Restriction of Administrative Powers]. Economic Research 經濟研究, (2) (2003): 18–26, 92. He Jun 何珺. “Qian yi woguo qiye rongzi jizhi” 淺議我國企業融資機制 [A Brief Discussion of China’s Enterprise Financing Mechanisms]. Xinjiang Finance 新疆金融, (8) (1997): 45–47. Li Shuqing 李淑清, and Long Chengfeng 龍成鳳. “Guanyu wanshan woguo qiye rongzi jiegou de ji dian sikao” 關於完善我國企業融資結構的幾點思考 [Reflections on Perfecting the Financing Structures of Our Enterprises]. Taxation and Economy 稅務與經濟, (3) (2006): 33–39. Research Team of Tax Science Research Institute, State Administration of Taxation, People’s Republic of China. “Woguo zhijieshui yu jianjieshui guanxi de fazhan he zhanwang” 我國直接稅與間接稅關係的發展和展望 [The Development and Prospects of Direct and Indirect Taxes in China]. Taxation Research 稅務研究, (1) (2005): 47–52. Wang Shaoguang 王紹光. “Zhongguo gonggong weisheng de weiji yu zhuanji” 中國公共衛生的危機與轉機 [Crises and Opportunities of China’s Public Health System]. Comparative Studies 比較, (6) (2003). Wang Yanzhong 王延中. “Zhongguo shehui baozhang shi nian fazhan shuping” 中國社會保障十年發展述評 [Review of China’s Ten-Year Social Security Development]. Paper presented at the Third Social Policy International Forum, October 25, 2007. China Elections and Governance, October 25, 2007. Accessed February 18, 2016. http://www.chinaelections.org/ article/507/117692.html. Xie Xuren 謝旭人, ed. Zhongguo caizheng 60 nian. 中國財政60年 [China’s Public Finance over 60 Years]. Beijing: Economic Science Press, 2009. Yang Bin 楊斌, and Hu Xueqin 胡學勤. “Zhengfu shui wai shoufei de lilun yanjiu yu shizheng fenxi” 政府稅外收費的理論研究與實證分析 [Theoretical Study and Empirical Analysis of Government Nontax Charges]. In Fei gai shui”:

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jing ji xue jie ru shi shuo 費改稅：經濟學界如是說 [Tax for Fees: Perspectives from the Economists], edited by Gao Peiyong 高培勇, 249–87. Beijing: Economic Science Press, 1999. Zhang Jie 張杰. Jingji bianqian zhong de jinrong zhongjie yu guoyou yinhang 經濟變 遷中的金融中介與國有銀行 [Financial Intermediaries and State-Owned Banks during Economic Transformation]. Beijing: China Renmin University Press, 2003. Zhao Lingyun 趙淩雲, and Zhang Lianhui 張連輝. “Xin Zhongguo chengli yilai fazhan guan yu fazhan moshi de lishi hudong” 新中國成立以來發展觀 與發展模式的歷史互動 [Historical Interactions between the Concept of Development and the Development Model since the Founding of New China]. Contemporary China History Studies 當代中國史研究, 2005(1): 24–32. Zhongguo caizheng nianjian 2006 中國財政年鑒2006 [Finance Yearbook of China 2006]. Beijing: China State Finance Magazine, 2006.

English materials:

Bernard, Paul and Guillaume Boucher. “Institutional Competitiveness, Social Investment, and Welfare Regimes.” Regulation & Governance, 1(3) (2007): 213–29. Cao Yuanzheng, Qian Yingyi, and Barry R. Weingast. “From Federalism, Chinese Style to Privatization, Chinese Style.” Economics of Transition, 7(1) (2003): 103–31. Ebbinghaus, Bernhard. Reforming Early Retirement in Europe, Japan and the USA. Oxford: Oxford University Press, 2006. Esping-Anderson, Gøsta. Social Foundations of Postindustrial Economies. New York: Oxford University Press, 1999. ———. The Three Worlds of Welfare Capitalism. Princeton: Princeton University Press, 1990. Hall, Peter A., and David Soskice. “An Introduction to Varieties of Capitalism.” In Varieties of Capitalism: The Institutional Foundations of Comparative Advantage, edited by Peter A. Hall and David Soskice, 1–68. Oxford: Oxford University Press, 2001. Huber, Evelyne, and John D. Stephens. Development and Crisis of the Welfare State: Parties and Policies in Global Markets. London: University of Chicago Press, 2001. Kolberg, Jon Eivind, and Gøsta Esping-Andersen. “Welfare States and Employment Regimes.” In The Study of Welfare state Regimes, edited by Jon Eivind Kolberg, 3–36. New York: M. E. Sharpe, 1992. Korpi, Walter. “Contentious Institutions: An Augmented Rational-Action Analysis

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of the Origins and Path Dependency of Welfare State Institutions in Western Countries. Rationality and Society, 13(2) (2001): 235–83. Modigliani, Franco, and Shi Larry Cao. “The Chinese Saving Puzzle and the LifeCycle Hypothesis.” Journal of Economic Literature, 42(1): 145–70. Soskice, David. “Divergent Production Regimes: Coordinated and Uncoordinated Market Economies in the 1980s and 1990s.” In Continuity and Change in Contemporary Capitalism, edited by Herbert Kitschelt, Peter Lange, Gary Marks, and John D. Stephens, 101–34. Cambridge: Cambridge University Press, 1999. Thelen, Kathleen. “Varieties of Labor Politics in the Developed Democracies.” In Varieties of Capitalism: The Institutional Foundations of Comparative Advantage, edited by Peter A. Hall and David Soskice, 71–103. Oxford: Oxford University Press, 2001.

Chapter 14 Chinese materials:

Gao Peiyong 高培勇, ed. Zhongguo cai shui tizhi gaige 30 nian yanjiu: Benxiang gonggong hua de Zhongguo cai shui gaige 中國財稅體制改革30年研究：奔 向公共化的中國財稅改革 [Research on the 30 years of China’s fiscal and taxation system reform]. Beijing: Economy & Management Publishing House, 2008. Liu Zuo 劉佐. Zhongguo shuizhi gailan 中國稅制概覽 [Survey of the Chinese Tax System]. Beijing: Economic Science Press, 2008. State Administration of Taxation, People’s Republic of China. Zhonghua Renmin Gongheguo shuishou jiben fagui 中華人民共和國稅收基本法規 [Tax Laws and Regulations of the People’s Republic of China]. Beijing: China Tax Press, 2007. Wang Bingqian 王丙乾. “Guanyu guoying qiyie shixing li gai shui he gaige gongshang shuizhi de shuoming” 關於國營企業實行利改稅和改革工商稅 制的說明 [On the Implementation of “Tax for Profit” and Reform of the Industrial and Commercial Tax System]. Speech at the 7th Plenary Session of the 6th Plenary Session of the Standing Committee of the National People’s Congress, September 11, 1984. Wang Jialin 王家林. “Wo suo jingli de di er bu li gai shui” 我所經歷的第二步利改 稅 [The Second Stage of “Tax for Profit” As I Experienced It]. China State Finance 中國財政, (11) (2008): 74. Xie Xuren 謝旭人, ed. Zhongguo caizheng gaige 30 nian. 中國財政改革30年 [China’s Public Finance Reform over 30 Years]. Beijing: China Financial & Economic Publishing House, 2008.

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Zou Dongtao 鄒東濤, ed. Zhongguo gaige kaifang 30 nian (1978-2008) 中國改革開放 30年（1978–2008） [China: 30 Years of Reform and Opening-Up (1979– 2008)]. Beijing: Social Sciences Academic Press, 2008.

English material:

Decision of the Central Committee of the Communist Party of China on Reform of the Economic Structure. Hong Kong: Joint Publishing, 1984.

174

Index ABC (Agricultural Bank of China) 34, 69 after-tax profits 59, 64, 151–54, 157, 160 agricultural production 3, 7, 9, 14–15, 17, 22, 29 asset-liability ratio 45, 78, 80–81 asset-liability ratio management 78, 80–81

credit difference contracting 65–70, 73–79, 81 credit funds contracting 71 credit plans 67–68, 70–72, 76, 79 Cultural Revolution 2, 12–14, 20–21, 24– 26, 28, 72, 99, 126

big rice pot 60, 79, 87, 89–90, 110, 144–46, 148, 150 BOC (Bank of China) 32, 34, 52 budget balance 96, 101, 123

decentralization 24, 69, 72, 98, 101, 110, 125–26 distribution according to work 22–24

capital, self-owned 55, 60, 88, 90–91 capital construction 3–5, 7, 12, 14–15, 17, 21, 50–55, 57–61, 64, 85, 91, 100 capital construction fund 59, 62–63 capital construction investment 51, 53–54, 59, 62, 64 capital construction projects 50–52, 54–57, 60, 62 CBRC (China Banking Regulatory Commission) 47 CCB (China Construction Bank) 34, 50–51, 53–57, 61 China Development Bank 63 class struggle 20, 24 collective economy 14, 17, 22 collective enterprises 77, 102, 134, 136–37, 147, 149 commercial banks 32–33, 42, 45–46, 61, 64, 69–70, 78, 80–81, 91, 124 CPC (Communist Party of China) 2, 7, 14, 17, 26, 100–101, 116, 134–35 CPC Central Committee 8, 24, 27, 50, 59, 80, 134, 146, 148

eating from separate stoves 34, 46, 95–97, 99–101, 103–5, 107, 109, 111–13 economic reform 27, 35, 37, 68–69, 78, 88, 125, 134, 141, 144, 148 economy fictitious 47–48 liberal 138 real 47–48, 70 efficiency losses 110–111 enterprises foreign-invested 38, 101–2, 125, 152, 157 state-funded 64 township 17, 23 village 38, 125 expenditure budgetary 127, 139, 157 fiscal 5, 18, 100, 120, 122–24, 129, 138 expenditure responsibilities 36, 96–102, 104, 140 extractive capacity 35, 126, 132, 138 financial incentives 98, 106–7, 111, 126, 132, 139, 141 fiscal appropriations 51, 58, 62, 84, 125, 127–29

175

Index

fiscal contracting systems 112, 130, 132 fiscal decentralization 46, 98, 141 fiscal policy, proactive 43, 47, 139 fiscal redistribution 125–26, 141 Five-Year Plan 2, 4, 6, 16–18, 25, 53, 55, 71–72 full loan financing 83, 85–89, 91–93

monetary base 79, 92 monetary policy 32, 80–81

Gang of Four 12 GDP 38, 41, 43–44, 112, 129, 132–33, 138–40 Great Leap Forward 2–6, 8–9, 13, 20–23, 26–28, 126

output agricultural 3, 9–10, 17, 21–22 industrial 2–3, 10, 13, 16–18, 131

household-responsibility system 22–23 household savings ratio 128 industries heavy 4, 10, 13, 15–16, 21, 26, 125 traditional 29 interest rates, differential 54–55, 88 investment budgetary 39, 58, 63 fixed-asset 39–40, 90–91, 93, 130 policy-oriented 63 investment contract responsibility system 52–53 labor reform 152, 157 lending, interbank 79 loans agricultural 72, 91 fixed asset investment 129–30 government-backed 50–52, 54–55, 58, 62, 84, 100 loans for appropriations 49–55, 57, 59–64, 100 market economy capitalist 122 coordinated 118–19, 137 liberal 118–19 176

National Development and Reform Commission 50 National People’s Congress 11, 24, 28, 148, 150

PBC (People’s Bank of China) 32, 45–46, 66–67, 69–75, 77–81, 84–86, 88, 90– 93 people’s commune, rural 7, 147 people’s commune movement 3, 6, 20, 126 People’s Construction Bank 50–51, 53–57, 61 policy, eight-character 2, 6–7, 10, 12, 14, 16, 20–23, 25–28 policy banks 45, 80–81 power devolution 35, 37–38, 42, 69, 132, 145–46 principle, six-character 6–7 privatization 125, 131, 137–41 production brigades 125–27 profit delivery 34, 90, 93, 101, 144, 146–47, 149–51, 153–54, 158–60 profit relinquishment 37–38, 42, 69, 145 profits, retained 60, 93, 145, 152–53, 159 reform joint stock 34, 92–93 loans-for-appropriations 56–58, 64 market-oriented 42, 125 tax-for-profit 150, 154 repayment ability 62–63 reserve ratio 80 revenue, budgetary 36–37, 44, 127, 132–33, 137–38, 140–141

Index

revenue-sharing contracts 104–8, 112 revenues extra-establishment 36–37, 44, 132, 140– 141 extrabudgetary 37, 132–33 sectors non-public 134–36 non-state-owned 125, 131, 137 private 17, 23, 34, 135 public 33–34, 125 Socialist market economy 25, 28, 135, 139 SOEs (state-owned enterprises) 32–35, 37–39, 42, 51–52, 64, 69, 84–93, 100– 102, 125, 127, 130–132, 134, 136–38, 144–57, 160 SOE reform 131, 134, 145–46 SOE tax reform 148 SOEs central 100–101, 153 local 93, 100, 102, 131, 153 specialized banks 34, 45, 67, 70, 75, 78–80 state appropriations 51, 54, 85–86, 93, 151– 52, 157 State Council 51–53, 61–63, 71–72, 78, 80, 85, 87–88, 103, 139, 145, 148–51, 153, 158–59 state-owned banks 38, 46, 48, 64, 69–70, 79, 81, 93, 129–30, 137 state-owned commercial banks 45–47, 80– 81, 139 State Planning Commission 6, 50–51, 53, 55, 57, 60, 63 state plans 24, 33, 50, 53–55, 57–58, 62–63, 70, 78, 81, 98, 103–4, 110–111, 123, 125, 144 surplus financial 34, 38, 42, 45–46 loan 67

tax agricultural 16, 102, 142, 147, 156 business 38, 47, 101–2, 147, 155–56, 158 construction 63, 102, 155–56 entertainment 147 house property 147, 155–56 income 43, 47, 64, 100–102, 105, 108–9, 139, 144, 147, 150–156, 160 inheritance 147 land property 147 market transaction 147 product 101–2, 155–56, 158 resource 102, 155–56 salt 100, 102, 147, 155 slaughter 147, 156 turnover 148, 160 urban property 102, 147 vessel license 102, 147 vessel usage 155–56 tax-for-fee reform 44, 142 tax-for-profit reform 35, 101, 112, 130, 143– 51, 153–55, 157, 159–60 tax for profits 146, 149–51, 154 tax-sharing contract 105–8, 112–13 tax-sharing reform 34, 42–43, 46, 108, 140– 141 tax types 43, 96–97, 101, 105, 148, 154–55, 160 taxation system 43, 144, 146, 149–50 taxing contracts 104, 106, 110, 112–13 Third Plenary Session of 11th CPC Central Committee 14, 17, 22–24, 27, 50, 59, 100, 148 treasury large 31–35, 37, 39, 41–43, 45–48 strong 34, 42 weak 34–36, 42 TVEs (Township and Village Enterprises) 125, 131–32, 134–35, 140

177

Index

VAT (value-added tax) 38, 43, 101–2, 108– 9, 140, 155–56, 158, 160 welfare regimes 118–22, 125–26, 128–29, 137, 139, 141–42 working capital 51–53, 60–61, 68, 79, 84– 93, 100, 152 state-appropriated 88 working capital loans 61, 68, 84, 88

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Reveals the Unique Milestones in China’s Public Finance Development Major Issues and Policies in China’s Financial Reform Volume 2 In the 60-year history of the People’s Republic of China, the Chinese economy underwent progressive transitions through three distinctive regimes: the centralized planned system at the very beginning, the planned commodity system born out of the 1978 Reform and Opening Up policy, and the socialist market system established in the 1990s — all composed of intriguing, if not enigmatic Chinese characteristics. Even more so are the figurative metaphors, jargonistic terminology, and conclusive slogans associated with the phenomena and policies amid China’s economic reforms. Any attempts to make sense of these terms without careful contextualization would be doomed, while neglecting them for convenience’s sake would prevent a thorough understanding of the events. Combining historical narratives and theoretical discussions, the four-volume Major Issues and Policies in China’s Financial Reform provides an in-depth examination of 28 key concepts that knit together the major issues and policies in the course of China’s financial reform, including evaluations of their present relevance. Volume 2 gets the ball rolling by comparing the two “eight-character policies” released against the economic plights succeeding the Great Leap Forward and the Cultural Revolution. The chapters on “large treasury, small bank,” “credit difference contracting,” “full loan financing,” “eating from separate stoves,” and “tax for profit” explore the relational changes between fiscal and banking systems, within the banking system, between the state, banks, and SOEs, between central and local governments, and between the state and SOEs, respectively. Nearing the end, the principle of “food first, construction second” is introduced to examine China’s struggles in balancing the needs for economic growth and raising people’s livelihoods.

Editors in Chief Chen Yulu is the President of the Renmin University of China, a member of the Monetary Policy Committee of the People’s Republic of China, the Vice President of the China International Finance Society, and the Deputy Secretary-General and Executive Director of the China Society for Financing and Banking. His major publications include The Development of Rural Finance in China (2010), Modern Finance (2000), Mixed Operation of the Financial Industry in China (2009), and Research on International Balance of Payments (1998). Guo Qingwang is the Dean of the School of Finance, Renmin University of China, and the Vice-President of the Chinese Tax Institute. Guo’s works cover public finance, taxation, and macroeconomic theory and policies. He is the author of Structural Reform in China’s Regional Governments (2012), The Effectiveness and Fade-Out Strategy of Active Fiscal Policy (2007), and Corporation Tax: International Comparison (1996).

Chinese Economic Studies