Major Issues and Policies in China's Financial Reform 9781623200695, 9781623200305

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Major Issues and Policies in China’s Financial Reform Volume 1

Chen Yulu Guo Qingwang

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: 2/F, Rays Industrial Building, 71 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 © 2016 by Enrich Professional Publishing, Inc. With the title Major Issues and Policies in China’s Financial Reform Volume 1 Translated by Barbara Cao Edited by Barbara Cao and 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. ISBN (Hardback) ISBN (pdf)

978-1-62320-030-5 978-1-62320-069-5

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 Preface

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vii

Chapter 1

Pants with Closed Crotch ............................................................. Yue Shumin and Wang Yipu

1

Chapter 2

Specialized Tax Administration System ..................................... Lü Bingyang

53

Chapter 3

Off-Budget Funds ............................................................................ Zhang He

73

Chapter 4

Overall Balance ................................................................................ Song Wei

107

Chapter 5

Polyandry ......................................................................................... Zhang He

125

Chapter 6

Credit Quotas ................................................................................... Lei Chengyao

143

Notes

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163

References

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173

Index

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187

Preface The 60-year history of New China can be evenly split into two periods with the economic transformation in the late 1970s as the dividing line. It goes without saying that to review and analyze the changes and achievements in China’s fiscal and financial systems during the two periods will be of great theoretical and practical significance. It can be said that the economic development and institutional transformations since the founding of New China provided us with abundant “stories” and historic events about fiscal and financial system reforms, which await our systematical analysis and interpretation. Studying these issues not only conforms to the practical needs of China’s further fiscal and financial reforms, but will also satisfy the pressing demand for the innovation of fiscal and financial theories for China. The task of this book is not to give a chronological analysis of the history of fiscal and financial changes of New China. Instead, it attempts to depict and decipher 28 landmark concepts in the history of China’s fiscal and financial transformation. This list, of course, is far from exhaustive, but the concepts were selected based on the well-known jargon frequently told and heard in China’s political and academic circles, such as “tiger in the cage,” “pants with closed crotch,” “debt-for-equity swaps,” “tax for profit,” “loans for fiscal appropriations,” and “credit difference contracts.” The historical background and theoretical summarization of each term can be treated as an independent story with its own logic and theoretical connotations, and at the same time, every concept is logically connected to each other. If arranged according to certain historical order, those concepts will make a vivid history of the fiscal and financial institutional changes of New China. In decoding the concepts and events in China’s fiscal and financial institutional changes, we pursue the integration of theoretical and historical logic, as well as the unity of the broad context and fine details. Each chapter is generally composed of descriptions and evaluations of the historical backgrounds, development, institutional significance, and theoretical findings of the events of interest. This book strives to come up with new ideas and hypotheses about fiscal and financial systems that have Chinese characteristics in order to push forward the construction of a new framework of China’s fiscal and financial theories. It should be noted that the systematic and detailed research and study of institutional changes in China’s fiscal and financial systems will be a long-term and arduous task. This book only serves as an initial attempt to this end, and it may contain some errors and omissions. Comments and suggestions are welcomed from all experts and readers.

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This book is a preliminary achievement from the disciplinary development and academic enhancement program of “Project 985” and “Project 211” of the Renmin University of China. The research and completion of this book were inseparable from the guidance and encouragement of Professor Huang Da, Professor Chen Gong, Professor Wang Chuanlun, Professor Zhou Shengye, Professor An Tifu, and Professor Yuan Zhenyu. Of particular note is that they participated in almost each and every discussion of the project study and book compilation despite their advance age. Their patient guidance, earnest instructions, and pragmatic attitude towards academic study have greatly benefited the young and middle-aged scholars involved. In addition, grateful thanks are also due to the following people for their far-sighted and constructive suggestions proposed at the seminar for finalizing the draft of this book in late November 2010: Professor Li Yang, Vice President of the Chinese Academy of Social Sciences (CASS); Professor Gao Peiyong, Director of the Institute of Finance and Trade Economics of CASC; Professor Jia Kang, Director of the Research Institute for Fiscal Science (RIFS), Ministry of Finance of China; and Professor Liu Zuo, Director of Taxation Science Research Institute, State Administration of Taxation (SAT) of China. All possible errors and mistakes are of the authors’ sole responsibility.

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Chapter

Pants with Closed Crotch

MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 1

Term Definition “Pants with closed crotch” (lian dang ku 連檔褲) is a figurative way to describe the relationship between government finances and banking under the planned economy. It is believed that government finances and banking were the two channels for centralized capital distribution by the state, and the two tools of macroeconomic regulation. Government finances and banking were closely bound up with each other and could not be separated, just like the two legs of a pair of pants. Therefore, their relationship is likened to pants with closed crotch.1 In analysis of the relationship between government finances and banking, and between fiscal and credit funds, people commonly refer to the connection as a “closed-crotch pants relationship,” sometimes going as far as to describe the intertwined system between government finances and banking as a “closed-crotch pants system.” The treasury and banks are also referred to as the “two moneybags of the state that were connected to each other.”2

The Close Tie between China’s Fiscal and Banking Systems In the long course of China’s planned economy, the treasury and banks were two moneybags of the state which were connected to each other.3 Huang, who draws attention to the moneybags metaphor, comments elsewhere: “There are interlaced junctions between the receipt and disbursements of fiscal revenue and bank credit, which denotes there exists an interlocking connection between the two.”4 In fact, then as now, it is hard to draw clear boundaries for the junctions, since the fiscal and banking systems are inextricably interwoven in multiple aspects. This close fiscalbanking relationship has been given comprehensive and in-depth elaborations in theoretical literature:5 Their linkages can be found in the following aspects: 1. Treasury management by the central bank Like many currency-issuing banks around the world, China’s central bank serves as the central government’s fiscal agent, managing the treasury (as the public purse) by keeping revenue and making payments on command. It also handles the funds transferred between upper-level and lower-level treasuries, as well as performs various fiscal tasks entrusted. During this process, not only does the central bank reap benefits from holding revenues, but the fiscal organs also benefits from banking services, such as cash deposits and withdrawals, and funds allocation and transfer.

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2. Payment of taxes and dividends by commercial banks Commercial banks, as enterprises, are obliged to pay taxes to the state. Banks that are state-owned enterprises have the duty to turn over a certain proportion of dividends to the state. 3. Allocation of additional credit funds by the fiscal authority The short supply of credit funds must be solved by the fiscal authority. This does not mean that the treasury will always have sufficient capital to make up for the credit balance deficit, but since the state only has two moneybags, it is natural for it to turn to the other moneybag when one moneybag is running out of funds. Otherwise, the state will have to increase the amount of money in circulation. Understandably, whether there is a fiscal surplus or deficit, the fiscal authority must make arrangements to compensate for the shortfall in credit funds, unless it is willing to tolerate excessive money in circulation and a disrupted balance between supply and demand in the market.6 4. Loans and overdrafts from banks Although it is commonly prescribed that the fiscal authority cannot borrow or overdraw from the central bank, this is often the case when financial deficits appear. Governments commonly sell bonds to banks or designate banks as agents to sell the bonds to the public. When government bonds are not totally purchased by the public, banks often have to underwrite a portion of the bonds. This is a common practice in most countries around the world.7 5. Fiscal surplus deposits with the central bank Fiscal surpluses constitute a source of credit funds for the central bank. If left unused for a long time by the government, this sum of money can be utilized by the bank as long as it can ensure the availability of alternative sources of funds upon the demand of the government.8 6. Compensation of state-owned enterprise losses from fiscal and credit funds For some reason, China’s state-owned enterprises are able to continue as a going concern despite their operating losses. In principle, the treasury will pay the bill for state-owned enterprises. However, if the deficits cannot be fully made up for in time by the treasury, banks are bound to cover the losses with credit funds. Similarly, losses from other causes, such as reported stock losses, selling at reduced prices, and those resulting from the closedowns, suspensions, business mergers, and shifts of production lines of state-owned enterprises during business restructuring, will also be paid by either the treasury or banks.9

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7. Currency issuance by the central bank It is the central government of a country that has the right to issue money, be it banknotes or coins. The government grants the central bank the privilege of issuing currency. Meanwhile, the fiscal authority will levy a currency issuance tax on the central bank, and the tax rate will affect the size of the credit funds of banks. 8. Management of foreign exchange reserves by the central bank The foreign exchange reserves of a country are usually directly managed by its central bank. The volume of the foreign exchange reserves will impact the overseas business of the bank. This, at the same time, reflects a country’s fiscal capacity in terms of foreign payments. Moreover, the appreciation and depreciation of exchange rates will affect the value of a country’s foreign reserves in domestic currency terms. A depreciation of the domestic currency against others will inevitably bring about changes in the value of the country’s foreign reserves. This will in turn influence fiscal revenue.10 Two more things of note: (1) The first two of the eight points are complementary, such that the banking system is, on the one hand, able to control a portion of fiscal funds through its function of treasury management, while on the other hand, obliged to hand over a portion of bank capital to the fiscal authority in the form of taxes or dividends. These two channels of capital transfer between banks and the fiscal authority are bound to coexist in any case. (2) Points 3 and 4 are mutually exclusive. The fiscal authority will either increase its allocation of credit funds to banks and or take out bank loans and overdrafts during a given time period. As shown, regular, almost “ordinary” contacts between the fiscal and banking systems can frequently be seen in modern daily economic life. Governments at all levels open accounts in banks, while banks collect taxes, fees, and fines on behalf of, and transfer funds between, the fiscal departments of different levels of governments. In case of revenues arriving later than expenditures, banks will offer governments overdraft facilities.11 Apart from these daily contacts, a fiscal imbalance cannot be addressed without the help of the capital formation mechanism of credit funds. At the same time, in many market economies, the financial sector receives strong financial support from the treasury. For instance, governments intervene in the economy by entrusting financial institutions with the work of granting credit, giving national support to the founding of policy-based banks, and allocating large sums to rescue the financial system.12 The inevitable junctions are the necessary channels for the mutual support between fiscal and credit funds…. [They] may be channels for the treasury

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to obtain part of its funds from banks, or channels for banks to secure part of its funds from the treasury…. It is exactly the multiple channels from these complex junctions that have given us vast possibilities, to support the treasury with credit funds or support the credit market with fiscal funds. This ensures that the necessary fiscal and credit demands of economic development are satisfied.13 The inseparable connection between the fiscal and banking systems is inevitable for economic development. This fact requires the Chinese government to properly deal with the relationship between the two in economic regulation and control. In the past, the Chinese government often stressed the balance between state revenue and expenditure, and between credit sources and uses, as well as the overall balance of fiscal and credit funds based on the close connection between the fiscal and banking systems. In formulating economics for the reformed state, Huang establishes the relevance of this fiscal-banking tie to modern economies: In fact, the close fiscal-banking (credit) tie is a natural phenomenon in the modern economy. In the past, we used to attribute this close link to the planned economic system, but experience since the Reform and Opening Up era and understanding of Western market economies show that the existence of this close tie has a very important basis; that is, in whichever kind of economic regime, the modern capital formation mechanism and the law of currency movements share common features that bypass institutional differences.14 The closed-crotch pants relationship between the fiscal and banking systems is not historically specific, only that with the development of the economy, their connections have come to be reflected in different aspects. In different historical periods, this relationship has also been treated and manipulated in different ways, which reveals distinctive characteristics and leaves behind marks of specific times.

Evolution of the Fiscal-Banking Relationship during the Planned Economy Era The fiscal-banking relationship during the planned economy era Prior to the founding of New China In 1932, the Provisional Central Government of the Chinese Soviet Republic started to build the national treasury, and instructed the National Bank and its branches to

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MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 1

manage the central treasury and branch treasuries, respectively. The state treasury and branch treasuries were placed under the direct command and supervision of the Ministry of Finance. Taxes collected by governments at different levels were delivered regularly to either the state treasury or branch treasuries for storage, and the state treasury and branch treasuries, which were responsible to the Ministry of Finance, reported their payments to the ministry every seven days in the form of a list.15 In order to ensure good treasury management, the People’s Committee of the Provisional Central Government promulgated the Provisional Regulations on Treasuries in 1932. It specified that the operation of the state treasury was commissioned to the National Bank, and all the revenues of the country should be placed under the management of the Treasury Management Authority of the People’s Commissariat. Also, the posts of the directors of the state treasury, branch treasuries, and subbranch treasuries were to be held concurrently by the presidents of the head office, branches, and subbranches of the National Bank. In this way, the National Bank executed the decisions of the Provisional Central Government, set up corresponding organizational arrangements, undertook the responsibility of treasury management, and performed part of the government’s fiscal functions.16 It is clear that the close fiscal-banking connection had been formed long before the establishment of New China.

During the period of socialist transformation The main tasks of China during the period of socialist transformation were to stimulate the recovery of the national economy and carry out the socialist transformation of the means of production. In September 1949, the Organic Law of the Central People’s Government of the People’s Republic of China explicitly incorporated the People’s Bank of China (PBC) into the State Council as a directly affiliated unit and affirmed its legal status as national bank. In 1952 which signified the end of the recovery period of the national economy, the PBC established a topdown organizational structure and realized the unified management of all kinds of financial institutions.17 This unified management structure continued until the eve of the Reform and Opening Up era. During that period, banks and the Ministry of Finance were inextricably linked to each other, with many fiscal functions performed through banks. The relationship between the two was one between leader and follower, and between decision-maker and passive receiver. The custody and storage of state revenue rested upon the government’s fiscal agent, namely, the PBC. Priority of fiscal expenditure was given to the financial needs of military forces, expenses for consolidating the power of the government, and necessary investment for restoring the economy. The PBC was the general

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agency responsible for cash management of the state. It also assisted with budgeting, by performing unified funds allocation for military and political organs and public-owned enterprises,18 as well as issuing loans to economic sectors which needed to be strengthened. This shows that the PBC not only conducted policyrelated business, but also undertook a variety of fiscal functions on the behalf of the Ministry of Finance. It played a vital role in the national fiscal management system.19 In terms of credit funds management, fiscal surpluses were an important source of banks’ credit funds under the planned economy. To adapt to the highly unified banking system, the Chinese government set up a centralized and unified management system for credit funds in 1953. Under the consolidate credit plan, credit funds across the country, including the sources or uses of these funds, were controlled by the head office of the PBC, and the management measure of “unified state control over deposits and loans” (tong cun tong dai 統存統貸) was implemented. The consolidated credit scheme was included into the national economic plan. The PBC carried out the function of organizing and adjusting the circulation of currency, and conducted all kinds of credit operations. In 1954, the central government established the People’s Construction Bank of China under the Ministry of Finance to specially deal with the appropriation of funds for capital construction. With the expansion of capital construction and changes in the corresponding management system, the Ministry of Finance entrusted the People’s Construction Bank of China with the responsibility of directly participating in the allocation of funds for capital construction, and also empowered the bank to examine and approve the final accounts of construction units. As a result, the Construction Bank took up both fiscal and banking functions: it was responsible for not only the appropriation of funds for the capital construction of the whole country, but also monitoring the use of the funds (through such means as economic accounting and financial management) and calculations with respect to capital construction investment.20

The Great Leap Forward period In 1956, Chinese society entered into the stage of comprehensive socialist construction. During this period, due to the advocacy of abolishing commodities and currency, the business system and principles of banks were severely undermined. In December 1958, the State Council decided that the previous practice of “double-source supply” (shuang kou gongying 雙口供應) of working capital for state-owned enterprises by both the treasury and banks be replaced by single-

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source supply under the unified management of the PBC. This decision not only increased the workload of banks, but also completely transferred the conflict between the supply and use of enterprises’ working capital to the banking sector. This was overwhelming for banks. At the same time, the practice of “decentralized management of deposits and loans, contracting according to the state plan, credit gap management, and centralized funds transfer”(cundai xiafang, jihua baogan, cha’e guanli, tongyi diaodu 存貸下放，計劃包干，差額管理，統一調度), which caused great confusion to the supply and management of working capital for banks. This resulted in a new conflict in capital arrangement between the fiscal authority and banks.21 The blind decentralization of power by banks during the Great Leap Forward period led to out-of-control credit supply and excessive money creation. During this period, the annual growth rate of total deposits of the National Bank reached 25%, while that of total loans arrived at 20%. Moreover, at the apex of power decentralization, a great number of banks were downsized, merged, or closed. For example, the People’s Construction Bank of China was revoked in 1958.

During the Cultural Revolution In this period, both the state and society were unified to a high degree, and all capital flows were in the hands of the central government. Fiscal and financial institutions and functions were fused, disrupting normal business activities. This was harmful to the division of labor based on specialization. The banking system was abolished, the functions of banks were weakened, banking institutions were either revoked or merged, and banking staff was dramatically cut. The Ministry of Finance and the PBC were merged in the fall of 1969, and the People’s Construction Bank of China was incorporated into the PBC in April 1970. For a time, the management of fiscal and financial matters was overseen by a single “fiscal business unit” and a single “banking business unit”; in fact, both fiscal and financial operations almost came to a standstill. There were no more than a hundred staff engaging in financial services at the worst time, and the vice finance minister doubled as the bank president. In effect, banks were under the direct supervision of local fiscal departments. The set-up of local bank branches was at the discretion of local governments, and there was no unified and centralized operating system. Banks existed as secondary units of fiscal departments, serving as their cashiers allocating money to enterprises whenever instructed. Banking functions were severely undermined, and banks’ dependence on the fiscal authority clearly increased. Not until 1972 were some of the institutional setups, such as divisions and bureaus, gradually restored, but fiscal and banking organization remained bound together.

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Pants with Closed Crotch

Characteristics of the fiscal-banking relationship during the planned economy era “Large treasury, small banking” From the early days of New China to the eve of the Reform and Opening Up era, the Ministry of Finance played a key part in the allocation of society’s resources. Every link in social reproduction was under the unified planning and control of the ministry. It was the principal investor in social investment, funding all kinds of social undertakings, and its responsibilities extended to a variety of financial functions of the society. The mechanism of fiscal expenditure was wide and comprehensive. It not only appropriated funds for economic construction, but also provided fixed-quota working capital for state-owned enterprises. In addition to that, it also bore the expenses of national defense, foreign affairs, administration, science and technology development, education, cultural activities, and public health. On the other hand, the PBC, as an affiliated unit of the Ministry of Finance, was the center and pivot of the fund-raising activities of various sectors of the national economy. More precisely, it was the general accountant and cashier of the country.22 Hence, the bank was positioned as an accountant and cashier instead of a for-profit economic organization or an institution which helped to implement the financial microcontrol measures of the state.23

“Treasury squeezes bank, bank issues bills” Given the then fiscal-banking relationship and the principle of “overall balance,”24 a balanced budget would increase fiscal deposits and in turn boost income from credit operations, which would be beneficial for balancing the sources (i.e., fiscal deposits) and uses of credit funds. From the founding of New China to the planned economic period before the launch of the Reform and Opening Up policy, the treasury not only bore the expenditures of public administration, social management, the development of social undertakings, but also financed key economic construction projects. However, China’s fiscal capacity was weak during that period, and fiscal revenue often could not meet the demand of fiscal expenditure, resulting in financial difficulties. Especially when the scale of capital construction and investment was large, the fiscal authority had no choice but to resort to the cumulative budget surplus over the years or bank overdrafts, which gave rise to the phenomenon of the treasury “squeezing” the central bank, and the central bank printing more money (caizheng ji yinhang, yinhang fa piao zi 財政擠銀 行，銀行發票子).

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Repeated changes in the fiscal-banking division of labor Due to the lack of essential experience in economic construction, the Chinese government had made several attempts in reforming the fiscal and banking systems. The focus centered on the financial management structure of capital construction and the supply system of working capital for state-owned enterprises. For the first issue, China established the Peoples’ Construction Bank of China in 1954. Under the authority of the Ministry of Finance, the bank was mainly responsible for the appropriation of funds for capital construction. In 1958, the fiscal contract system (caizheng baogan zhi 財政包干制) was put into place, and the People’s Construction Bank of China was revoked. Four years later, in 1962, the Construction Bank resumed operations, and was integrated into the PBC in April 1970. In April 1972, the Construction Bank restored its independence. For the second issue, the fixed-quota working capital of state-owned enterprises was mainly funded by government revenue, but the system of working capital supply was adjusted for several times. Between 1951 and 1954, working capital was provided by both the fiscal authority and banks. Between 1955 and 1957, it was totally supplied by the fiscal authority. In 1958, capital was again offered collectively by fiscal and bank funds. From 1959 to 1961, it became a total-credit supply (quan’e xindai 全額信貸) system; that is, all funds were supplied by banks. From 1962 to 1965, the source of supply became the fiscal authority again. Between 1966 and 1971, the fiscal authority and banks collectively shouldered the responsibility of fixed-quota working capital supply. From 1972 and 1987, the fiscal authority again resumed the role of sole capital supplier.

The formation and increasing influence of the overall fiscal-credit balance theory China gradually came to realize the significance of properly dealing with the fiscalbanking relationship and the overall balance of fiscal and credit funds through practical experience gained through the national economic recovery period following the founding of New China (1949–1952) and the first Five-Year Plan period (1953–1957). In the early days of New China, the Chinese leaders had already gained deep understanding of the importance of a balanced budget in stabilizing the economy through the practice of unifying financial and economic administration and stabilizing prices and the economy. After the “small premature advance” in 1953 and the “large premature advance” in 1956,25 people became more and more aware of the vital role of the overall balance of fiscal and credit funds in stabilizing the economy.

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Pants with Closed Crotch

In managing the relationship between the fiscal and banking systems, the Ministry of Finance spontaneously and systematically provided support for bank credit in view of the difficulties of banks in funding loans with deposits. Starting from 1954, the item of “additional allocations of credit funds to banks” was added to the state budget plan. It was based on the practice of this period that Vice Premier Chen Yun formally announced the “three major balances” (san da pingheng 三大平 衡) as a guiding theory for economic construction in his report Construction Scale Must Be Compatible with the National Strength. The three major balances were the balance between fiscal revenues and expenditures, between the sources and uses of credit funds, and between the supply and demand of goods and materials. This underlay the principle of unified and coordinated overall balance among the three mentioned aspects. Chen advocated that the funds for economic construction could not exceed the financial strength of the country, and the latter should agree with the material resources, because without material resources, money would be of no use and inflation would result. He added, “Both fiscal revenues and expenditures, and bank credit must be balanced, and it is even better to have a small surplus. As long as the respective balances of fiscal funds and credit funds are achieved, there will be a general balance between social purchasing power and material supply.”26 The theory of the overall balance of fiscal funds, credit funds, and material resources played an active guiding role in promoting the stability and development of the national economy during the periods of Great Leap Forward, Cultural Revolution, and respective subsequent economic adjustments.27

Separated management of fiscal and credit funds The separated management of fiscal funds and credit funds, as was the overall balance of fiscal and credit funds, was a general law that must be obeyed in banking operations.28 The fiscal and bank credit systems were two tools for mobilizing and allocating capital, and they were indispensable for the healthy development of the national economy. But due to the differences in the form and function of capital formation and allocation, fiscal and credit funds must be managed separately, based on which an overall balance should also be maintained.29 The main principles behind the separated management and uses of fiscal and credit funds were: (1) funds to be granted without compensation should be placed under the management of the fiscal authority while those allocated with compensation under the management of banks; (2) long-term tied-up capital should be financed by the treasury while short-term funds should be provided by banks; (3) it was prohibited to utilize credit funds for fiscal purposes or use working capital to finance capital construction. These principles were set according to the characteristics of the sources, turnover, and recovery of the two types of funds.30

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Causes of the formation of the closed-crotch pants relationship during the planned economy era There had always been a close link between the fiscal and banking systems. But at the beginning of New China, the political and economic environments intensified the integration of the two systems under the leadership of the fiscal authority.

Influence from the Soviet economic model China was deeply influenced by the Soviet model during its transition from New Democracy to Socialism. From a theoretical point of view, it was taken for granted that to develop socialism, China needed to abolish the market system and establish a planned economy featuring highly centralized administration, just as what the Soviet Union had done. The Soviet Union continued with a highly centralized unitary banking system which was compatible with the planned economic system until the 1980s. It was a huge banking system with low structural diversity. With the State Bank (Gosbank) at the center and composed of the Construction Bank (Stroibank), the Bank of Foreign Trade (Vneshtorgbank), and state labor savings offices (sberkassas), it took on the financial and credit business of the whole country. The responsibilities of Gosbank were very wide, covering the functions of both a central bank and a commercial bank. It not only dealt with the formulation of monetary policy and currency issuance, but also handled deposits and loan business, which caused blurred its role as central bank. Stroibank was mainly responsible for investment and loans for capital construction in the industrial sector, while Vneshtorgbank undertook foreign trade settlements and remittance for nontrade activities. The savings outlets known as sberkassas absorbed residents’ cash for supporting national economic construction. All these specialized banks only played a supplementary role in certain banking business areas for the State Bank, and were not eligible for independent accounting. Therefore, it can be said that the whole banking system at that time was not sound and highly dependent on the fiscal authority; banks functioned only as settlement centers and had little to do with funds allocation. Under a planned economy, the financial institutions of the Soviet Union managed financial business on the behalf of the state as administrative units. They executed the decisions of the finance ministry to appropriate funds for enterprises. Making profits was not their objective or work. Interest rates were kept unchanged all year round. Soviet banks had insufficient autonomy and self-restraint and no sound basis of credit.31 However, the Soviet fiscal-banking relationship was taken as a role model of New China.

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The planned economy — the fundamental cause In the early 1950s, the economic foundation of China’s socialism was gradually established, and the nature of the socialist economy was confirmed to be a planned economy on the basis of public ownership. From 1949 to 1952, the central government first implemented planned management over the financial industry and foreign trade, and carried out planned procurement and distribution of cotton yarn, cotton cloth, and several other key commodities. From 1953 to 1956, planned management was basically extended to the whole commodity market. In 1958, the central government took direct control of economic operations in rural areas, which signified the completed formation of the planned economy.32 During the period of the socialist planned economy, an important feature of national economic life was planning. State plans were everywhere and dominated everything from production to distribution, circulation, and consumption. It was natural that the fiscal system was marked by features of the planned economy, for it acted as the main tool for raising funds for the country, implementing state plans for national economic and social development, and allocating resources. The fiscal authority performed the function of allocating the fruits of production among the whole society. Since the founding of New China, the fiscal authority had been considered the key actor of social distribution. Correspondingly, the responsibilities of the fiscal authority covered every aspect of social production: production and construction, public consumption, and people’s livelihoods. Among them, production and construction held a dominant position, which constituted a feature of socialist fiscal allocations.33 Moreover, traditional public finance theory holds that government finances of socialist countries center on production and construction, and are an important component in social reproduction. Enterprises have neither the power to invest nor the capacity to expand reproduction. Fiscal organs take the place of enterprises to be the principal investors in social investment. The planned economic system demands that elements of capitalism be eliminated from all sectors of the national economy. Therefore, during China’s planned economy era, there was no ground for the existence of private banks, joint-stock banks, and other financial institutions that served the market economy and the financial market. Moreover, the money-value relationship was subject to great restrictions as it developed largely dependent on commodity circulation, and banks which were responsible for managing money and giving and accepting credit were reduced to a secondary place in financial resources utilization. Besides that, since the Ministry of Finance adopted the practice of “unified control over fiscal revenues and expenditures” (tong shou tong zhi 統收統支), business activities of enterprises were put under central budgetary control and their financing needs

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were supported by fiscal grants. Standing only as subsidiaries of the fiscal authority, banks could only operate on a small scale, performing limited financial supervision and control over enterprises. In fact, they acted only as cashiers of the state.

Strong macroeconomic regulation and control From the founding of New China to the eve of the Reform and Opening Up era, the strong desire for a prosperous and powerful country had urged the Chinese government to pull all the forces of the country to develop all kinds of undertakings by means of economic planning. Consequently, a highly centralized macrocontrol system was established. It was characterized by unified transfer and allocation of goods and materials, centralized control over revenue and expenditure in the fiscal system, centralized management of deposits and loans in the banking system, and the pursuit of the overall balance of fiscal and credit funds. First, the state conducted planned regulation of the national economy through the means of “use value” and “value.” First, the central government took control over the production, supply, and marketing of goods and materials. The stateowned commercial and state-owned material supply systems dominated the production, supply, and marketing of industrial products; rural supply and marketing cooperatives were in charge of the purchase and sales of agricultural products as well as the back selling of grain crops and industrial products; and the grain department was responsible for grain procurement, processing, and selling. Moreover, as goods go where the money is, the central government made use of the means of value in resource allocation in order to regulate product circulation and consumption. This macrocontrol approach was built upon the economic basis of underdeveloped productive forces, relative material scarcity, short supply, and the whole society being a seller’s market. In a long period after the founding of New China, in the face of numerous twists and turns in the development of the national economy, the central government introduced planned regulation on the supply and demand of materials and goods, and social funds were raised and allocated under centralized management. These measures were both necessary and feasible.34 Second, the fiscal system was the means through which national plans were carried out. After national plans were formulated, the implementation of specific work would rely on the fiscal authority. Through executing budget plans and participating in the value distribution of national income, the fiscal authority would gradually accumulate various sorts of funds, such as depreciation funds for simple reproduction, consumption funds for the reproduction of labor power, and accumulation funds for additional investments. With these funds, the monetary purchasing power of units and individuals would be formed, and the unity

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between use value and value in the field of circulation could be achieved. It was also during this process that national plans would be completed.35 Third, good coordination of the fiscal-banking relationship was crucial to the overall planning and arrangement of funds as well as the healthy development of the economy. Although there was no such a term as “macrocontrol” in era of the planned economy, this practice did exist under the alternative name of “overall balance.” The relationship between the fiscal authority and banks was coordinated under the guiding principle of overall balance.36 The fiscal and banking systems were the two channels for centralized capital distribution, and the purchasing power generated by fiscal revenue and credit was an important component of social aggregate demand. The balances between fiscal revenue and expenditure and between credit sources and uses were important prerequisites for the equilibrium between the supply and demand of materials and goods. Under the highly centralized fiscal and banking systems, mere deposits and regular currency issuance were far from enough credit sources for satisfying enterprises’ demand for working capital loans. Therefore, the government emphasized the use of fiscal revenue to support credit funds in order to achieve an overall balance. When Li Nianxian held the post of Minister of Finance, he pointed out that the fiscal authority and banks should work hand in hand to achieve an overall balance while maintaining their respective balances. For example, when the country carried out economic adjustment in 1962, the economy was further centralized and unified, as a result of which new bank deposits were reduced. In order to enable banks to meet the loan demand for working capital and support the development of production, Li proposed expanding the proportional allowance of retained profits for banks so that they could replenish their credit funds. This measure played a vital role in lifting the national economy out of the trough back on the track of development and contributed to the fundamental improvement of financial and economic conditions.37 Overall, as Wang comments, “during the period of the planned economy, in the absence of both an institutional basis and the concept of coordination between fiscal and monetary policies, the overall balance was achieved, under the theory of overall balance and the framework of economic management, mainly through balances in the aspects of government finances, credit, goods and materials, and exports. This macrocontrol approach played a major role during the time of the planned economy.38

Political basis in a highly centralized administrative system China has long been peopled with peasants, and it has had a strong tradition of administrative power dominating society. The Communist Party of China has

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established a totalitarian regime under its own leadership on the basis of a kind of prestige which was formed over the course of long-term revolution.39 Abiding by a centralization ideology expressed through the slogan “The same chess game for the whole nation” (quanguo yi pan yi 全國一盤棋), the Chinese government made several attempts to centralize government finances, credit, and corporate jurisdiction. The banking sector implemented strict vertical leadership with banks at lower levels subordinate to higher-level ones, and centralized management was also extended to the functions and customers of banks. Under such a circumstance, banks actually operated as government administrative departments and a link in the departmental management system.

Repeated fiscal-banking mergers In the structural adjustments in the 1950s, 1960s, and 1970s, the Ministry of Finance and the PBC were combined together to be some “Fiscal and Financial Bureau” (caizheng jinrong ju 財政金融局). There was almost no room for the existence of the PBC, which seemed to be dispensable and insignificant. The three times of mergers in fact implied that the fiscal and banking systems could be treated as one. It was because of these three mergers in history that people gradually formed the opinion that the nature and functions of the two institutions were identical.40

Evaluations of the closed-crotch pants relationship during the planned economy era Positive effects of the closed-crotch pants relationship After the founding of New China, the country embarked on the road of socialism. It implemented a planned economy, and established a highly centralized fiscal management system. This was out of both historical and realistic reasons. From 1949 to 1978, despite all the major setbacks such as the Great Leap Forward and the decade-long Cultural Revolution that started in 1958, efforts in socialist economic construction and social development resulted in considerable achievements. During this process, the fiscal and banking systems which complied with the planned economy played an important role in the following aspects. Stabilizing prices in response to the needs of the period For over a decade after the founding of New China, the country had to wrestle with hyperinflation left behind by the Kuomingtang government. Commodity prices were soaring, national industries were on the verge of collapse, a large number of

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workers were unemployed, and civil war continued in parts of the country. These resulted in huge government expenditures. But, as fiscal and taxation policies were not unified across the country, tax revenue was delivered slowly to the central government. The newborn regime was not consolidated yet. It was the fiscal and banking systems that enabled the central government to implement unified fiscal and economic policies and stabilize prices in a short period of time, which led to an upturn in the economy. By 1951, the Chinese government had achieved a fiscal balance with a small surplus. The closed-crotch pants relationship made remarkable contributions to restoring the national economy, improving people’s livelihoods, suppressing speculative capital, supporting the Korean War, and consolidating the new regime.41 Contributing to a relatively comprehensive national economic system Owing to a special fiscal revenue mechanism, a broad fiscal expenditure mechanism, a highly centralized management system, and the closed-crotch pants relationship between government finances and banking, the central government was able to avoid dispersed and consumption-oriented use of funds, and concentrated all possible financial and material resources of the country to finance large-scale economic construction. As a result, a relatively mature national economic system was established, with priority given to the development of the heavy industry. This largely changed the course of development of Chinese society and transformed China from a poor and backward agricultural country into an emerging socialist country moving towards industrialization.42 Contributing to the development of social undertakings Through the highly centralized fiscal mechanism, the country operated various social undertakings in the areas of technology, education, culture, and public health, among others, and established a relatively comprehensive structure of state-owned institutions which covered almost all the fields of social undertakings. This paved the way for and played an active role in the economic development and all-round social progress of New China.

Drawbacks of the closed-crotch pants relationship With the rapid development of the socialist economy, economic relations became more and more complex, and the demand of people for material and cultural life constantly grew. As time went by, increasing disadvantages of the closed-crotch pants relationship between the fiscal and banking systems came to be exposed.

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The deviation from banking functions During that period of time, the PBC played the dual roles of a central bank and a commercial bank, assuming a variety of financial functions. Thus, it could not concentrate on developing and formulating effective monetary policy. This deviation from the central banking functions deprived the PBC of its role as the “bank of banks.” Moreover, commercial banks suffered from low efficiency. On the surface, banks performed economic accounting, but this was only limited to cost accounting and balancing revenues and expenses. Banks were not responsible for their own profits and losses, and profit making was not part of their objectives and missions. Financial services provided by banks were not diverse and there was a lack of autonomy and self-restraint in banking operations. At the same time, banks were managed the same way as state organs, and the interest rate was not a primary indicator of performance appraisal. As a result, banks were indifferent to the profitability of credit funds, resulting in a decline in the investment efficiency of credit funds. The banking industry increasingly lost its own character as well as the vitality and internal drive for development.43 The lack of an incentive mechanism One feature of the closed-crotch pants relationship was excessive centralization of power and hence overexpansion of government functions. The fiscal authority performed the function of microeconomic decision-making in place of enterprises. The social hierarchy took the form of a top-down power pyramid: Not only did people have little economic autonomy, which prevented enterprises and individuals from exerting their abilities, but it was also next to impossible for people to be remunerated according to their work performance. This suppressed the enthusiasm and creativity of all government departments and economic units, and was harmful to the long-term sustainable development of social productive forces.44 Defects in the financial management structure of capital construction Under the traditional structure, capital construction expenditure took the lion’s share of China’s fiscal expenditure, accounting for 30%–40%. The Ministry of Finance was the most important investor in social investment, and the financial management structure for capital construction played a decisive role in the operation of the national economy and the formulation of national economic development plans. However, the financial management of capital construction of that period failed to break away from the model of fiscal grants according to the national economic plan. As such, experiencing several rounds of ups and downs, the China Construction Bank remained an institution specializing in fiscal allocations

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for capital construction, and was far from playing the role of a bank in its true sense in spite of its certain monitoring functions. This led to a disconnection between the rights, responsibilities, and interests of capital construction investment, reflecting a lack of an internal investment restraint mechanism. Projects of capital investment were examined and approved by the planning authority before being included into the national economic plan; the fiscal authority would prepare the national budget based on the national economic plan, allocate expenditure for capital construction, and disburse funds to the China Construction Bank; and the China Construction Bank would provide money for project undertakers based on the approved capital construction plans as well as monitor the use of the funds. If the project ended in a success, everyone would be happy; but even if otherwise, the responsibilities would just be too large for any party to shoulder. So under the system of unified control over state revenues and expenditures, project undertakers had no need to worry about the risks of capital construction investment. Consequently, unrestrained competition for projects and investments, and a runaway scale of capital construction became persistent headaches of the closed-crotch pants system.45 Unrealistic compression of working capital demand Under the system of unified control over state revenues and expenditures, stateowned enterprises did not have production funds at their disposal. Expansion and renovation projects of enterprises had to be financed by fiscal appropriations, and working capital was supplied by both the treasury and banks. In fact, the demand for working capital had always been overlooked, and it seemed that this demand could be greatly compressed. However, the demand for working capital during a certain period of time is inelastic and must be satisfied, whether the money is provided jointly by the treasury and banks or not, and regardless of the financing ratio between the two. Thus, in preparing economic plans, when it was found that fiscal funds and possible short-term loans from banks were unable to meet this demand, it would be necessary to compress other expenditures in order to ensure the necessary supply of working capital. Unfortunately, the planned economy period showed a shortfall in this regard. The short supply of working capital could be attributed to a variety of reasons, but the most direct one was that part of the demand for fixed capital was satisfied by cutting down on the supply of working capital. Besides that, working capital was often misappropriated by enterprises. Due to the fact that working capital would only be allocated after other expenditures were satisfied, the gap between the supply and demand of working capital had to be filled by banks, although this act would probably lead to the excessive input of bank credit, thereby upsetting the overall balance of fiscal and credit funds. Perhaps it can be said that under the

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system of unified control over state revenues and expenditures, excessive credit injections stemming from inadequate working capital allocations posed one of the greatest threats to the overall fiscal-credit balance.46 The lack of standardization and legislation The closed-crotch pants fiscal-banking system had obvious deficiencies in standardization and legislation. The fiscal system underwent frequent changes during the first 30 years of New China, and by the end of 1978, no official national law had been imposed on fiscal distribution. There was no legal basis for the functions of banks, whose business was developed according to the temporary needs of economic development and regulated by administrative regulations, and was thus quite arbitrary. All these were harmful to the formation of a clear and stable institutional system and the improvement of economic efficiency. An overly close connection The old closed-crotch pants system emphasized the unity of economic plans, government finances, and banking in accordance with the principle of the centralization of power. Government finances were forcibly tied with credit and money supply following an egalitarian ideal, while the independence of the fiscal and monetary means and the special regularities of capital flows were neglected.47 This led in many ways to a departure of the two systems from their respective roles as economic levers in terms of functioning channels and coverage. Banks’ role as economic lever was weakened as many areas of funds allocations which should have been adjusted by bank credit and interest rates were assigned to the fiscal authority. At the same time, unconditional fiscal grants tempted enterprises to develop a typical “investment hunger,” such that they had little awareness of the concepts of repayment, turnover, working capital, interest rates, and time. This greatly reduced the economic efficiency of capital use and inflicted a negative impact on national construction.48 A lack of restrictions The vitality of national macroeconomic regulation and control lies in the coexistence of both interactions and mutual checks. However, as a result of the overly tight coupling mechanism of the old days, there was a lack of necessary constraints. Neither the fiscal authority nor banks imposed a clear cap on money transfer, whether it was fiscal appropriations for banks or the profits turned over by banks to the fiscal authority. For example, banks handed 50% of their profits over to the government from 1958 to 1971, and 20% from 1972 to 1974. Moreover, under the old system, both the fiscal authority and banks were excused from the

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responsibilities, rights, and interests involved in capital use. No fees or interest would be incurred at the additional allocation of credit funds to make up for a credit balance deficit, the use of fiscal deposits by banks, and the appropriation of bank capital by the fiscal authority. The unconditional grant of funds following the principle of indiscriminate egalitarianism seriously went against the operating law and demands of the commodity economy. Consequently, the national economy was trapped in the vicious circles of either “budget deficit — borrowing from banks — treasury squeezing banks,” or “unbalanced credit funds — additional fiscal allocation of credit funds — banks squeezing treasury.” Both of them would result in additional issuance of money. Therefore, in the national economy, a failure in any link would end up leading to increased money issuance at the expense of the market.49

Evolution of the Closed-Crotch Pants Relationship during the Planned Commodity Economy Period The fiscal-banking relationship during the planned commodity economy period Individual development of the fiscal and banking systems The advancement of the Chinese economy and the increasing number of financial institutions created a pressing need for the unified management and comprehensive coordination of the banking industry. In December 1977, the State Council convened a national banking work conference and decided to restore the independent organizational structure of banks in the hope of giving full play to the role of banks. In January 1978, the Ministry of Finance and the PBC headquarters were officially separated as two divisions. In January of the next year, the Agricultural Bank of China resumed service for the purpose of strengthening support for the rural economy. On September 17, 1983, the State Council decided that the PBC should perform only the functions of a central bank and that savings and loan business be transferred to a specialized bank (namely, the Industrial and Commercial Bank of China, which dealt with domestic business while the central bank foreign business). From January 1, 1984, the PBC started to function as a central bank. It focused on studying and implementing national financial policies at a macro level, and enhanced the control over credit aggregates and capital adjustment in financial institutions to maintain monetary stability. In the same month, the Industrial and

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Commercial Bank of China was established, making up for the vacuum left by the withdrawal of the PBC in industrial and commercial credit and savings services. At that point, the PBC had divested itself of basically all commercial business and officially became the central bank of China. The newly established Industrial and Commercial Bank of China became the largest specialized bank, responsible for providing loans to industrial and commercial companies. To support the above changes, the China Construction Bank became independent from the Ministry of Finance and was in charge of capital construction loans. The Agricultural Bank of China was responsible for rural service loans.50 In 1985, the State Council clearly stipulated that the Ministry of Finance and the PBC were under the direct authority of the State Council and were at the same administrative level. The equality between the PBC and the Ministry of Finance was basically achieved. China’s financial system began to transition towards a modern free-market financial system. As for government finances, after the launch of the Reform and Opening Up policy, the Chinese government adopted multiple measures to promote the development of the national economy. Those measures included: decentralization of power and transfer of profits to enterprises; reforming the national income distribution pattern to increase the shares of residents, local governments, and enterprises; reducing the tax burdens of enterprises and allowing them to retain more profits; “tax for profit” (li gai shui 利改稅), that is, replacing profit remittance by taxation to increase enterprises’ financial strength; and granting financial subsidies to urban and rural residents. Unfortunately, while the economy was picking up, state revenue was greatly sacrificed with the fiscal capacity decreasing year by year and yet limited reductions in fiscal expenditure, which put the Ministry of Finance in a predicament.

Loans for fiscal appropriations Prior to 1984, investments for national capital construction were financed by fiscal appropriations. After that, the fiscal management system was reformed. While the practice of centralized collection of revenue was abolished, the centralized allocation of local expenditure was retained, which resulted in an overly heavy burden on the state treasury and huge fiscal deficits. On the other hand, with the growth in household savings, state-owned banks then had ample funds to fill the gap left by the Ministry of Finance in financing, investment, and macroeconomic control. Soon, the gradually growing state-owned banks replaced the fiscal authority as main investors in capital construction. In 1978, the savings surplus of urban and rural households just amounted to CNY21.06 billion, but by 1985, this figure had surged up to CNY162.26 billion, 7.7 times as large as that of 1978.

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The increase in household savings supplied banks with sufficient money to extend loans for technical innovation and fixed-asset investment purposes (known as “medium- to short-term equipment loans” at that time), and working capital was no longer the only loan type. In this way, banks played a key role in enterprises’ fundraising for production and expansion. It was under such a backdrop that the policy of “loans for fiscal appropriations” (bo gai dai 撥改貸) was introduced. In December 1984, the State Planning Commission, the Ministry of Finance, and the People’s Construction Bank of China jointly decided that from 1985 onwards, all investments for capital construction in the state plan would be supplied by bank loans instead of fiscal appropriations, and this policy was promoted nationwide.51

Enterprises, a new component in the fiscal-credit balance With the abolition of the centralized control over revenues and expenditures, corporate income and spending became an independent unit in the overall fiscalcredit balance. In capital management, enterprises were given considerable autonomy in controlling parts of their profits to form all kinds of production funds. The government’s burdens of financing fixed-asset replacement and technological upgrading and supplying working capital were greatly lessened. Banks and enterprises established ties in not only the flow of working capital but also that of fixed assets. As a result, enterprises played a larger role in the overall balance of credit and fiscal funds, and this was reflected in three aspects: 1. In terms of fixed-asset investment, there arose the new issue of coordination between centralized credit funds and the countless decentralized corporate production funds, which increased the difficulty for the Chinese government of implementing planned management for the benefit of the overall fiscalcredit balance, compared with the time of unified state control over revenues and expenditures. 2. In terms of technological upgrading and fixed-asset replacement, it was very likely that enterprises would redirect the funds for replacement and renovation to business expansion when they had discretion over the money. This would build up the pressure on bank credit since renovation and replacement projects were also inevitable. 3. There had not yet been provisions on the use of enterprises’ retained profits to supplement working capital. The demand for working capital remained an inelastic demand that everyone wanted to compress in order to use the capital to expand production but no one was successful. If enterprises resorted to securing extra bank credit by misappropriating the granted working capital for other uses, the ultimate result would be the

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forced expansion of bank credit supply, which would increase the risk of a fiscal imbalance. Therefore, in trying to maintain the fiscal-credit balance, attention should be given to not only the fiscal authority and banks but also enterprises. If capital utilization was out of control in enterprises, overall control over capital supply would be difficult to achieve, let alone the target of overall balance.52

Problems in the fiscal-banking relationship during the planned commodity economy period The “default” mechanism of state-owned enterprises During that period, most of the fixed-asset investments and over 90% of the working capital of state-owned enterprises came from bank loans. State-owned enterprises typically financed production by loans and repaid debts by new borrowings — in such a way, something of a “default” mechanism was formed. Some enterprises still stuck with the old mentality of “iron rice bowl,” while in order to maintain economic growth, banks were obliged to continuously inject capital to enterprises whereas the underfunded enterprises would not hesitate to take money from banks and build their capital demand on banks. However, what the huge bank funds brought in return was not a modern corporate system and efficient profitability. Instead, a large number of loans turned out to be nonperforming loans. Many enterprises defaulted on debts on purpose even though some of them were capable of repaying their loans. In some places, banks had to issue loans to “financially distressed” enterprises under the administrative orders of local governments.53

The loophole in the management of working capital The State Council decided that working capital of state-owned enterprises must be managed by banks, and it also forbade banks to grant loans to local governments, governmental departments, and state-owned enterprises for new or expanded fixed-asset investments unless they were in possession of no less than 30% of the working capital. However, in the state budget, there was no clear regulation on how the capacity of working capital supply was to restrain fixed-asset investments. This was a key issue in properly dealing with the fiscal-banking relationship in macroscopic capital allocation. Due to this loophole in working capital, the fiscal authority, local government departments, and state-owned enterprises continued to be overambitious in fixed-asset investment while neglecting the supporting role of working capital. Worse still, some even diverted working capital to capital

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construction, resulting in a runaway scale of capital construction, one of the important reasons for economic setbacks.54

Mutual encroachment of funds between the fiscal authority and banks Encroachment of bank funds by the fiscal authority First, fiscal deficits and borrowings showed a long-term expanding trend. To make up for fiscal deficits and the gap in working capital, the fiscal authority would resort to bank overdrafts, which would add pressure to the supply of credit funds. A fiscal overdraft was in fact a long-term unpaid occupation of bank credit funds and the transfer of fiscal burdens to banks. Given that fiscal revenue was saved in banks without receiving any interest and the fiscal account always maintained a stable surplus, banks might well help the treasury get through temporary financial difficulties by providing limited overdrafts and borrowings. But unlimited overdrafts and borrowings would seriously impair the allocation and utilization of banks’ credit funds. According to statistics, the year-end balance of fiscal borrowings from banks increased year by year from CNY57.6 billion in 1988, to CNY68.5 billion in 1989, CNY80.1 billion in 1990, and CNY106.7 in 1991.55 State-owned banks are the last line of defense in suppressing social aggregate demand. In the face of fiscal overdrafts, to prevent the expansion of social aggregate demand, banks must correspondingly suppress the total amount of loans; otherwise, it will be forced to issue more money, which will lead to inflation. At the end of 1989, the balance of fiscal overdrafts and borrowings reached CNY79 billion while fiscal deposits only amounted to CNY46 billion. This created a large challenge to the maintenance of the credit balance and increased the difficulty for banks in controlling social aggregate demand.56 Second, a part of credit funds was directly used to purchase government bonds, and maturing bonds were repaid by debt conversion, that is, using new debts to pay off old debts. This means that this part of credit funds was occupied by the treasury in the long term. Third, bank loans were borrowed to make up for the arrears of fiscal appropriations and allocations. Encroachment of fiscal funds by banks First, banks repeatedly raised interest rates, which increased enterprises’ burden of repayment. According to the financial regulations at that time, the interest rates of all commercial and industrial loans, including default interest, should be listed as the costs of production and operation. Higher interest rates would thus add to the costs of enterprises and in turn decrease fiscal revenue, thereby indirectly turning potential fiscal revenue over to banks in the form of interest rates.

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Second, the macrotightening policy of banks also affected the economy and production to a certain extent. It is necessary for banks to implement prudential policy in the presence of economic overheating and inflation. However, at that time there was not only demand-driven inflation but also sectoral inflation. When carrying out tightening policy, banks often adopted the indiscriminate approach of pressing down total loans instead of a differentiated approach of sectoral compression based on different situations, thus creating negative impacts on social production and the economy. In fiscal terms, this practice resulted in a decrease in government revenue and an increase in spending.57 Third, taking advantage of their role as fiscal agents for the treasury, banks were able to appropriate treasury funds without demanding compensation or convert them into credit funds. Fiscal funds thus constituted an important and stable source of credit funds. What is more, some banks even asked their branches to use treasury funds to invest in real estate, stocks, futures, and various other industries, in order to carry out so-called diversified operations and bank-enterprise cooperation. In addition to this, there were also the problems of delayed transfer of fiscal revenue to the treasury, illegal misappropriation of taxes, delayed submission of bank profits to the treasury, and the failure to appropriate budgetary funds according to the demand and progress of economic development. In the first half of 1993, the problem of the misappropriation of fiscal funds by banks prevailed across the country, and the cumulative amounts of the involved funds reached tens of billions of yuan.58

Unclear division of labor between the fiscal authority and banks Banks taking over fiscal functions Banks’ credit funds, which are supposed to be used for profit-making purposes, were often granted without receiving any compensation through a variety of administrative means. When it came to fixed-asset loans, everything from the total size to specific projects, and from new loans to loan recovery was under the control of mandatory plans. Loans must be issued according to the state plan irrespective of project returns and repayment capacity. In effect, this portion of credit funds was allotted like fiscal funds. There was a great variety of policy-oriented loans, many of which shared the nature of fiscal funds. Those loans played a certain role in maintaining political and social stability, but a considerable part of them contradicted national industrial policy, the principle of economic efficiency, and the principles of credit. In the long run, this was harmful to economic development and monetary stability.

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The acquisition of agricultural and sideline products had always been a focus of financial support. But due to the delayed supply of purchasing funds by the treasury as well as the misappropriation or diversion of funds by the parties concerned, the abnormality of banks replacing the fiscal authority and other government departments to provide purchasing funds resulted.59 As for government subsidies to the grain industry, the pillar enterprises, the education sector, and other entities, the money was mainly granted on bank loans rather than from local treasuries due to the financial constraints of local governments. Lastly, to relieve displaced workers laid off by financially distressed state-owned enterprises, banks were obliged to issue loans under such names as “loans for social stability and unity” (anding tuanjie 安定團結), which were intrinsically nonperforming loans.60 The fiscal authority taking over banking functions After the policy of “replacing fiscal appropriations by loans” was implemented, the Ministry of Finance massively expanded fiscal credit and set up a large number of fiscal credit companies at central and local levels, forming a fiscal-financial investment system of considerable size and strength. In this way, the fiscal authority engaged in credit activities, providing financial services and establishing financial institutions. It had evolved into a “second bank.” On the surface, this practice enabled the fiscal authority to take on nonprofit deposits and lending business which banks were unable or unwilling to undertake, thus promoting the reform of the investment system, satisfying the capital demand of basic industries, infrastructure construction, and nonprofit organizations, and realizing the adjustment of the socioeconomic structure. However, in actual practice, many fiscal credit companies were still profit-seeking and even pursued profit maximization. Since fiscal credit was necessarily driven by power and interests, there was a clear tendency of fiscal funds transforming into credit funds, which to a certain extent disturbed the normal financial order and hindered the healthy and orderly development of finance.61

Exacerbation of fiscal-banking conflict by “pretax loan repayment” According to the policy of “pretax loan repayment” (shui qian huan dai 稅前還貸) at that time, repayments of enterprises’ fixed-asset investment loans could be made from pretax profits. This arrangement in effect had the treasury and enterprises collectively pay off enterprises’ loans at the rate of the income tax. Essentially, this was an altered form of fiscal grants in which ex-post fiscal appropriations were made with banks acting as intermediaries. In such a way, the borrowing risk and the accountability of capital use were transferred from the borrowing enterprises

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to the fiscal authority. On the level, this approach weakened the leverage of interest rates, especially when the pretax repayment policy allowed the withdrawal of employee benefit and bonus funds, thereby greatly stimulating enterprises’ desire to invest. On another level, as a large portion of the principal and interest payments received by banks was recovered at the expense of fiscal revenue, the growth of fiscal revenue was impeded. Between 1979 and 1988, pretax repayments made by enterprises amounted to CNY108.47 billion, implying a diversion of CNY54.2 billion of fiscal revenues if the amount had been shared equally between fiscal revenue and banks. Compared with the figure of 1979, pretax repayments in 1988 had increased by 19 times from CNY1.54 to CNY29.32 billion, and this proportion to national income by 5.5 times from 0.46% to 2.54%.62

An irrational institutional structure The problem in the institutional structure was best reflected in the role of the China Construction Bank. Under the planned economy, the China Construction Bank was responsible for appropriation of funds and capital management related to capital construction. It thus performed fiscal functions, and should be regarded as an affiliate of the Ministry of Finance. However, the State Council decided to incorporate the China Construction Bank into the banking system under the leadership of the PBC. While this seemed to have clarified the nature, responsibilities, and reporting line of the bank, in fact, the China Construction Bank was still under dual leaderships and had two identities. It was under the authority of the PBC in conducting credit business but the Ministry of Finance with respect to financial sources and administrative management. It performed both fiscal and banking functions. This “two-in-one” operational mode of the China Construction Bank was a clear reflection of the distorted fiscal-banking relationship.63

The root cause of the closed-crotch pants relationship A yet-to-be mature economic system Generally speaking, the incompletely formed economic system was a major cause of conflicts in the fiscal-banking relationship during the period of economic transition. China’s economy experienced a gradual transition from the traditional planned economic system to a market economic system; therefore, for quite a long period of time, the old and new systems coexisted. Moreover, reform is a process of readjustment and redistribution of interests. In China’s progressive reform, to maximize support and reduce resistance, it was imperative to respect and maintain

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the vested interests, any violation against which must be compensated. This process was akin to the concept of Pareto improvements. With such a consideration, the old system which was entrenched in society could not be totally eliminated in a short time, for its inherent conceptions and rules were bound to stay on and become a resistance to the formation of the new system. On the other hand, while the new system was slowly taking shape, its institutions and rules were yet to be complete and mature. Such underlay the transitional characteristics of the entire economy and society. Under such an economic situation, a property rights system had not yet been fully established and a variety of institutional reforms were only starting to take effects. Meanwhile, some of the rules of the old system must be retained out of consideration for the vested interests. This in turn further increased the rigidity of the vested interests and the difficulty of making breakthroughs in reform, putting China’s economic reform in a more complicated and difficult position.64

Operational difficulties of state-owned enterprises Under the influence of the planned economy, the fiscal authority, banks, and stateowned enterprises had always been the three core links in the economic operation of the country. If any of these links went wrong, the central government would interfere and introduce administrative orders to elicit help from the other two links. During the transition from the planned economy to the market economy, the nominal responsibilities of the three links were clearly divided, but in de facto capital flows, their connections established since the beginning of the planned economic period had never been truly cut off. Starting from 1979, the Ministry of Finance stopped injecting capital into state-owned enterprises, and they became independent economic units in society. However, it was irrefutable that most state-owned enterprises had low efficiency and long-run losses due to multiple reasons. Widespread losses in state-owned enterprises had tremendous repercussions to the treasury: not only did this deplete financial resources and hence weakened the growth potential of the country’s fiscal revenue, but it also forced state subsidies to cover losses to expand; and eventually, in the name of various policy-based loans, the losses of enterprises were transferred to banks. Although bestowed under the name of “loans,” those subsidies were in fact an exercise of fiscal functions. In 1994, for example, among the CNY4-trillion bank loans, 70% went to state-owned enterprises, that is, CNY2,800 billion. Comparing the official interest rate of 12% to the market interest rate of 25%–30% at that time made a difference of between 13% and 18%. That is to say, if economic resources had been distributed following the rules of the market economy, the profits of state-

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owned enterprises would have been cut by CNY364 billion to CNY504 billion. But the total profits of all state-owned enterprises amounted to merely CNY260 billion. Worse still, state-owned enterprises tried to dodge their liabilities or turn their loans into unenforceable debts by means of mergers, spinoffs, acquiring quality assets, fictitious bankruptcies, and other consolidation methods, which resulted in a large volume of nonperforming assets in banks.65

Unclear property rights of state-owned enterprises Nonmarket behaviors of state-owned enterprises resulting from unclear property rights exerted an enormous impact on the operation of the fiscal and banking systems. First, the state was the de jure owner of state-owned enterprises and the risk bearer of last resort. But the state had no real human representatives, and its ownership functions had to be divided among various levels of governments and authorities, which could intervene in the operation of state-owned enterprises but were not responsible for maintaining and increasing the value of company assets. Operators of corporate loan funds were not accountable for the losses of enterprises. Due to the absence of a subject to exercise property rights, a sound and rational system of checks and balances, and an effective incentive and restraint mechanism, enterprises were poorly managed with low operational efficiency. Second, the ambiguity in the property rights of state-owned enterprises encouraged enterprises’ blind expansion of capital demand. Under ceaseless direct or indirect interventions from governments and authorities at various levels, enterprises failed to develop a sense of responsibility to assume risks of investment and financing and lacked internal pressure and restraints for repaying debts. The absence of business responsibilities and ethics could not be compensated by mere external rewards and punishments for corporate managers. Finally, as state-owned enterprises were owned by the country, out of consideration for fiscal revenue and the recovery of invested capital, the central government often assisted backward state-owned enterprises and enterprises that were unable to revive through all kinds of preferential treatment and support. Without circulation of property rights, there could hardly be mergers, company auctions, or bankruptcies. And even if there were occasional instances of these events, they would just be mere formalities, as wishful asset consolidation by the government sector, rather than market-oriented behaviors. Consequently, this would inevitably lead to the inefficient allocation of social resources and massive accumulation of nonperforming assets in banks, imperiling the survival and development of banks.66

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Unsound macrocontrol mechanism During China’s transition from a pure planned economy to a combination of planned and market economies, the traditional mechanism of planned regulation was largely undermined. But while enlivening the economy at a micro level, the central government failed to establish and improve a new fiscal-banking-centered regulatory mechanism in a timely manner. Reform had shattered the system of unified collection of fiscal revenue and given rise to diverse economic agents, each of which was in charge of certain financial resources. As a result, the financial resources held by the fiscal authority were relatively lessened, so were its regulatory capabilities. At the same time, the regulatory means of banks were undiverse, with the interest rate lever playing a negligible role due to huge capital demand, and bond markets, which should serve as intermediaries of indirect regulation, yet to form. Credit size became the only means of economic regulation of the central bank. The flexibility of monetary policy could not come into play, such that a loose policy would bring about disorder while a tight one economic stagnation. Because of such an unsound macrocontrol mechanism, the target of a fiscal-credit balance could not be achieved.67

Long-term short supply of fiscal and credit funds and the lack of an effective coordination mechanism After the launch of the Reform and Opening Up policy, the functions of the fiscal authority and banks were clearly divided. But due to the inseparable connections between the two systems, the economy was in want of an effective mechanism which could properly deal with the fiscal-banking relationship and coordinate between capital utilization and macrocontrol. Consequently, the fiscal authority and central bank regarded their internal balance as their respective policy target, giving little consideration to the coordination and cooperation between each other as well as the overall balance of aggregate social capital. In the formulation and implementation of national policies and plans, when facing a shortage of funds, the two systems tended to shift their respective difficulties to one another. The fact was that due to the huge gap between capital supply and demand, both the fiscal and banking systems were unable to make ends meet and maintain their internal equilibrium. Any adjustment of their relationship would inevitably bring about the redistribution of capital, affecting the economic interests of both parties. To make it plain, a promotion of one-way flows of capital would definitely be met with resistance from the outflow side. This hurdle made problems pile up and left little

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leeway for capital redistribution. Funds which could be used for adjustment were few and the poor coordination between the fiscal and banking systems became even worse.68

The Evolution of the Fiscal-Banking Relationship under the Market Economy The fiscal-banking relationship under the market economy Individual development of the fiscal and banking systems By the 1990s, capital flows in China had undergone radical changes. At the beginning of the 1990s, 70% of the capital invested in enterprises came from nonbudgetary sources. Even in the scope of state investment, bank loans and fundraising by enterprises themselves made up the majority. This was totally different from the situations under unified state control over revenues and expenditures in the early days of economic reform. This change elevated financial policies to a leading position in macroeconomic regulation and control. Since 1993, according to the Decisions of the State Council on the Reform of the Financial System, the PBC further strengthened its duties of financial control, supervision, and services, and split off commercial banking and policy-related business. On March 18, 1995, the Law of the People’s Republic of China on the People’s Bank of China was promulgated. The Chinese government confirmed for first time the status of the PBC as a central bank by legislation, and this law signified that China’s central banking system had begun to acquire a formal, legal basis. On May 10, the Law of the People’s Republic of China on Commercial Banks was passed at the 13th Meeting of the Standing Committee of the Eighth National People’s Congress, opening a new era of commercial banking. In November 1997, the Chinese government convened its first national financial work conference and confirmed a series of guidelines, policies, and measures for financial reform. The conference explicitly stated the significance of reforming state-owned commercial banks and proposed reinforcing credit management and lowering the proportion of nonperforming loans. It also aimed to transform the four specialized banks (Industrial and Commercial Bank of China, Agricultural Bank of China, Bank of China, and China Construction Bank) into four commercial banks. On the part of the fiscal system, the results of the tax sharing reform of 1994 were undoubtedly remarkable. Before the reform in 1993, the total fiscal revenue was CNY434.90 billion, while in 2003, this figure surged up to CNY2,171.53 billion. Fiscal revenue had increased by five times within just a decade, and its proportion

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in GDP rose from 12.6% in 1993 to 18.6% in 2003. During the same period, the proportion of central government revenue in national fiscal revenue grew from 39% to 54.6%. The enhancement of national financial power and the expansion of central fiscal revenue effectively strengthened the exertion of fiscal functions as well as the capability of the central government in macroeconomic regulation.

Changes in the closed-crotch pants relationship For a long period of time, fiscal deficits had been financed by loans and overdrafts from the central bank and fiscal surpluses would be automatically occupied by the central bank as well. In 1993, the State Council issued a circular terminating fiscal overdrafts from the central bank. On December 25 of the same year, the Decisions of the State Council on the Reform of the Financial System formally went into effect. It stipulated that the Ministry of Finance must stopped borrowing from the PBC, budgetary shortages resulting from spending in advance of revenue collection should be financed by short-term government bonds, and fiscal deficits should be compensated by issuing government bonds. After that, the Budget Law of the People’s Republic of China and the Law of the People’s Republic of China on the People’s Bank of China were successively implemented. The two laws cut off the direct connection between the fiscal authority and the central bank by means of legislation. Article 29 in the Law of the People’s Republic of China on the People’s Bank of China stipulated that “The People’s Bank of China must not make any overdraft for the government, and may not directly subscribe or underwrite State bonds or other government bonds.”69 Since 1994, the traditional practices of excluding debts from fiscal deficits and making up fiscal deficits by overdrafts or loans from the central bank have been put to an end, and an internationally accepted method have been adopted to calculate and patch up fiscal deficits; that is to say, revenue from debts is no longer listed in the normal fiscal revenue. This reform played a crucial role in normalizing the fiscal-banking relationship. In December 2002, the Ministry of Finance and the PBC jointly issued the Interim Measures on the Interest Payment on Treasury Deposits, and interest started to be paid on all treasury deposits. It was for the first time after the founding of New China that fiscal funds were valued according to the market price.70

Problems in the operation of the closed-crotch pants system Poor fiscal-banking coordination After the PBC was set apart from the Ministry of Finance and formally assumed the role of a central bank in 1984, it has been working with the Ministry of Finance in

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managing the macroeconomy. Judging from the characteristics of their respective targets, fiscal policy focuses more on structural adjustment while monetary policy emphasizes the adjustment of aggregate social demand. However, in actual cooperation, there has been a lack of a regulatory mechanism to coordinate fiscal and monetary functions, leading to the slow adjustment of the industrial structure. Considering their long-term targets, both fiscal and monetary policies have responsibility in encouraging economic growth, thus requiring yet-to-be fulfilled delineation of their respective targets. In terms of stage-specific characteristics, fiscal and monetary policy targets are both discretionary. While fiscal policy tries to minimize its correlation with the economic temperature, monetary policy is also transforming itself from an engine into a stabilizer of economic growth. This has led to increasingly evident conflict in policy goals between the two policies. The conflicts between the two policies are reflected in the following aspects.71 Poor coordination between the fiscal and monetary policy tools The management of national debts is the junction between fiscal policy and monetary policy. Normally, the central government adjusts government expenditure through issuing bonds as it implements expansionary or tight fiscal policy, whereas the central bank adjusts the market interest rate by trading government bonds in an attempt to affect the investment and output of the public. However, finding it difficult to withdraw base money by open market operations of government bonds alone, the PBC started to issue central bank bills in 2002. Since then, the number of central bank bills issued has been increasing year by year and these bills have become the most popular product type in the interbank bond market. This has created a crowding-out effect on the government bonds with the same maturities, especially after 2005, when the maturities on central bank bills demonstrated a clear trend of extending towards medium terms, further affecting the interest rates of medium- to long-term government bonds. The prices of government bonds have since fluctuated with those of central bank bills. Poor coordination between the fiscal and banking authorities Under the new macroeconomic situation, the Ministry of Finance and the central bank lack coordination in the aspect of policy instruments. For example, during the PBC’s eight consecutive cuts of the deposit and loan rates following 1996, the Ministry of Finance and the central bank worked in isolation from each other. In February 1998, the Ministry of Finance started to issue government bonds, but before they had been completely subscribed, the PBC announced on March 25 reductions in the deposit and lending rates of financial institutions. The consequence was that the deposit and loan rates of banks went significantly lower than the government

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bond rate, which created huge pressure on the Ministry of Finance. In response, the Ministry of Finance decided ad hoc to suspend the issuance of the government bonds and lower the bond rate to approximately the same level as the deposit rate before resuming the issuance. This poor coordination between the fiscal authority and the central bank brought much pressure to bear on the treasury. The costs of government bonds surged greatly and became a high-cost income, such that in 1997, the volume of government debts issued amounted to CNY250 billion, but the issuance costs were as high as CNY45 billion. Another example took place in 1998, when China’s economy experienced severe demand insufficiency, deflation, and sluggish economic growth. To stimulate domestic demand and fuel economic growth, the Chinese government implemented a series of proactive fiscal policies, such as issuing another CNY100 billion of government bonds to commercial banks and launching CNY270 billion of special government bonds to wholly state-owned banks. But the central bank hardly introduced significant policies, most of which were austerity measures, building up the pressure on national revenue. This impaired the effects and potential of domestic demand expansion, and more importantly, increased national fiscal risks. Mismatches between fiscal and monetary policies in terms of policy goals and effective time frames An aspect of coordination between monetary and fiscal policies is to match up policies of different effective time frames. Monetary policy gives priority to finetuning. It plays an insignificant role in stimulating economic growth but has a long-term effect on inhibiting economic overheating and inflation. Fiscal policy is characterized by operational efficiency. It plays a significant role in rapidly promoting investment and driving economic growth but can easily induce excessive fiscal deficits, economic overheating, and inflation. Therefore, fiscal policy acts as an engine of economic growth, and can only be used for short-term adjustments rather than be applied extensively for long-term goals. However, at present, there is no clear distinction between the short-term and long-term uses of the two types of policy tools. Fiscal policy is used more frequently in real economic operations, whereas monetary policy is too minimal to be effective when dealing with the overheating of the macroeconomy. Moreover, attempts of monetary adjustment of economic aggregates and fiscal structural adjustment have not fully met the expected results.

“Fiscalization” of financial risks “Fiscalization” of financial risks refers to the use of fiscal means to bail out financial institutions, so that financial risks are removed through being transferred to the

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fiscal system. Banks are at the core of the modern market economy and their stability pertains to the security and sustainability of the whole economy as well as the stability of society. Therefore, whenever the financial system runs into trouble, which will increase the chance of a financial crisis outbreak, the government will surely step in to dissolve the financial risks. Injecting government investments in banks During the restructuring of the banking industry in transitional economies, capital injection in state-owned banks is very common. Results of empirical studies indicate that although quickly getting on the track of a market economy and realizing the market-oriented reform of banks are long-term objectives of most developing countries, especially transitional economies, a radical move towards the privatization and marketization of banks is not usually feasible. Therefore, it has become a fashion for governments of those countries to help the domestic banking industry, especially government banks, to meet the standards of the Basel Accords and win international recognition through capital injections and emphatic promotion. This mentality has largely affected the preference of the decisionmakers of banking reforms.72 After the outbreak of the 1997 Asian financial crisis, the Ministry of Finance of China, acting as an investor, undertook the task of disposing of the nonperforming assets of banks. By doing so, the risks of banks were transferred to the fiscal system. In 1998, the Ministry of Finance issued CNY270 billion of special government bonds to replenish the capital base of the Big Four state-owned banks in order to increase their capital adequacy ratio. In 2004, Central Huijin Investment Ltd. incorporated under the approval of the State Council injected CNY22.5 billion into the Bank of China and the China Construction Bank to improve their capital adequacy ratio. The ultimate owner and investor of the company, obviously, was the Ministry of Finance.73 In 2005, the central government diverted CNY15 billion of foreign exchange reserves to replenish the capital base of the Industrial and Commercial Bank of China.74 Post-crisis support was likewise given to the policy banks. For example, on top of the CNY50 billion, CNY20 billion, and CNY5 billion of registered capital allocated to the China Development Bank, the Agricultural Development Bank of China, and the Export-Import Bank of China upon their establishment in 1994, respectively, the Ministry of Finance injected a further USD20 billion of capital base into the China Development Bank through Central Huijin at the end of 2007.75 Fiscal bailouts of exiting or restructuring financial institutions Since 1995, the central and local fiscal authorities have individually or jointly bailed out restructuring or exiting financial institutions. For example, in 2006, the

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Ministry of Finance cooperated with the Guangdong provincial government to set up a comanaged fund to make up for the funding gap during the restructuring of the China Guangfa Bank.76 Relieving the historical debts of banks and other financial institutions In 1997, the Ministry of Finance wrote off the CNY30 billion of bad debts owed by the state-owned commercial banks. In 1998, another CNY40 billion of bad debts was written off. Between 2003 and 2005, when the Industrial and Commercial Bank of China, the Bank of China, and the China Construction Bank underwent financial restructuring, the Ministry of Finance recognized the loss of its equity claims on the three banks which it owned on the behalf of the state. For the Industrial and Commercial Bank of China in particular, the Ministry of Finance coestablished a fund with the bank for the installment purchase of its loss assets. To alleviate the historical financial burdens of rural credit cooperatives, governmental subsidies were given to loss-making cooperatives in 2003, and by the end of 2007, a total of CNY8.80 billion of subsidies had been given out.77 Establishing asset management firms and acquiring nonperforming assets of state-owned commercial banks In 1998, the State Council set up four financial asset management corporations (AMCs) — China Cinda AMC, China Huarong AMC, China Orient AMC, and China Great Wall AMC — one for each of the Big Four state-owned commercial banks: the China Construction Bank, the Industrial and Commercial Bank of China, the Bank of China, and the Agricultural Bank of China. The four AMCs were established according to the business nature of the Big Four banks, for which they specialized in buying up bad debts. A sum of CNY1.4 trillion of policy-related nonperforming assets were stripped off from the Big Four banks. In 2004, the Bank of China and the China Construction Bank put in place a joint-stock reform. According to the reform plan, the basic idea of the financial restructuring was to transform the two banks’ owner’s equity, reserve funds, and profits made in 2003 all into risk reserves for the use of writing off asset losses. The doubtful loans of CNY149.8 billion and CNY128.9 billion owed by the Bank of China and the China Construction Bank, respectively, were sold to the AMCs in a market manner. Unlike the last time, the market mechanism was introduced in these divestitures. However, after all, it was the central government who footed the bill in both cases.78 Open and hidden subsidies from the Ministry of Finance Open subsidies from the Ministry of Finance have been used for repaying the sovereign debts of some closed financial institutions. Moreover, state-owned

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commercial banks taking over assets and debts from closed financial institutions can be exempted from paying interest for relending loans [loans made by the central bank for further lending to other customers] taken out from the central bank within a certain period of time. This equals receiving hidden subsidies from the Ministry of Finance.79

“Financialization” of fiscal risks Fiscal risks of the central government Although overdrafts or borrowings from the central bank by the government was outlawed after 1994, the outstanding loans granted before 1994 were still one of the factors affecting monetary policy. It was not until 2003 when the central government issued CNY166 billion of convertible bonds to the central bank that the loans borrowed from the PBC by the central government prior to 1994 were finally solved.80 In addition to that, due to historical problems in China’s banking system, the central bank continues to lack independence. As a result, there were instances of “forced currency issuance” where the Ministry of Finance directly or indirectly forced the central bank to lend money and the central bank had no choice but to increase the monetary base, which inevitably ratcheted up the pressure of inflation. In years of higher inflation pressure, this act will definitely augment financial risks.81 Debts from policy banks have led to inelastic expansions of the monetary base. When China set up the three policy banks in 1994, one of its original intentions was to cut off the connection between policy-based finance and the monetary base so as to set aside a portion of the fiscal funds for the direct support of some industries. However, the result has been the fiscal authority owing policy banks huge debts. Those debts include delayed appropriations and financial subsidies to policy banks, and allowances for policy-related losses to agricultural and sideline product procurement companies. This has caused an increase in the central bank’s issuance of relending loans to policy banks.82 Fiscal risks of local governments Suffering different levels of fiscal constraints, China’s local governments started to transfer fiscal risks to local bank branches. The problem of the financialization of local fiscal risks has been very prominent. First, there were some irregularities in the state-owned enterprise reforms conducted by local governments. This incurred huge losses of financial assets during the reforms. In fact, it was banks which bore the costs of reform on behalf of local governments. Over a considerably long period of time, state-owned

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enterprises had assumed a lot of social responsibilities and created massive hidden budgetary deficits. During the state-owned enterprise reforms, these historical problems gradually showed up and were waiting for local governments to solve. However, in balancing the interests between enterprises and banks, local governments usually favored local enterprises, whose interests they protected at the cost of banks. Local governments were inclined to help these enterprises out through corporate restructuring, some going as far as to help them evade their debts under the pretense of enterprise reorganization. In fact, banks’ credit funds were considered “quasi-fiscal funds” and used unwisely by local governments to finance new projects. The blind pursuit of speed and achievements resulted in lowlevel, redundant development and high reform costs, most of which had to be paid by banks.83 Second, local governments have been overenthusiastic in operating financial institutions. Government-run financial institutions and funds can be found all over the country, with all sorts of social fundraising, capital stock communities, and foundations. Local fiscal risks resulting from governmental fiscal operations have largely been passed onto local bank branches under various seemingly legitimate names. Besides that, local governments have also sought financing from the PBC under a variety of names. For example, in 1997, during the cleaning up and rectification of trust and investment companies, urban credit cooperatives, rural foundations, and the “three arbitrariness” in cities (san luan 三亂; i.e., arbitrary approval or setup of financial institutions, arbitrary development of financial services, and arbitrary fundraising), governments of 26 provinces, municipalities, and autonomous regions applied for a total of CNY141.1 billion loans from the PBC with the local treasuries as collateral, in order to pay off the legitimate consumer and international debts owed by the revoked financial institutions. But the repayment capacity of the local treasuries was clearly insufficient. Consequently, the nonperforming loans had to be solved by injecting cash into the monetary base.84 Third, debts of the public sector which are within the scope of local fiscal supply have been increasingly aggravated. In view of this situation, local bank branches have consciously or unconsciously taken up the role of “second fiscal authorities” under interest inducements from local governments. Over quite a long period of time, due to local financial inadequacy, governments at all levels have been burdened with serious debts in social spending such as expenditures for culture, education, science, health care, and social security. Local governments thus pin their hopes on local banks, expecting their financial shortages to be solved through the local banking sector. The common practice is to arrange bank loans

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with government-subsidized interest. Some government-subvented institutions, such as all kinds of schools which are run on bank loans, end up running huge debts. Using bank loans to fill the financing gap is just robbing Peter to pay Paul, and the ultimate victim will be banking institutions.85 Fourth, the investment desire of local governments has been growing. In 1998, China implemented a proactive fiscal policy. Under the impetus of this policy, the enthusiasm of local governments to invest, which had been suppressed for a long time, was stirred up, and an investment boom driven by the direct investment of local governments emerged in many places of China. Yet limited by the severe shortages of local financial resources, local governments have to rely on borrowing to maintain their high financial inputs. In terms of borrowing methods, due to the central government’s strict restrictions on the direct borrowing of local governments, more and more local governments have created “flexible” means of debt financing, such as raising funds by establishing the likes of “window companies” to be debtors. To create legal debtors and facilitate financing activities, local governmental departments, especially prefecture-level departments, have been setting up all kinds of companies in recent years. For instance, urban construction departments have founded urban infrastructure construction companies, fiscal departments state-owned asset management companies, and transportation departments construction firms named after different roads. Those enterprises have spun off many independent corporations through capital contribution or equity participation for separate fundraising and government investment activities. Among the funds raised to finance government debts, credit funds from banks have been increasing year by year. Local governments have promoted the extensive involvement of bank branches in fields of government investment through flexible means. Consequently, a large number of credit funds have been extended to be long-term ones and function like fiscal funds. If this trend was furthered to a certain extent, it would lead to a “hollowing out” of credit funds. The banking sector would have to pay for the huge asset losses of local governments or the fiscal system, and the risks of the banking sector are likely to be further exacerbated. Furthermore, local fiscal risks can be “financialized” through many indirect channels. For example, if local governments levy excessive taxes or increase nontax charges on enterprises, credit funds will be indirectly converted into fiscal funds; and if local governments act against the will of enterprises or demand enterprises to invest in projects exceeding their financial capacity, the investment risk will be transferred to financial institutions in an indirect way considering that most of the working capital of local enterprises comes from bank loans.86

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Causes for the problems in the fiscal-banking relationship under the market economy Inevitability of the mutual shifting of fiscal and financial risks During the development of the socialist market economy, the Chinese government is obliged to correct market failures and maintain socioeconomic stability. Especially under the condition that China’s market system is not very mature, when the economy goes wrong and encounters financial risks or crises, the fiscal authority has not only the moral responsibility but also the obligation to bear some of the problem-solving costs.87 After the launch of the Reform and Opening Up policy, all sorts of saving deposits have been continuously growing and the money supply capacity of banks constantly enhanced alongside the development of the economy and the rise in corporate and household income. Nevertheless, as China’s financial system is largely controlled by the government, when the functions of the fiscal authority comes into conflict with its fiscal capability, the government will inevitably intervene in the activities of financial institutions directly or indirectly. At this time, the financial functions will partially substitute for the fiscal functions owing to the quasi-fiscal nature of the former, preventing the macroeconomy from getting out of control. Therefore, during the economic transition, the reciprocal shifting of fiscal and financial risks will be inevitable.

Poor coordination between fiscal and monetary policy First, there is a lack of an effective transmission mechanism from monetary policy to fiscal policy. Under China’s current conditions, monetary policy is largely subordinate to fiscal policy. This is reflected in the following aspects. 1. The formulation of monetary policy is subject to the development plans and budgetary targets of the national and local economies. The economic growth model of China is transforming from extensive to intensive growth, and macroeconomic control and regulation still shows a strong administrative flavor. Consequently, monetary policy cannot effectively work against economic trends but has to passively adapt to economic development and fiscal policy. It may even contribute to cyclical economic fluctuations. 2. The central bank acts much less independently relative to the fiscal authority. The fiscal authority often indirectly forces the financial sector to increase money supply, which directly or indirectly enlarges the money creation of the central bank. At the same time, the development of fiscal credit has

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dispersed the financial resources of the country and weakened the financial strength of the central bank, directly leading to the weak macroregulation capability of the central bank. For example, in combating the economic overheating in 2004, the PBC adopted a series of contractionary monetary measures such as selling government securities through open market operations and raising reserve requirements. However, what really worked were a series of documents released by the State Council, the National Development and Reform Commission, and other relevant departments between March and May 2004. These documents cooled down the economic overheating in some industries and regions. This showed that under the current situation of China, the lack of independence of monetary policy and the central bank will inevitably cause the financial system to be passively affected by fiscal policy. 3. The application of economic means to intervene in the market economy by the government is still limited to the level of administrative orders. More experience and further scientific studies are required for the effective use of fiscal policy. In the development of the market economy, there are both financial risks resulting from the irregularities in financial institutions and risks from improper government interventions in financial activities. When risks emerge, the government has to use its fiscal power to address them. Second, the improper transmission channel between fiscal policy and monetary policy has resulted in the offsetting of policy effects. The current transmission mechanism between fiscal and monetary policies is that the fiscal authority issues government debts to enlarge fiscal expenditure while raising taxes to drive up fiscal revenue. The transmission of fiscal revenue towards fiscal spending has offset the expansionary effect of the proactive fiscal policy. In actual economic life, this is reflected in enterprises’ practice of directly handing over the money from fiscal appropriations to the government in the form of tax payment upon receipt. At the same time, the boundary between fiscal policy and monetary policy is not clear at the operational level. Fiscal policy is often operated with the instruments of monetary policy and vice versa, and the two kinds of policy fail to play their own due role. Moreover, the poor cooperation between fiscal policy and monetary policy has also given rise to the mutual shifting of fiscal and financial risks.88

Unregulated behaviors of local governments Over a long period of time, local capital shortages have not been fundamentally solved, and local governments have insufficient financial resources for the

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development of all kinds of undertakings and economic construction. There has been no radical change to the functions of local governments either. The situations of excessive governmental intervention in the economy and enterprise operations as well as improper direct governmental investment still exist. Besides that, driven by the desire to make more achievements, local governments have been striving to expand local social undertakings and the local economy. In times of fiscal deficiency, local governments typically use administrative means and exercise their economic and social management functions to force banks to inject capital into the fields of infrastructure construction, municipal construction, market development, investment attraction, and social undertakings. Banks are compelled to substitute for local treasuries in funds supply.89

Theoretical Discussions of the Fiscal-Banking Relationship Balance A premise for governmental macroeconomic regulation and control There is a close connection between the fiscal and banking systems as well as between fiscal funds and credit funds. It is impossible to completely cut off this connection in any periods. The Asian financial crisis of 1997 and the global financial crisis of 2008, as well as the response of the Chinese government during these crises once again proved that the closed-crotch pants relationship between the fiscal and banking systems will exist for a long time. What is more important is how to properly deal with this relationship, coordinate between the two parties, and use this connection to serve governmental macroeconomic regulation and control. Therefore, balancing the fiscal-banking relationship is a premise for governmental regulation of the macroeconomy through economic means. This requires more standardized and harmonious support and coordination between the two parties in light of the time-specific characteristics of their relationship. After the start of the Reform and Opening Up policy, the closed-crotch pants relationship between the fiscal and banking systems has been widely discussed. Shen first proposed in 1981 the unified management of national capital construction funds by banks, to allow the fiscal authority to withdraw from the primary distribution of national income and from the fields of production and construction.90 Ning raises objection to this opinion, thinking that the role of the fiscal authority in the distribution of surplus value cannot be replaced, and its role as national accountant cannot be shaken.91 Ren holds the view that the treasury and banks as the two money bags of the country should work hand in hand to mobilize

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financial resources and support each other, and it is unrealistic to try to draw a clear line between the two. To solve the problem of transferring fiscal pressure to banks, measures should be taken to achieve an overall fiscal-credit balance, he adds.92 Zhen advocates establishing a fiscal and credit funds management mechanism which can coordinate the macromanagement and micromanagement of the funds. He emphasizes that fiscal and banking systems should be separated and coordinated at the same time, and equal importance should be given to the two parties to realize integration.93 Deng puts forward that government fiscal departments and banks should maintain a reasonable division of labor on the basis of close coordination, in which the two parties can exercise their respective functions and perform their respective duties, after analyzing the theoretical basis and history of the differences, connections, and coordination and distribution of responsibilities between the fiscal and banking systems. He adds that the two tools of fiscal and credit policies should be actively used and their respective roles should be given full play.94 Zhou completely opposes the closed-crotch pants relationship between the fiscal and banking systems, and proposes establishing a new model of fiscalbanking relationship. He believes that the primary connection between fiscal and credit funds should be established based on a lending relationship. The central bank should hold the issuing power of money and overissuance should be subject to taxation. Government fiscal departments should cooperate with banks to invest in enterprises. A system of banks’ earnings distribution should be formed, and earnings should be distributed among four items, including tax payment.95 On the contrary, Yu is in favor of the closed-crotch pants theory. He emphasizes that the inner linkage and interaction between the fiscal and banking systems cannot be overlooked. He also analyzes the internal connection between the two from four aspects: the orientation and volume of investments, the income from or recovery of the funds, the economic efficiency and benefit distribution of enterprises, and the use of funds by enterprises.96 Wang considers three layers of the fiscal-banking relationship: the relationship between government fiscal departments and the banking mechanism, the relationship between fiscal policy and monetary policy, and the relationships between various influential factors behind fiscal and monetary policies. He denies the idea that the central bank should be independent from the central government and disapproves of the independence of the central bank. The policy goals and measures of the central bank and fiscal authority, he argues, should be essentially the same.97 Fan deems the old fiscal functions to be the root cause of governmental constraints on banks under the new economic system. He suggests confirming the

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role of banks as the major source of capital distribution for national production and construction, replacing hidden subsidies from governments with independent bank investments, and decentralizing fiscal administrative power.98 Likewise, Zhang insists on the independence of the central bank, which will restrict the excessive expansion of government credit.99 Zhu argues that the cause of the excessive distribution of national income is not bank overdrafts or loans by government fiscal departments, and the coordination and solidarity between the fiscal and banking systems are the internal condition for the use of fiscal and monetary leverage in regulating the economy.100 As Yu argues, while it is perfectly justified that fiscal and banking institutions should fulfil their respective functions in national economic operations, strive to maintain their own balance, and respect each other’s autonomy, we cannot ignore or deny the internal link between the two parties as well as their inevitable mutual influence. Only by recognizing this can the central government take precautions beforehand and achieve a real overall balance and effective economic regulation. Yu so elaborates on the closed-crotch pants metaphor: This is just like a pair of closed-crotch pants. Although pants can be cut and sewed into two separate legs at people’s will, the human body that they — the two pant legs — serve remains to have inseparable legs. Without the steady and powerful standing of one leg, it will be impossible for the other leg to stride forward; and if one leg slips on the ground while the other does not simultaneously do, the best scenario can only be that this other leg strenuously supports the whole body and prevents it from falling down altogether, possibly at the risk of being sprained. Although the pants seem on the surface to have become two independent pant legs, in fact they are still closely connected to each other. They must support and coordinate with each other in order to exert their effects, and this will not be changed by people’s will.101 It is an indisputable fact that the fiscal and banking systems are interrelated. The key questions are how to help fiscal and monetary policies adapt to market needs and play a better role in indirect economic regulation and control, and how to coordinate government fiscal departments and banks so that they work closely to better achieve the targets of macroeconomic regulation and promote balanced economic development. These questions should always be contextualized in the present reality of economic operations and the mechanisms of internal fiscalbanking connections specific to the current regime.

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Theoretical conclusions on fiscal-banking coordination Strengthening the effective cooperation between fiscal policy and monetary policy At the policy level, the coordination between the fiscal and banking systems is reflected in the effective cooperation between fiscal policy and monetary policy. Fiscal and monetary policies are two important means of national macroeconomic control and regulation. Fiscal policy mainly uses public debts, public expenditure, taxes, government investments, and fiscal subsidies to influence aggregate social demand. Monetary policy relies on the tools of interest rates, open market operations, discount rates, and deposit reserve ratios to indirectly adjust aggregate social demand. Fiscal funds and bank credit are two channels through which governments can achieve the centralized distribution of funds. They both adjust aggregate social demand and jointly act on economic operations. But fiscal and monetary policies are different in the respects of operating mechanisms, functional directions, and the effects of expanding or tightening demand. Therefore, it is necessary to make flexible use of the two policies in macroeconomic regulation and coordinate the objectives of the two policies to ensure stable and rapid economic growth.102 In addition to that, it is also necessary to make overall arrangements and ensure the coordination between fiscal and monetary policies through the medium- to long-term plans of national economic and social development. To be more specific, the government needs to coordinate the objectives of the two policies, conduct regular tracking and estimates of fiscal deficits and nonperforming financial assets, make provisions for fiscal and financial stability, carry out interactive efficiency assessment of fiscal and financial policies and tools, and make arrangements for solving bad debts of financial institutions. Fiscal policy should play a large role in promoting economic growth, optimizing the economic structure, and adjusting income distribution. Monetary policy should aim at maintaining the stability of the value of the currency, balancing aggregate demand and supply, and developing a sound transmission mechanism of monetary policy. It is also important to improve the statistics system and monitoring system of economic operations, and strengthen the functional complementation and information sharing between the departments that have a hand in macroeconomic regulation.103

Continuing to maintain the overall fiscal-credit balance The fiscal and banking systems are two important comprehensive sectors of the national economy, and government finances and bank credit are two important

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levers regulating the macroeconomy. In the period of the planned economy, the investment scale of economic construction was determined by how much the state invested, and the investment capacity of the fiscal authority was determined by production. After the launch of the Reform and Opening Up policy, China’s economic system underwent dramatic changes and the sources of investment were diversified. However, in the total investment of the national economy, fiscal investment still contributes a large share and fiscal policy always restricts the volume and structure of all kinds of investments. Under such a condition, Chen’s core theory on the overall fiscal-credit balance is still applicable.104 Fiscal revenue and expenditure and credit supply and demand are the key links in reflecting and controlling currency circulation. 105 The balance between receipts and disbursements in credit operations is essentially a matter of currency circulation, and the purpose of maintaining a balance between fiscal revenue and expenditure is to stabilize currency circulation and coordinate market supply and demand. Therefore, to attain the overall fiscal-credit balance is to ensure the stability of money circulation and the basic coordination between market supply and demand. This is crucial for reproduction to be carried out smoothly and for the basic proportional relations of the national economy to reach a balance.106 In practice, to reach an overall fiscalcredit balance, it is necessary to fulfil the following requirements: (1) The central government has to make scientific forecasts on the trends of the national economy, formulate fiscal and credit budget plans, and make overall arrangements for fiscal and credit funds. (2) The laws and regulations on fiscal and credit funds must be enacted to regulate the operation of the two funds. (3) A dedicated supervisory body should be established to review the operation of fiscal and credit funds.

Further enhancing the independence of the central bank Since the 1990s, the independence of China’s central bank has been improved. To help the branches of the central bank get rid of the control of local governments and increase their independence, the central government abandoned the practice of setting up bank branches according to administrative divisions and established nine transprovincial branches, which, despite some drawbacks, undoubtedly had a positive effect on the self-improvement of financial institutions. But on the whole, the policy-making power of monetary policy has not fully been returned to the hands of the central bank. It is even more impossible for the central bank to act on its own will when there are serious disagreements between the central government and the central bank in major economic decisions. The lack of independence of China’s central bank is a main reason for the payment of fiscal expenditure by banks and the transfer of fiscal risks to the banking sector.107

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Two things need to be done in order to enhance the independence of the central bank. First, the central bank’s right over the making of monetary policy must be confirmed in law to raise the legal status of the central bank. Second, any forms of fiscal overdrafts must be blocked to cut off the financing relationship between the fiscal authority and the central bank. Specifically, the Chinese government should strengthen the central bank’s role in financial macrocontrol so as to realize macrocontrol through indirect regulation, thereby reducing or even completely eliminating government intervention in domestic financial institutions. Management over those institutions should be achieved through fiscal policy tools such as laws, taxes, and industrial policies, in order to enable commercial banks to operate following the modern corporate system.

Properly dealing with the relationships between fiscal departments, banks, and state-owned enterprises Over the years, the long-term huge losses of state-owned enterprises have been an important factor affecting China’s fiscal-banking relationship. So it is crucial to regulate the relationship between government fiscal departments and banks, improve the fiscal-banking system, deepen the reform of state-owned enterprises, and coordinate the relationships between enterprises and fiscal departments and banks. First, it is necessary to establish a repayment enforcement mechanism for enterprise loans by straightening out the relationships between enterprises, banks and governments. Its key is to reform property rights. Under the old property rights system, the state is not only the owner of the economic resources of the whole society but also the sole owner of state-owned enterprises and state-owned banks. This means that neither state-owned enterprises nor state-owned banks are independent owners of property rights, and they are both subject to the state. In this way, the lending and borrowing between state-owned banks and state-owned enterprises are not acts in the interest of different property owners, but are more like taking money from one packet to put it into another. This kind of debts is not restricted by the ownership mechanism. To solve the problem of the absence of a repayment enforcement mechanism, the Chinese government needs to downsize state-owned enterprises through shareholding reform and cut off the reliance of enterprises on banks. At the same time, it is also necessary to break the dependence of governments on banks and separate government administration from corporate management, as well as the ownership of funders from the property rights of legal persons, in order to clarify and specify the owners of property rights. It is also important to reduce credit disorder arising from administrative intervention

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in order to turn state-owned banks into commercial banks and state-owned enterprises into profit-seeking enterprises in the true sense. By transforming them into legal entities that are independent, self-financing, self-improving, and selfrestraint, it is possible to enhance the efficiency of resource allocation and avoid inefficient allocation by administrative power. Second, the Chinese government needs to establish and improve its modern corporate system and build corporate operational mechanisms and systems that can invigorate state-owned enterprises and make them more competitive.108

Promoting the reform of fiscal investment and financing and the management of government debts In the reform of the investment and financing systems, it is a must to clarify the boundary between government fiscal departments and commercial banks in investment and financing activities so that the efficiency of fiscal investment can be improved and monetary policy can be protected from the shocks of policy-based financial business. The government has to regulate, strengthen, and consolidate bond markets, cut off hidden channels for financing local fiscal deficits, bar enterprises and banks from blind investment with credit funds, and channel effective investments into the normal tracks. It is also crucial to improve the management system of national debts to allow the Ministry of Finance to make flexible arrangements for the size and terms of government bonds based on market conditions. Moreover, the government should coordinate and improve the open market operations of the central bank and strike a balance between fiscal and monetary policies.109

Regulating the construction of financial markets Another focus in the coordination between the fiscal and banking systems is to perfect the financial market environment. Good development of the whole financial market system including the monetary market and the bond market will provide a more favorable external environment for the cooperation between fiscal and monetary policies. To this end, there are two things that need to be noted besides the unification and improvement of the markets and the construction of an effective mechanism. The first is to regulate the players of financial markets, that is to optimize the internal governance structure for market players in order that fiscal and monetary policies can be coordinated on the two levels of the real economy and the monetary economy, because the coordination between fiscal and monetary policies is ultimately reflected in the activities of market players. The second aspect

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is to provide financial support for financial innovation. The financial deepening of a country should be backed by the all-rounded coordination between fiscal and monetary policies. Corresponding financial support is indispensable for both the development of financial products and transaction innovation.

Strengthening financial supervision over the banking sector Under the modern market economy, the realization of banks’ power partially relies on the fiscal authority and banks’ power is an indirect expression of fiscal power. However, with the expansion of banks’ financial strength, banks may reject the power of the fiscal authority. The fiscal authority is the general representative and manager of the rights over banks’ state-owned assets, and the financial supervision of the fiscal authority on the banking industry is an important part of the financial supervision system. Therefore, when injecting foreign-exchange reserves in stateowned commercial banks, the fiscal authority must perform the roles of financial contributor and ultimate obligor in carrying out financial supervision. Regarding financial supervision over the PBC, the government should make efforts in the following areas: • Deepening institutional reform and perfecting the bank’s functional system; • Researching on and formulating regulations on departmental budgeting, establishing standards for personal quotas on basic expenditure, and developing standards for expenditure quotas that comply with the features of the bank; • Improving the budgetary management system in consideration of the demands of departmental budgetary management; and • Strengthening financial supervision and ensuring the safe, regulated, and effective use of budgetary funds.110 And on strengthening financial supervision over commercial banks: • Building sound registration and inspection systems for financial transactions; • Ensuring the execution of financial transaction examination and regulation; • Establishing sound financial regulatory institutions and giving full play to the functions of specialized financial supervision offices; • Setting up an announcement system for risk profiles and credit ratings, and performing performance appraisal to prevent financial risks; • Formulating a punishment system for irregular operations; and • Developing a coordination system among different financial supervisory departments and enhancing divisions of labor and coordination.111

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Finally, for strengthening financial supervision over policy-based banks: • Cleaning up historical debts; • Clarifying the business scope; and • Deciding on the financing models in a scientific way.112

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Chapter

Specialized Tax Administration System

MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 1

Term Definition The specialized tax administration system (shuishou zhuan guan 稅收專管) was a tax management system adopted by the Chinese government from the founding of New China to the beginning of the 1990s. It was characterized by highly concentrated powers over tax levying, management, and inspection. The people responsible for tax management work were known as “specialized tax administrators” (shuishou zhuan guan yuan 稅收專管員). The specialized tax administration system can be classified into two kinds: “separate management of different taxes” (fen shui zhuan guan 分稅專管) and “unified management of all taxes” (ge shui tong guan 各稅統管). The distinctive feature of the former was that management work was divided based on tax types, according to which specialized tax administrators performed specified tax management. Thus, a taxpayer must establish connections with several tax administrators. The advantage of this kind of management method was that the division of taxing work was highly specialized and the job responsibilities of specialized tax administrators were simple. Its disadvantage was that specialized tax administrators lacked comprehensive and complete knowledge of the tax obligations of a taxpayer. This would easily lead to the situation where every specialized tax administrator worked in isolation, which was harmful to unified and coordinated management. The latter method was characterized by dividing taxing works on the basis of taxpayers, with specialized tax administrators conducting unified management towards all kinds of taxes payable by a taxpayer. The relationship between specialized tax administrators and taxpayers was simple and fixed. The strength of this method was that specialized tax administrators were able to get a comprehensive picture of a taxpayer’s tax liabilities while its weakness was that the management work of a specialized tax administrator was so complicated that it would easily cause the tax administrator to lose focus, discouraging the improvement of management quality.

Historical Background The specialized tax administration system was implemented in the early 1950s. At that time, economic construction had just begun, and the Chinese central government was badly in need of capital to undertake economic transformation and recovery. In the first national tax conference in November 1949, the National Tax Administration Enforcement Regulation was prepared according to Article 40 of the Common Program of the Chinese People’s Political Consultative Conference. The article stipulated that “the tax policy of the state shall be based on the principle of ensuring

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supplies for the revolutionary war and taking into account the rehabilitation and development of production and the requirements of national construction. The tax system shall be simplified and practices an equitable distribution of tax burden.”1 The National Tax Administration Enforcement Regulation (hereinafter referred to as the Tax Regulation) was promulgated by the Government Administration Council in January 1950. It instituted a highly unified tax system and designated 14 categories of taxes to be levied throughout the country, including commodity tax and industrial and commercial business tax. To enact the Tax Regulation, local governments in many parts of the country carried out specialized tax administration work and adopted “separate management by tax type and fixed taxpayer (community or district) administration” (ge shui fen guan, guding guan hu 各稅分管，固定管戶). Separate management by tax type was reflected in the setup of three offices for the administration of commodity tax, business tax, and local tax levied in the production process. Fixed taxpayer (community or district) administration referred to the delineation of tax administration jurisdictions based on industries in large- and medium-sized cities, and based on districts or both industries and districts in small cities. This can be regarded as the prototype of China’s specialized tax administration system. The complete specialized tax administration system was born in the 1950s. In 1965, the nationwide socialist reform of the ownership of the means of production was basically finished, and China entered the era of constructing a planned economy. To adapt to the needs of the construction of a socialist planned economy, the taxation system underwent dramatic changes. Under the influence of left-wing ideology, the tax system was so streamlined that only one tax was imposed on state-owned enterprises and two taxes collectively-owned enterprises. Therefore, the separate management of taxes was no longer necessary and was replaced by the mode of “unified management of all taxes by one tax administrator for one taxpayer” (yi yuan dao hu, ge shui tong guan 一員到戶，各稅統管). Tax collection, management, and inspection for a taxpayer were in the charge of a single tax administrator. After the launch of the Reform and Opening Up policy, China carried out a two-step “tax for profit” (li gai shui 利改稅) reform, and the taxation system became more and more complex. But the system of specialized tax administration continued to function. Vesting tax collection, management, and inspection power in one taxing officer was the most important feature of the system. The specialized tax administration system remained effective for a long period, and this was owing to a special historical background. It is unreasonable to deny past practices based on today’s standards. As Qian puts it, “it is unwise to substitute the contemporary perspective for the historical perspective.”2 There were technical and economic aspects to the historical background for the enforcement of the

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specialized tax administration system. In terms of the technical background, since the tax system was simple and computer networking technology was not popularized at that time, tax administration work had to be done manually. The specialized tax administration system was suitable for a situation with a small number of taxpayers, a simple tax system, and a single taxation target. As for the economic background, the economy at that time was not divided into different sectors. Before the implementation of the Reform and Opening Up policy, China’s economy was dominated by the public sector, which contributed 99% of the country’s GDP in 1978. Under a simple tax system, there would not be a wide divergence of interests among taxpayers. Accordingly, each specialized tax administrator was able to perform unified tax management for one enterprise in straight adherence to the tax laws and regulations. They acted as both judges and executors and were in charge of all taxation work from tax collection to tax management and inspection. This was beneficial to the unified execution of taxation policies. The specialized tax administration system was generally effective in administrative mobilization and efficient in tax collection and management. It allowed the taxation department to complete the tax targets at great speed and optimal efficiency, thus complying with the demands of the planned economy. As a side note, there were in fact not only specialized tax administrators in the taxation field, but also specialized credit administrators (xindai zhuan guan yuan 信貸 專管員) responsible for credit management in the banking industry and specialized on-site fiscal supervisors (caizheng zhu cang yuan 財政駐廠員) responsible for the management and supervision of state-owned companies from government fiscal departments. Both specialized credit administrators and fiscal supervisors were vested with extraordinary power.3

Institutional Transformation The transformation of the tax management system Since the founding of New China, the taxation system constantly improved along with the country’s political and economic development. China’s taxation system has experienced three stages of development: (1) From the birth of New China to 1978, the taxation system was amended, reformed, and streamlined to adapt to the planned economy. (2) From 1979 to 1993, a two-step reform was introduced, substituting taxation for profit remittance in order to fit in with the planned commodity economy. (3) After 1994, the taxation system underwent a comprehensive reform to fulfil the requirements for building a socialist market economy. The tax management system, however, experienced five stages of change.

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It was in the first two stages that the taxing officials were called “specialized tax administrators,” and in the other three stages, they were known simply as “tax administrators” (shuishou guanli yuan 稅收管理員) (Table 2.1).4 Table 2.1

The transformation of China’s tax management system

Title of taxing officials Specialized tax administrator

Duty

Mode of management

Taxpayer Dedicated management management Separation of tax collection, management, and inspection

Tax administrator

Tax affair Tax declaration, agency service, management and inspection

Combination of taxpayer and tax affair management

Period 1950s–Mid1980s Mid-1980s– Early 1990s Early 1990s– Mid-1990s

Unified tax collection and selective inspection on the basis of tax declaration and service optimization, with the aid of computer networking

1997–2004

Unified tax collection, selective inspection, and intensified management on the basis of tax declaration and service optimization, with the aid of computer networking

After 2004

The five stages of the development of the tax management system are as follows: 1. The first stage: Dedicated management (zhuanze guanli 專責管理) referred to the practice that taxing officials were responsible for specific commercial and industrial enterprises, which were decided according to districts, industries, or business nature. This management method was characterized by “unified management of all taxes by one tax administrator for one taxpayer.” 2. The second stage: On the basis of the previous dedicated management mode, tax inspection teams were set up to strengthen internal supervision and constraint, and intensify tax inspection. The duties of tax collection, management, and inspection were separated and designated to different specialized tax administrators responsible for specific enterprises (duo yuan jin chang, zheng, guan, cha fenli 多員進廠，徵、管、查分離). 3. The third stage: The Law of the People’s Republic of China on the Administration of Tax Collection implemented on January 1, 1993 and the major tax reforms in 1994 for the purpose of adapting to the market economy posed new challenges

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to tax levying and management work. In 1995, the State Administration of Taxation formulated the plan and specific rules for deepening the tax levying and management reform and confirmed the management mode of “tax declaration, agency service, and inspection” (shenbao, daili, jicha 申報、 代理、稽查) based on the discussions in the Beidaihe work conference. 4. The fourth stage: In 1997, the General Office of the State Council circulated the Proposal for Deepening the Reform of Taxation Administration by the State Administration of Taxation as its No.1 policy document, and advocated the establishment of “one scheme and four systems” (yi ge zhidu, si ge tixi 一個 制度，四個體系). “One scheme” referred to the building of a taxpayer selfdeclaration system. “Four systems” comprised a taxation service system integrating both taxing authorities and social intermediary organizations, a computer networking–based management and monitoring system, an inspection system combining both manual and computerized auditing, and a tax levying and management–based institutional system (composed of management service, collection monitoring, tax inspection, and policies and regulations). 5. The fifth stage: The goal of the management mode of this stage was to achieve scientific and detailed management in tax levying and management work. Here, “intensified management” not only indicated an overall demand on tax levying and management work, but also emphasized the strengthening of taxpayer management through a division of labor in tax collection, management, and inspection. The transformation from the specialized tax administration system to the eventual tax administrator system has realized five major changes. First, tax levying and management work has been broken down with a division of labor along the lines of tax collection, management and inspection. Now, tax administrators designated for each area perform their respective duties and are mutually constrained. Second, the process of tax levying has been transformed from being decentralized to centralized. Tax service halls have been set up in towns and cities to offer a one-stop service, and tax centers (taxation branch offices) have been established in each economic zone in rural areas. This transformation has enhanced the service awareness of taxing officials and reduced the taxation costs of taxpayers. Third, the management mode has changed from on-the-spot tax collection to self-declaration. The rights and obligations of both taxing officials and taxpayers are clearly defined and their legal awareness and sense of responsibility are constantly improved. Fourth, professional inspection teams are formed, so inspection has moved from an extensive and general orientation to a selective and targeted one. Fifth, unified tax

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collection has facilitated the application of information technology in tax levying and management, enabling a shift from manual operation to computer-controlled operation. A taxation network has been built to exercise overall supervision over taxpayers, improving the efficiency and quality of tax levying and management.

Features of the specialized tax administration system up to the mid1990s The introduction of the specialized tax administration system was inseparable from the historical context from which it emerged. At the beginning of New China, the Chinese government started reformation and reconstruction of the national economy, and the public sector gradually gained absolute dominance. The system of planned economy gave the country a strong mobilizing capacity in various fields. Coupled with a simple taxation system and simple social morality, there was a high level of tax compliance. Against such a backdrop, the specialized tax administration system guaranteed unified, centralized, and effective collection of taxes. The most significant feature of the specialized tax administration system was that specialized tax administrators carried out a full range of duties from tax collection to tax management and inspection, and maintained direct and effective control over taxpayers. Specialized tax administrators were responsible for keeping a record of the particulars of the (corporate) taxpayers — including their founding, closing down, and relocation; tax payment information; and internal organization, business mode, and taxation facilitator (hu shui renyuan 護稅人員) name lists — under their jurisdiction in tax levying and inspection books. In addition to this, the taxing officials also had to communicate tax policies and regulations to taxpayers, organize industrial and commercial business owners to study the tax law, teach accountants to faithfully keep accounts and declare and pay taxes, seek assistance from enterprise employees in tax levying, and help business owners to prepare accounts and invoices. They needed to organize and guide the leaders of taxation teams to review tax declaration forms and urge business owners to pay taxes on time. It was also their responsibilities to keep track of taxpayers’ payment information and prevent tax evasion. Finally, the specialized tax administrators were required to stay informed about the general operations of different industries and capture the trends of industries’ development, profitability, and seasonal variations. For decades, the reform of the country’s tax management had been grounded on the specialized tax administration system at the grassroots level. Every tax reform, whether towards the centralization or decentralization of power in tax levying and management, was put in place via the specialized tax administration system. The

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persistence of the specialized tax administration system can be attributed to not only historical circumstances but also the system’s own effectiveness. However, admittedly, the defects of this system were also obvious. First, the doorto-door tax collection approach and the “nanny-style” management provided by specialized tax administrators were not conducive to fostering the law-abidingness of both taxing officials and taxpayers in tax collection or payment. Second, since specialized tax administrators were tax collectors, management authorities, and inspectors rolled into one, they had excessive discretionary power. In the absence of a supervision and restriction mechanism, this would give rise to administrative corruption. Third, as the management tools were backward, taxing officials had to manually carry out the taxation work. Therefore, a tremendous amount of manpower was needed, resulting in low tax collection and management efficiency and quality, and high taxation costs. Fourth, specialized tax administrators worked in isolation with no communication or information sharing, and synergy could not be formed in the taxation office to perform macromanagement.5 After 1978, and especially after 1987, economic opening up and reforms brought tremendous shocks to the specialized tax administration system. The restriction of specialized tax administrators’ power became an issue of public concern, as the abuse of power under the specialized tax administration system was increasingly criticized. Soon, the specialized tax administration system fell out of favor. What took its place was a unified collection and management system developed based on the division of taxation duties into tax collection, tax management, and tax inspection.

Features of the unified tax collection system of 1997–2004 To adapt to the tax sharing reform of 1994, the mode of China’s taxation management between 1997 and 2004 was adjusted to “unified tax collection and selective inspection on the basis of tax declaration and service optimization, with the aid of computer networking.” This mode was characterized by unified collection. To put it simply, tax service halls were be built in each city and county to offer onestop service from taxation publicity and consultation to tax registration, receipt and invoice management, tax declaration, tax collection and storage, and data filing, in order to realize unified tax collection. On the basis of this, independent tax inspection agencies were set up at the grassroots level to regulate the process of tax levying and management. In terms of effects, this unified collection system, which was oriented towards the management of tax affairs (guan shi 管事) — as opposed to that of taxpayers (guan hu 管戶) — better prevented the problems of lax law enforcement, corruption,

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and confusions in the responsibilities of specialized tax administrators so prevalent under the old specialized tax administration system. The new system also facilitated the application of information technology in tax levying and management, greatly improving work efficiency, lowering the costs of taxation, and improving taxation services to a certain extent. But with further practice, some of its weaknesses were also exposed. First, focusing on the management of tax affairs but overlooking the management of taxpayers resulted in a loss of control over potential taxpayers and due taxes. The prerequisite of tax collection “on the basis of tax declaration” required high tax compliance and tax filing proficiency of all taxpayers; otherwise the tax returns would be unreliable. Many taxing authorities held an overtrusting attitude towards the tax declaration of taxpayers. There was the phenomenon of taxing officers waiting at the office for taxpayers to file tax returns without verifying their accuracy or questioning the situations of the enterprise’s production, operations, and finances, but taking the declared items and amounts for granted. As a result, the tax revenue collectible went beyond the control of the taxing officials. Moreover, unified tax collection was supposed to realize the concentration of information by computer networking; the concentration of taxing officials and tax service offices through the setting up of tax service halls and taxation branch offices (tax centers) by local governments was largely a misinterpretation. Although this act reduced the costs of taxation, it lengthened the distance between taxing authorities and taxpayers. Taxing officials lost control over taxpayers, especially those who did not submit their tax returns, failed to pay taxes, had suspended their businesses, and were scattered and mobile. The process of tax levying was transformed from active, on-site investigations into business production and operation situations by specialized tax administrators into passive, remote management by taxing officials who were just waiting in the office away from taxpayers’ businesses. Consequently, the control over potential taxpayers and due taxes was significantly weakened: Tax affairs of large taxpayers were not managed in detail while many small taxpayers were left out. Second, the division of tax collection, management and inspection duties led to a diminishing sense of accountability. According to the principle of splitting taxing collection, management and inspection, many local taxing authorities established separate offices for tax collection, tax management, and tax inspection. The separation of taxation work resulted in different levels of responsibility among the three units. For instance, the tax collection office mainly relied on the tax declaration hall to complete tax collection and payment, and thus had lower requirements for business skills and performance assessment; the inspection office had higher demands on professional skills but could not enforce taxation; the management

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office took charge of daily management, and its staff were major executors of taxation plans. The work pressure on the management office was the largest among the three offices. Consequently, there were a lot of conflicts and buck passing between the three units. Besides that, due to the lack of a standardized appraisal system, it was difficult to apportion responsibility and demand accountability when problems occurred in the process of taxation, which led to poor management and a weak sense of accountability. Inadequate knowledge of the number of taxpayers within the jurisdiction as well as the business scope, reliability of tax returns, state of production and operations, and financial situations of taxpayers encouraged tax evasion, giving rise to a large number of tax dodgers, taxpayers filing a “zero” or “negative” return, and “missing” taxpayers. This ultimately was also a problem of weak monitoring of potential taxpayers by taxing authorities. Third, being tax planning oriented, this management system encouraged the practice of focusing on large taxpayers while letting go of the small ones in the management of potential taxpayers. In many places, the fulfilment of tax plans was a major indicator in the appraisal of grassroots tax authorities. A few large taxpayers would suffice to play a decisive role in the completion of the tax revenue quota, thus attracting close attention from the taxing authorities. In many cases, grassroots taxing organizations were able to meet the taxation target assigned by a higher taxing authority without complete knowledge of all taxpayers. This led to the neglect of small taxpayers. With the advancement of economic globalization and the further confirmation of China’s status as a market economy, taxation gained an increasingly large role in the national economy. The separation of the three tax administration powers and the passive manner of management had not only increased the burden of taxpayers (such as the need for repeated filing for different kinds of taxes), but also kept tax authorities away from taxpayers. Effective management of potential taxpayers is a benchmark for the functionality of a tax management system. Therefore, the taxation department imposed a further reform on the tax management system in 2004. The new tax management system differed from both the specialized tax administration system and the tax affair–oriented management mode. Absorbing the advantages of both systems, it was named the “tax administrator system.”

Features of the tax administrator system after 2004 Tax administrators are functionaries of local tax authorities who handle the tax affairs of a certain area or industry. The tax administrator system comprises the relevant administrative regulations and management scheme which guarantee effective regional management in line with the goal of “active management of

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individual taxpayers, assigning responsibilities to tax administrators, and matching tax administers to taxpayers” (guanli dao hu, zeren dao ren, ren hu duiying 管理到 戶，責任到人，人戶對應). Integrating the tax affair and taxpayer management orientations of the previous two systems, the tax administrator system adopted since 2004 is distinguished by two major features. The first feature is adapted from the specialized tax administration system: the identification of individual responsibilities. The advantage of the specialized tax administration system lies in its clearly defined personal responsibilities, which could fully mobilize the taxing staff and arouse their sense of responsibility. Years of experience with the unified tax collection system proved that a well-established legal system and advanced technology might not always stimulate officials’ initiative, but might on the contrary create blind dependence. Many cases of tax evasion in China were a result of taxing officials’ low initiative and excessive dependence on computers and tax returns rather than defects in the legal system or technological backwardness. Learning from the specialized tax administration system, the tax administrator system seeks to pair the duties of taxing administrators with the obligations of taxpayers, facilitate the active management of potential taxpayers, and collect first-hand information about them in order to reduce possible oversight of due taxes. Second, the integrated management of tax affairs and taxpayers is realized with the aid of information networks to increase work efficiency. The old unified tax collection meant to motivate taxpayers to file their own tax returns and hence lessen the pressure of taxpayer management on taxing authorities in order to enable them to focus on tax affairs and enhance taxation efficiency. The tax administrator system now optimizes the effect of modern technology on potential taxpayer management, so that it becomes more comprehensive and responsive. The new system is geared to the development of the market economy, integrating the management of taxpayers and tax affairs and giving equal emphasis to the efficiency and effectiveness of management. .

Historical reasons for the transformation from the specialized tax administration system to the tax administrator system The changes in the title of taxing officials from specialized tax administrators to tax administrators and in the management orientation from taxpayers to tax affairs and further to both taxpayers and tax affairs reflect the gradual improvements of the tax management system. The adoption of a particular tax management system is determined by the historical conditions of a particular period. Major changes

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in the historical backgrounds to the tax management system are displayed in following three aspects. First, technological differences. Prior to the 1990s, computer networking technology was not popularized, and tax management work had to be done manually. Today, information technology is pervasive in economic activities, and informatization has improved information collection, processing, storage, and application, saving tax administrators from intensive and repetitive manual chores and making possible the scientific and detailed management of potential taxpayers. Second, economic marketization. Since the launch of the Reform and Opening Up policy, the ownership structure of China’s economy has become increasingly diversified and tax policies have also increased in complexity. The rapid expansion and considerable complexity of the tax base makes it impossible for an individual taxing official to perform all taxation work as it was under the specialized tax administration system. The tax administrator system was established based on a professional division of labor, centralized management, informatization, and detailed legal provisions, and could effectively utilize the advantages of the tax department as a whole and better cope with the complexity of tax sources. Third, changes in the positioning of taxation functions. The most important function of taxation is to organize the collection of tax revenue, but as to how to achieve this goal, there are two kinds of approaches: facilitating tax revenue by either coercive management or providing services. Tax collection in the period of the specialized tax administration system was, to a large extent, a compulsory administrative act, which was widely accepted by taxpayers at that time. However, in today’s society, the legal conception and tax consciousness of taxpayers have been enhanced. They attach great importance to the protection of their own legitimate interests and are less affected by the individual will of taxing officials. Therefore, under the tax administrator system, providing tax services is an important duty of tax administrators. The awareness of taxing authorities of the importance of service provision is enhanced and equal stress is laid on both taxation management and services.

Theoretical Explanation From the perspective of institutional economics, the transition of the tax management mode from the specialized tax administration system to the tax administrator system is in fact the refinement and division of tax administration powers under the premise that private ownership cannot be eliminated in tax management in order to diminish, to the greatest extent, the “residual claim” to tax revenue in tax administration and improve the quality of tax collection and management.

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Irremovable private ownership in tax administration The goal of tax administration is to eliminate tax evasion and rent seeking of taxpayers as much as possible in order to ensure the collection of all due taxes. However, in actual practice, there are a large number of tax evasion activities in China as well as other countries. Whether this goal can be met in actual tax collection depends on two conditions: first, the taxing capacity of taxing authorities, which mainly hinges on the number of taxing staff, their professional skills, the level of informatization, and other objective variables; and second, tax effort, which is a measure of the extent to which taxing authorities are able to collect statutory taxes payable, and this mainly depends on subjective variables such as the professional ethics of taxing officials.6 For the first condition, it is impossible to completely avoid tax evasion no matter how perfect the tax administration system is, how extraordinary the professional skills of taxing officials are, and how advanced the computerized management of taxation is. As for the second condition, demanding every taxing official to devote 100% tax effort is out of the question. Lax attitudes and rent-seeking attempts will reduce the work effort of taxing officials, thus stunting the growth of tax revenue. From a legal perspective, all taxes, collected or still outstanding, belong to the government. But here, what one should be concerned about is the de facto tax ownership rather than the de jure ownership. Barzel stresses that it is more resource consuming to delineate de facto than de jure property rights.7 In fact, the government just has the ownership of the taxes paid and the gap amount between taxes paid and taxes payable does not belong to the government. Then, who has the ownership of the gap amount? Zhou illustrates the delineation of de facto property rights with an easy example:8 The corridors of a building are built to facilitate the movement of occupants in and out and therefore its ownership belongs to the public. But we still can observe the phenomenon that many personal belongings are piled up in public corridors. That is to say, the corridors nominally belong to the public but are occupied by individual occupants in reality. The underlying reason is that it is easy to delineate the ownership of the corridors of a building in law but difficult to implement it in reality because resources need to be spent on efforts such as effective supervision, punishment of violators, and cleanup of illegal occupation of public areas. As the costs of maintaining de jure property rights are high and the implementation of de jure property rights is difficult, individual occupants become the real owners of the de facto property rights to the corridors. Barzel names the situation of individuals seizing the property rights to public resources “welfare capture.”

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In tax collection, there are two types of “welfare capture” resulting from inadequate taxing capacity of taxing authorities and insufficient tax effort. First is welfare capture by taxpayers. Taxpayers occupy part of the country’s taxes by tax evasion. Second is welfare capture by specialized tax administrators. Specialized tax administrators may collude with taxpayers in tax evasion and benefit from rent seeking. Fig. 2.1 illustrates the legal and actual ownership of taxes. In Fig. 2.1 the horizontal axis represents taxes payable while the vertical axis represents taxes paid. When taxes payable amount to OD, the tax gap will disappear only if taxes paid reach AD. In reality, due to the limited taxing capacity of taxing authorities, caused by factors such as low-level informatization, the expected taxes payable will just arrive at CD even at 100% tax effort of the taxing officials. If the taxing officials fail to devote 100% tax effort, the taxes payable will fall into somewhere between C and D, such as B. As a result, the taxing capacity of taxation authorities will be CD/AD, and the tax effort will be BD/CD. Undoubtedly, AD indicates the legal ownership of taxes, and BD indicates the actual ownership. Under inadequate taxing capacity and tax effort, taxes will stay in the public domain and become the target of welfare capture by the private sphere. Fig. 2.1

Legal and actual ownership of taxes t

A

C B 45˚ O

D

T

Under the specialized tax administration system, to prevent the decline of the tax effort of specialized tax administrators, taxing authorities could have adopted some measures to reinforce their management and supervision over specialized

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tax administrators. Theoretically, taxing authorities could have implemented “ten prohibition” rules, for example, to regulate the behavior of specialized tax administrators. These rules, which were indeed promulgated, prohibited the taxing officials from: 1. Accepting gifts or invitations to meals from taxpayers; 2. Purchasing goods at a lowered price from taxpayers; 3. Making purchases on credit or borrowing money or things from taxpayers; 4. Extorting or taking bribes by taking advantage of their authority; 5. Granting tax favors without authorization; 6. Covering up or conniving at tax evasion and tax arrears; 7. Giving unauthorized tax breaks or reducing overdue fees; 8. Collect taxes without issuing invoices or with blank notes or false tax receipts; 9. Embezzling, occupying, or appropriating taxes, and 10. Arbitrarily withholding and confiscating the cash, commodities, or tools of hawkers or imposing unjustified levies or fines.9 However, since the powers of tax collection, management, and inspection were all centralized in the hands of the specialized tax administrators, compounded with the insufficient degree of informatization back in those days, it was very hard to monitor their behavior. The very existence of the “ten prohibitions” implied that there were indeed rent-seeking behaviors, such as accepting invitations as bribes, granting tax favors without authorization, and extorting or taking bribes, in tax collection and management. Even though taxing authorities could strengthen supervision and punishment to partially make specialized tax administrators abide by the “ten prohibitions,” the specialized tax administrators still could reduce their tax effort by virtue of their own control over their own skills. Therefore, as long as the taxing capacity of authorities and tax effort of officials remained inadequate, there would be a tax gap and part of the ownership over taxes would be left in the private sphere. The objective of the tax management reform was to minimize the ownership of taxes left in the private sphere, and one of the solutions was to subdivide tax administration power.

Prevention of potential infringements through the subdivision of tax administration power Governments are managed by people, and governments’ behavior is necessarily a result of the interaction between individuals who pursue maximum personal interests. The goal of specialized tax administrators as individuals, namely,

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maximizing personal interests, may not have been consistent with the goal of taxing authorities, which was to collect all due taxes. When the personal goal of specialized tax administrators was to maximize their personal interests, it was possible that they would use their enormous centralized powers of tax collection, management, and inspection to seek rents or become slack in work. Zhou points out that the opportunities to seize public resources by individuals can stimulate welfare capture, which will lead to capture losses and in turn propel those who have a vested interest in the rents to safeguard the rents from dissipating.10 One of the solutions of protecting the public resource of taxes from dissipating is to limit or divide the power of specialized tax administrators. Let us first observe the general attribute of tax administration power. The goal of decentralizing tax administration power is to ensure the collection of all due taxes. But taxing officials have no idea about the authenticity of tax returns and taxpayers’ daily management of tax-related finances, so it is necessary to reinforce regular tax management over taxpayers. Moreover, taxpayers may evade taxes due to the pursuit of personal interests. Therefore, in addition to tax collection and management, tax supervision also needs to be strengthened. In such a way, the general attribute of tax administration power can be further subdivided into the three attributes of tax collection, management, and inspection powers. Barzel notes: Individuals sometimes choose to divide the ownership of commodity attributes among themselves because the most efficient owner of one attribute is not necessarily the most efficient owner of other attributes of the same commodity. When different attributes of a commodity are owned by different individuals, a special effort is required to exclude each of them from using attributes belonging to any of the others.11 Following this logic, it would be well-reasoned for China to divide tax administration power. From the mid-1980s to the beginning of the 1990s, tax inspection was put in place in order to strengthen the internal restriction and supervision mechanism. Tax inspection teams were organized by provincial, municipal, and county-level taxing authorities and an administration mode where the duties of tax collection, management, and inspection were separated and designated to different specialized tax administrators responsible for specific enterprises, to which they paid visits. The State Administration of Taxation promulgated the Opinions on the Reform of National Tax Collection and Management in December 1989. This document further clarified the guidelines, main content, methods, and steps of the tax collection

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and management reform. After that, the practice of separating tax collection, management, and inspection powers (known as “three separations,” i.e., san fenli 三分離), or at least separating tax collection power from tax management and inspection powers (known as “two separations,” i.e., liang fenli 兩分離), was promoted nationwide. However, whether tax administration power was split into two or three parts, the target of tax management remained taxpayers rather than tax affairs. It would be hard to prevent the collusion between specialized tax administrators and taxpayers as long as they kept a direct contact. Moreover, manual management added to the difficulty of the quality improvement of tax administration. With the implementation of the new taxation system in 1994, tax policies became increasingly complicated and standardized, and informatization had grown to be an important issue that taxing authorities must face. Under such a backdrop, the State Administration of Taxation proposed the administration mode of unified tax collection and selective inspection on the basis of tax declaration and service optimization, with the aid of computer networking in 1997. To put it simply, tax service halls were built in each city and county to offer one-stop service from taxation publicity and consultation, tax registration, receipts and invoices, tax declaration, and tax collection and storage to data filing, in order to realize unified tax collection. On the basis of this, the organizational structure and functions of tax agencies at the grass-roots level were adjusted and transformed to regulate the process of tax levying and management. Unified management also facilitated the application of information technology in tax levying and management, which not only greatly improved the efficiency of the management work but also prevented the collusion between tax officials and taxpayers and minimized the slackness of taxing officials in work by changing the administration target from taxpayers to tax affairs. That is to say, this new administration mode compressed the “residual claim” of tax administrators to the greatest possible degree. However, the shortcomings of stressing tax affairs while neglecting taxpayers were gradually exposed in practice. Unified management placed emphasis on unified tax collection and selective inspection. Although the task of managing due taxes and potential taxpayers was assigned to the management departments and management agencies were set up in many areas, the management of potential taxpayers was not yet put in place and there was a divorce between tax affair management and taxpayer management. As a result, taxing officials were just auditing the tax returns and invoices in the tax service halls and would not proactively collect information about the production and operation of taxpayers or changes in due taxes. As a result, the tax administrators lost control over taxpayers, especially those who did not submit their tax returns, failed to pay taxes, suspended

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their businesses, or were scattered and mobile. The management of potential tax revenues was transformed from on-site investigation into the business production and operation situations of taxpayers by specialized tax administrators to the passive management of tax administrators who were just waiting in the office and physically distant from taxpayers’ businesses. Consequently, the management over due taxes was significantly weakened and tax affairs of large taxpayers could not be managed in detail while many small taxpayers were left out. The problems of poor management and a weak sense of responsibility became prominent. To reverse this trend, in July 2004, the State Administration of Taxation reformed the tax management mode into unified tax collection, selective inspection, and intensified management on the basis of tax declaration and service optimization, with the aid of computer networking. At the same time, it also set the general requirement of “vigorously implementing scientific and detailed management.” The newly added “intensified management” not only was a general requirement on tax administration work, but also suggested an emphasis on the management of potential taxpayers in response to the division of tax collection, management, and inspection powers. The system of management by tax administrators was developed on the basis of divisions of labor, unified management, informatization, and detailed legal provisions. Its strength is that it can effectively exercise the overall advantage of taxing authorities and better cope with the complexity of tax sources.

Economic Impacts The specialized tax administration system was an extensive regime. It had two advantages. First, specialized tax administrators conducted all-round management of taxpayers on a regional or industrial basis, and their scope of work and duties were clear. Second, through door-to-door service, specialized tax administrators could not only inform taxpayers of tax policies in a timely manner, but also provide convenience for taxpayers and hence lower tax-paying costs. Third, the direct contact between specialized tax administrators and taxpayers enabled the taxing officials to have an accurate knowledge of the production, operation, and tax declaration situations as well as financial status of taxpayers, and to undertake timely monitoring over them. The most outstanding weakness of this system was the lack of an effective self-restraint mechanism. With the implementation of the specialized tax administration system, many local governments issued relevant disciplinary guidelines, work regulations, and rules governing specialized tax administrators. But the coercive force of those rules and regulations was not strong enough, and

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there was no effective enforcement mechanism, so the abuse of power could not be effectively eliminated. Later, with the improvement of the economic situations, the discretionary power of specialized tax administrators aroused a lot of controversy. Because of this, the taxing authorities had to frequently strengthen the management of specialized tax administrators by means of peer review, that is to have specialized tax administrators perform cross-checks of each other’s work under the framework of unified tax collection, management, and inspection powers. Yet, while such an inspection measure allowed problems to be easily spotted, its effectiveness was largely limited by the incomprehensive scope. Even less so if the mutual inspection between specialized tax administrators was not strict. It was exactly because the “residual claim” of specialized tax administrators could not be totally eliminated in the system that there were a lot of violations on the part of specialized tax administrators at that time, such as arbitrary tax reduction or exemption and taking bribes from taxpayers. The tax administrator system currently in force integrates tax affair management with taxpayer management. Tax administrators maintain an institutionalized contact with taxpayers in accordance with relevant laws and regulations, and offer professional taxation service and guidance to taxpayers to help them make timely and accurate tax declaration while ensuring the efficiency of tax management work. Moreover, through the on-site investigation reports of tax administrators, taxing authorities can have access to key tax-related information such as taxpayers’ record in the business registry, financial accounting, capital turnover, and turnover so as to provide targeted and effective tax management services. Through door-to-door taxpayer management, the taxing authorities can have a better control of due taxes. Consistent with the transition from the specialized tax administration system to the tax administrator system, China’s tax revenue has been growing ahead of its GDP after the tax sharing reform of 1994. As shown in Fig. 2.2, if we compare tax growth to the growth of GDP, it is clear that the tax elasticity has been higher. From 1986 to 1992, the tax elasticity (tax growth rate / GDP growth rate) was just 0.43,12 but this ratio reached 1.39 between 1995 and 2009. If we compare the tax growth rates before and after the tax sharing reform, we will find that the growth rate after the reform has been far higher than that before the reform. In 1986 to 1992, the annual growth rate of tax revenue was 7.2% while it grew to 17.8% in 1995 to 2009. Many researchers have pointed out that this phenomenon is related to the reinforced tax management by the taxing authorities.13 There are many ways to strengthen tax management, such as the application of information technology in taxation, the expansion of taxing officials, and the setting up of national and local taxation agencies. What cannot be denied is that the shift from the specialized tax administration system to the tax administrator system has undoubtedly enhanced

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the sophistication and scientific level of due tax management, thus encouraging the rapid growth of tax revenue. Fig. 2.2

Comparison of the growth rates of nominal GDP and tax revenue (1986–2009)

(%) 40 35 30 25 20 15 10 5

Nominal tax revenue growth rate

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

0

Nominal GDP growth rate

The specialized tax administration system was compatible with China’s situations in the long period of the planned economy when productivity was low, the economy was not diversified, economic aggregates and tax revenue were small, the tax system was simple, and tax collection and management methods were backward. The specialized tax administration system was a traditional, multifunctional, and extensive management scheme. Despite many inborn defects, it was widely adopted in the tax collection and management work of China as long as the level of economic development remained low, the taxation system simple, and informatization inadequate. Under the economic background of that time, the specialized tax administration system with on-site tax administrators proved to be beneficial for the government in centralizing taxation power in order to rapidly carry out taxation work. But with the development of the market economy and the gradual perfection of the market order, the specialized tax administration system became increasingly unsuitable for tax management, and a reform of the system was put on the agenda of the Chinese government.

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Chapter

Off-Budget Funds

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Introduction As an important part of government funds, off-budget funds refer to fiscal funds of various types that are not covered in regular government budgetary management. These funds are collected, raised, arranged, and used by government agencies, public institutions, social organizations, corporate administration departments, and other agencies entrusted by the government with the aim of performing duties delegated to them or on behalf of the government in accordance with relevant laws, regulations, and legally binding rules.1 Off-budget funds are specific to China and have distinct Chinese characteristics. In Western democracies with well-developed public finance management, there is no such thing as “off-budget funds” because all government revenues and expenditures are listed in the government budget, and there is no room for the existence of fiscal plans beyond the national budget. In China, however, off-budget funds came into shape at the beginning of New China and since have experienced a history of more than 60 years. The coverage of off-budget funds has been constantly changing during different periods of China’s economic development (Table 3.1). Table 3.1

Changes in the coverage of off-budget funds

Time

Composition of off-budget funds

1950

Self-raised funds of villages and towns: extra charges of the agricultural tax paid in grain Production income of government agencies: administrative and public institutions, farming units of the Reclamation Army and troops (from vegetable cultivation), labor reform organizations and production units of civil affairs departments

1953–1957

Earmarked funds for corporate management: incentive funds, benefit funds, and overhaul funds Income from public undertakings: industrial and commercial tax surcharges levied by local governments, tolls for highway maintenance, waterway conservation fees, forestry fees, and miscellaneous expenses of primary and secondary schools Miscellaneous income of administrative and public institutions

1958–1960

Industrial and commercial tax surcharges, agricultural surtax, urban public utility surtax, tolls for highway maintenance, forestry funds, income from the work-study program, enterprises’ retained profits, overhaul funds, revenue from enterprises financed by governments at the county or municipal level, revenue from labor reform organizations, and social funds

1961–1965

Publicly-owned enterprises covered in the national budget and policy of profit retention put to an end

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(Cont’d) Time

Composition of off-budget funds

1966–1977

Corporate depreciation funds 40% of profits from small fertilizer plants, small cement plants, small coal mines, small machinery plants, and small steel plants established by county-level governments to be managed as off-budget funds within two or three years

1979–1985

Enterprises’ business capital, retained profits, and depreciation funds, part of enterprises’ after-tax profits, administrative and public service charges (educational surcharges and vehicle purchase surcharges), and school funds (revenue from running factories and farms by primary and secondary schools in educational reform)

1986–1992

Additional charges of various kinds collected by local fiscal authorities according to regulations of the state; self-collected funds of public and administrative institutions for own expenditure; various earmarked funds assigned to state-owned enterprises by competent authorities; corporate revenue turned over to local and central competent authorities not included in the budget; and other nonbudgetary revenues in accordance with regulations of the state

1993–2001

Administrative and public service fees, funds, and extra changes established by State Council and Ministry of Finance, approved by State Council, provincial governments, and their subordinate fiscal and planning (price control) departments, or stipulated by laws and regulations; self-raised and -collected funds of township governments for own expenditure; and social security funds (before separate government budgetary system for social security)

2000 to date

Separate management of off-budget revenue and expenditure gradually replaced by nontax revenue management; off-budget funds officially abolished in 2011

As a kind of fiscal capital, off-budget funds are not included in the government budget but are necessary for the government to fulfill its responsibilities. These funds came into being in the early days of New China, but after the launch of the Reform and Opening Up policy, especially after the setting up of the market economy, they rapidly expanded along with the huge changes in government functions and the social income distribution pattern. In 1978, national off-budget funds were recorded at CNY34.7 billion, equivalent to 30.7% of the budgetary revenue. After that, China’s off-budget funds rose rapidly during the institutional transition and the fiscal decentralization reform and reached CNY385.5 billion in 1992, amounting to 97.7% of the nation’s budgetary revenue. In 2007, off-budget funds further soared to CNY682 billion. The percentage of off-budget funds relative to the budgetary revenue grew from the lowest level of 4.18% in 1953 to 110.7% in 1992 before declining to 13.3% in 2007 (Fig. 3.1 and 3.2).

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The size of China’s off-budget funds was constantly changing, so was its percentage compared to the budgetary revenue. In fact, this also reflected the process of the constant perfection and improvement of China’s budgetary and public finance systems. Fig. 3.1

China’s budgetary revenue and off-budget revenue (1952–2007)

8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 1950 1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

0

Budgetary revenue (CNY1 billion)

Off-budget revenue (CNY1 billion)

Source: National Bureau of Statistics of China, China Statistical Yearbook, various years.

Fig. 3.2

Off-budget revenue as a percentage of budgetary revenue (1952–2007)

(%) 120 100 80 60 40 20

1950 1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

0

Source: National Bureau of Statistics of China, China Statistical Yearbook, various years.

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Historical Evolution of Off-Budget Funds Before the founding of New China, the revolutionary base areas were fragmented, and the fiscal system adopted a “half-supply” practice; that is, half of the financial resources were provided by the government while the other half were solved by each revolutionary base area via undertaking production. To ensure the victory of wars and relieve people’s burdens, various government agencies, military units, schools, enterprises, and public institutions carried out production activities and established “minor public treasuries” (xiao gong jia wu 小公家務).2 To timely and effectively overcome the financial difficulties, in December 1949, the Central People’s Government passed the annual budget and decided to issue People’s Victory Bonds valued in kind (renmin shengli zheshi gongzhai 人民勝利折實公債). This was the first national budget of New China. In terms of national revenue, agricultural income was still dominant, accounting for 44.4% of the total revenue, and corporate revenue took a small share of 17.1%. Major expenditure items were military and administrative expenses, which, respectively, took up 38.8% and 21.4% of the national expenditure. However, due to the fact that it was too difficult to implement this budget, with national expenditure exceeding the budget while national revenue falling short of the target, the State Council convened a national fiscal conference in 1950 and came up with the policy of curtailing expenditure, consolidating revenue, and unifying the fiscal working guidelines across the country.3

1950–1957: Initial emergence of off-budget funds National economic recovery period (1950–1952) In early New China, under the influence of the highly centralized budget management system, the Chinese government approved and released the Decisions on the Unified Management of Annual Fiscal Planning in hopes of solving the problem of funding for rural educational and administrative expenses and government agencies’ miscellaneous spending. The central government decided to allow several kinds of miscellaneous income, mainly the funds raised by township governments and production income of government agencies (that is, the sources of the minor public treasuries) to be managed and used by local governments and government agencies. This was the initial form of off-budget funds. Here, the “self-raised funds” (zichou zijin 自籌資金) of township governments mainly came from extra charges of the agricultural tax paid in grain, which were used to support expenditures for developing rural culture, education, and health care services, administrative costs,

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and expenses of rural welfare undertakings. For production income of government agencies, the main sources included administrative and public institutions, farming units of the Reclamation Army and troops (from vegetable cultivation), labor reform organizations, and the production units of civil affairs departments, all of which were principally applied to the miscellaneous spending of government agencies. This meeting was of historic significance to the fiscal and economic work of New China. Since then, China’s fiscal and economic work had entered into a new period of transformation from separate operation to basically unified fiscal management. In March 1951, the State Council promulgated the Regulations on the Further Consolidation of Municipal Finances, and further standardized off-budget funds. This document unified the kinds and rates of various surcharges. For example, the rate of the industrial and commercial tax surcharge should be within 10% and 15%; the rate of the real estate surtax should be no higher than 20%; the surcharge rate of public utilities should be decided according to local conditions and had no fixed standard; and the rate of the agricultural surtax was fixed at 20%. For the income from various charges and fees, there was no unified regulation, and the rates should be decided based on local conditions. After three years of economic recovery, the financial situation of the country fundamentally picked up. Therefore, the State Council issued the Decisions on the Unified Arrangement of the Production of Government Agencies in March 1952. This document pointed out the negative effects brought about by the decentralization and blind development of governmental production, despite affirming the contribution of this activity in the revolutionary years. Consequently, the State Council decided to put an end to this practice, and urged government agencies of various levels to hand over their production operations to the state before April 30, 1952. Following the spirit of the above document, the Ministry of Finance launched the Regulations on Taking Over the Minor Public Treasuries of Government Agencies at All Levels. It required government agencies to abolish minor public treasuries; that is to say, all production agencies except the public production units under civil affairs departments and labor reform organizations would be managed as stateowned enterprises, and the income of those production units would be included in the national budget. For the self-raised funds of township governments, the policy of “government financing, agricultural surtax, and no apportionment” was introduced. “Government financing” meant that the expenses which used to be financed by township governments would be supplied by the state budget; “agricultural surtax” referred to the continued practice of charging an agricultural surtax at the maximum rate of 7% by local governments; and “no apportionment” banned any forms of apportionment of governmental expenses among enterprises other than those allowed by the above two practices. These changes played a vital

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role in stabilizing the economy and reducing the burdens of farmers. However, as nearly all incomes and expenditures were included in the national budget, offbudget funds shank. In 1952, the total off-budget funds only arrived at CNY1.36 billion, equivalent to 7.8% of the national budget of that year.

First Five-Year Plan period (1953–1957) To ensure the meeting of the financial demands of national economic recovery, the Chinese government implemented a highly centralized fiscal management system and regulated the rather chaotically managed off-budget funds. But the weaknesses of this highly centralized management approach were soon exposed: overly rigid management and a lack of flexibility and timeliness when dealing with the special needs of local governments, governmental departments, and administrative and public institutions. In 1953, China entered a period of largescale economic construction, and the fiscal system was reformed into a system of hierarchical administration with separate management of revenue and expenditure. Many enterprises implemented the economic accounting system. In view of the shortcomings of the highly centralized system and also for solving the special needs of government authorities while arousing their incentive, the items of offbudget funds were increased. Off-budget funds then covered funds earmarked for corporate management (inventive funds, welfare funds, and overhaul funds), income from public undertakings (industrial and commercial tax surcharges levied by local governments, tolls for highway maintenance, waterway conservation fees, forestry fees, and miscellaneous expenses of primary and secondary schools), and miscellaneous income of administrative and public institutions. In 1953, the offbudget funds of China only recorded CNY891 million, corresponding to 4.2% of the budgetary revenue. However, with the expansion of the items and scale of offbudget funds, the size of the funds also grew. By the end of 1957, national off-budget funds had grown to CNY2.63 billion, equivalent to 8.68% of the national budgetary revenue of the same year.4 This was the period when the concept, scale, effects, and management mode of off-budget funds took shape in China, and therefore became an extremely important stage in the reform of China’s fiscal management system.

1958–1977: The U-shaped development of off-budget funds Early stage of the Second Five-Year Plan period: Great Leap Forward (1958–1960) In 1957, the movement of increasing production and practicing economy was brought to a climax, which exerted positive effects on easing the acute shortage

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of supplies and solving financial difficulties. After the rapid development during the First Five-Year Plan period, in the first three years of the Second Five-Year Plan, the Chinese government introduced radical reforms to the industrial, commercial and fiscal management systems. It decentralized the financial and administrative powers, with a large batch of state-owned enterprises transferred to local governments. These enterprises were allowed to retain a certain proportion of profits, which were listed outside the budget plan, to themselves. The profits from enterprises financed by local governments or governmental departments were beyond the management scope of the national budget. As a result, off-budget funds were greatly multiplied. At that time, items of off-budget funds mainly included industrial and commercial tax surcharges, the agricultural surtax, the urban public utility surtax, tolls for highway maintenance, forestry funds, income from the “work-study program” (qin gong jian xue 勤工儉學), retained profits of enterprises, overhaul funds, revenue from enterprises financed by governments at the county or municipal level, revenue from labor reform organizations, and social funds. Given the context of power decentralization, off-budget funds rapidly expanded during the period of Great Leap Forward after those reforms. The total off-budget funds were doubled to reach CNY5.60 billion in 1958, compared with the previous year. And this figure further grew to CNY9.66 billion in 1959, and to CNY11.78 billion by the end of 1960, equivalent to 20.6% of the national budgetary revenue and 4.47 times that of 1957.

Later stage of the Second Five-Year Plan (1961–1965) For a period of time, China’s national economy ran into serious difficulties as a result of the mistakes in the guidance of economic work during the Great Leap Forward period and the concurrent impact of natural disasters. Moreover, while the state tried to expand the autonomy of enterprises, some necessary rules and regulations were destroyed, resulting in disperse finances, loose regulations, and lax management. Therefore, starting from 1961, the central government made adjustments to the fiscal system, restoring the unified management of the national economy and retrieving the administrative powers in production, capital construction, labor, acquisition and finances from the hands of local governments and departments. In February 1962, the Ministry of Finance and the People’s Bank of China issued the Joint Notice on the Unification of the Deposit Accounts of Budgetary and Off-Budget Funds of Local Governments. The Notice put forward the policy of “adjustment, consolidation, replenishment, and improvement” (tiaozheng, gonggu, chongshi, tigao 調整， 鞏固，充實，提高), and reimplemented the unified economic system by

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including certain off-budget funds items into the budget, lowering the percentage of income contributed to off-budget funds, and strengthening the management of off-budget funds with the aim of overcoming the serious imbalance and disorder in the national economy brought about by the Great Leap Forward. The Notice required including publicly owned enterprises into the national budget with unified management and putting an end to the profit retention system. It also stipulated that the off-budget funds under the management of local governments should be reported level by level up to the Ministry of Finance as a subsidiary part of the national budget. After the rectification, off-budget funds dropped from CNY11.78 billion in 1960 to CNY5.74 billion in 1961, and the ratio of off-budget revenue to budgetary revenue decreased from 20.58% to 16.12%. By 1965, national off-budget funds were reduced to CNY7.56 billion, equivalent to 16% of the budgetary revenue of the same year.5 This was a period when the scale and size of China’s off-budget funds were narrowed while management over them was intensified.

Cultural Revolution period (1966–1977) During the Cultural Revolution, the central and provincial governments transferred a large batch of enterprises and public institutions, together with their financial and personnel management powers, to lower-level authorities. Moreover, two new stipulations on off-budget funds were issued. First, starting from 1967, depreciation funds of enterprises would be left to themselves to be used as fixed capital and for renewing and upgrading equipment. Second, starting from 1970, 40% of the profits from the newly established enterprises of the “five small plant” types (small fertilizer plants, small cement plants, small coal mines, small machinery plants, and small steel plants) run by county-level governments would be managed as offbudget funds in the first two or three years; and for the existing “five small plants,” the country would allocate CNY8 billion of dedicated funds in the next five years for the use of provincial, municipal, and autonomous regional governments to support their development. Since various rules and regulations as well as financial and economic disciplines were seriously destroyed during the Cultural Revolution, local governments and governmental departments took the liberty of setting up off-budget items, and the phenomena of arbitrary changes, indiscriminate levies, and entering budgetary revenues as off-budget revenues were quite common, leading to the rapid expansion of off-budget funds. Moreover, in 1970 when the early unrest of the Cultural Revolution came to an end, the state initiated large-scale power decentralization and required the transfer of the administrative power of those enterprises suitable for

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local management to local governments. As a result, the administration of railways and civic aviation was decentralized to local governments, and many large coal mines, oil fields, and automobile factories were placed under the management of provincial governments. After the decentralization of power, the size of off-budget funds grew bigger and bigger. From 1970 to 1976, budgetary revenue increased by only 17.1% while off-budget funds grew by 172.8%. In 1975, the total off-budget funds amounted to CNY25.15 billion, accounting for 30.83% of budgetary revenue. In 1976, the national off-budget funds reached CNY27.53 billion, equivalent to 35.5% of the national budgetary revenue.6

1978–1993: Rapid expansion of off-budget funds From 1978 to 1979 Having experienced the decade-long calamity of the Cultural Revolution, the national economy was hard hit by a lot of problems. After the downfall of the Gang of Four, the Chinese government made a series of adjustments to the economic system. Among them, the main adjustments regarding off-budget funds were as follows: 1. In January 1978, under the approval of the State Council, the proportion of depreciation funds to be retained by enterprises was changed from 100% to 50% and the other half would be handed over to the central fiscal authority. In January 1979, 20% out of the 50% depreciation funds turned over to the national fiscal authority was listed as off-budget funds to be managed by local fiscal authorities. 2. The enterprise funds system was resumed. Enterprises which had fully completed the eight targets designated by the country (in the aspect of output, variety, quantity, raw materials and energy consumption, labor productivity, costs, profits, and the occupation of working capital) were allowed to retain a certain amount of enterprise funds proportionate to the total annual wages of employees for the purposes of providing collective welfare facilities and paying the cash prizes of business skill contests for employees. 3. Since 1978, 1% of the salt tax had been put aside as off-budget funds. After the above adjustments, China’s off-budget funds went up rapidly to amount to CNY34.71 billion in 1978, making up 30.69% of the budgetary revenue of that year.7

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From 1979 to 1985 As the Communist Party of China (CPC) gradually realized the defects of the traditional planned economy, it convened the Third Plenary Session of the 11th Central Community of the CPC in December 1978, which was of great historical significance to China. This meeting decided to shift the work focus of the Party and the country to the construction of socialist modernization. This implied that China entered the era of Reform and Opening up, and China’s economic construction was about to turn a new page. To adapt to the needs of the situations, it was necessary to undertake an all-round reform of the economic management system with the reform of the fiscal system as a breakthrough. At that time, to expand the power of enterprises and allow them to retain more profits, promote business vitality, increase economic returns, and grow financial sources became the primary objectives of the reform. In February 1980, the State Council promulgated the Interim Provisions on the Implementation of the Fiscal Management System of “Dividing Revenues and Expenditures between Central and Regional Governments and Holding Each Responsible for Balancing Their Own Budgets.” The launch of this document signified the transformation of China’s fiscal system from “eating from the same pot” (yi zao chifan 一灶吃飯) into “eating from separate pots” (fen zao chifan 分灶吃飯) and the distribution pattern of financial resources from being vertical to horizontal. The basic spirit of these changes was to clearly define the scope of the revenues and expenditures of central and local governments according the administrative hierarchy, determine the expenditure of local governments based on their revenue, and hold local governments responsible for balancing their own budgets. The content of the fiscal system of “eating from separate pots” was mainly as follows: 1. Fiscal revenues were classified into fixed revenue, fixed-ratio shared revenue (from corporate profits), and adjustment revenue (derived from certain taxes, such as the commodity circulation tax, the business tax, and the income tax, and income from public debts); 2. Expenditure responsibilities were divided according to the administrative hierarchy: the central government was responsible for financing central investment, geological prospecting, foreign aid spending, and state material reserves, whereas local governments bore the expenditures for local investment, public undertakings, city maintenance, and administration. 3. In term of the budgetary relationship between central and local governments, local expenditure would first be offset by fixed revenue and fixed-ratio shared revenue. If there was a surplus after the offsetting, it would be turned over to the central government. If there was a deficit, the adjustment

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revenue would be used to balance the budget. However, if the deficit still existed, the central government would allocate a fixed amount of subsidies to compensate for the gap. 4. In principle, the proportion or amount of local revenue handed over to the central government, adjustment revenue shared from certain taxes and public debt-derived income, and subsidies allocated by the central government should remain unchanged for five years once confirmed.8 In the same year, the Notice from the CPC Central Committee and the State Council on Reducing Nonproductive Expenditures and Opposing Waste stipulated: “All public institutions which are capable of organizing revenue have to actively explore their potentials and reasonably raise revenue by expanding their services in order to solve the deficiency in funding.” This provision broke the traditional mode of financing public institutions by the public purse and played a part in easing governments’ financial burdens and creating a new financing channel. However, it also directly led to the rapid expansion of off-budget funds, especially revenue from administrative and public service charges. In February 1983, the Ministry of Finance issued the Trial Measures for the Management of Off-Budget Funds. The Measures stipulated: “Off-budget funds are fiscal funds that are collected and taken out by government agencies, public institutions, and social organizations to perform governmental functions and social management functions in accordance with relevant laws, regulations, and legally binding rules.” This was for the first time that the central government clearly defined off-budget funds as a kind of fiscal funds. Although these funds were excluded from the budget, they were raised under the permission of governments and used by governments to fulfill their duties. The ownership of off-budget funds belonged to governments as a whole instead of a particular governmental department or public institution. As the reform of the economic system was in full swing, the off-budget funds of this period also underwent some changes: 1. Restoration of the enterprise funds system Starting from 1978, all the enterprises which had fully completed the eight targets set by the state in the aspect of output, variety, quantity, raw materials and energy consumption, labor productivity, costs, profits, and the occupation of working capital were able to take out 5% of the total annual wages of their employees as enterprise funds. Enterprises which only met the targets in output, variety, quantity, and profits as well as the supply and marketing contract could retain 3% of the total wages as enterprise funds.

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2. Profit retention system In July 1979, the pilot project of expanding the power of enterprises was launched. In January 1980, the system of profit retention was promoted nationwide, and production development funds and benefit and bonus funds for employees were established. In 1981, the profit retention system and the system of holding enterprises and government departments responsible for their profits and losses were implemented in state-owned industrial and transportation enterprises and their competent authorities according to their respective situations. 3. Adjustments in the management of corporate depreciation funds Since 1983, the state had been gradually raising the depreciation rate in some of the key enterprises. Starting from February 1985, the depreciation funds collected at a depreciation rate of 30% were no longer turned over to the central government but were at the disposal of local governments and competent authorities with mutual coordination. The depreciation method was changed from composite depreciation to classified depreciation. 4. Tax for profit reform The country conducted two reforms to substitute taxation for profit delivery in 1983 and 1984. The first reform stipulated that all the large and mediumsized state-owned enterprises which were profitable must pay income tax at a rate of 55% of their realized profits. A part of the after-tax profits had to be turned over to the central government under the incremental profit delivery contract scheme (dizeng baogan shangjiao 遞增包干上繳), the fixed-ratio profit delivery scheme (guding bili shangjiao 固定比例上繳), or the fixed-quota profit delivery contract scheme (ding’e baogan shangjiao 定額包干上繳), or in the form of a regulation tax (tiaojie shui 調節稅). The rest of the profit was left to enterprises themselves based on a profit retention level approved by the state for the purposes of building up production development funds and employee collective benefit funds and giving out bonuses. The second reform substituted 11 taxes for profit delivery by state-owned enterprises, indicating a gradual transition from the coexistence of taxation and profit delivery to the complete replacement of profit delivery by taxation. 5. Reform of administrative and public service charges The state first reformed the financial management system of administrative and public institutions. Starting from 1980, the method of “budget contracts and surplus retention” (jingfei baogan, jieyu liuyong 經費包干，結餘留用) was promoted. Then, the central government began to levy the educational surcharge, the vehicle purchase surcharge, and other administrative and public service changes. At the same time, public institutions were allowed to

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carry out diversified operations and paid services to increase their income. They were also encouraged to transform their financing method from being totally government funded to government-institution jointly funded and then completely self-funded. An enterprise-style management system was introduced to institutions which had comparatively stable revenue and expenditure. 6. Establishment of school funds In June 1980, the Ministry of Education, the State Labor Bureau, and the Ministry of Finance jointly announced the Trial Measures for the Establishment of School Funds and the Incentive System for Higher Education Institutions. It provided that revenue from school-run factories, farms, and hotels could be retained by the schools. Moreover, revenue from the factories and farms built by primary and secondary schools during the educational reform were to be excluded from the budget and should be managed as off-budget funds for improving the production conditions of school-run factories and farms; enhancing teaching conditions; purchasing books, teaching apparatus, audio-visual educational equipment, and hygienic facilities; and providing collective benefits and incentives for teachers, students, and administrative staff. During this period, owing to the adoption of the above measures, part of the budgetary funds was transferred outside the budget, and the size of off-budget funds was rapidly expanded. In 1981, off-budget revenue registered at only 51.12% of budgetary revenue, but in 1985, this percentage rose to 83.3% with the off-budget funds amounting to CNY153 billion.9

From 1986 to 1992 To strengthen the management of off-budget funds and further improve the corresponding management system, the State Council launched the Notice on Strengthening the Management of Off-Budget Funds in April 1986. The Notice defined the concept, range, and management method of off-budget funds, and stipulated that the sources of off-budget funds should be specified by the Ministry of Finance, the off-budget funds of administrative and public institutions should be managed and stored under dedicated fiscal accounts, and a planned management system should be introduced for funds management. It also pointed out that off-budget funds were funds that were not covered in the budget but were collected and used by local governments, governmental departments, and administrative and public institutions in accordance with relevant laws and regulations. Accordingly,

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off-budget funds were composed mainly of additional charges of various kinds collected by local fiscal authorities in accordance with the regulations of the state; self-collected funds of public and administrative institutions for their own expenditure; various earmarked funds assigned to state-owned enterprises by competent authorities; corporate revenues turned over to central and local competent authorities which were not included in the budget; and other revenues which were excluded from the national budget in accordance with the regulations of the state. Off-budget funds were characterized by being autonomous, dedicated, dispersed, and legal. Moreover, the document also specified the management mode of off-budget funds. Different methods could be adopted in the management of off-budget funds by local governments and governmental departments under the premise of unchanged ownership of funds. Each local government, governmental department, and administrative and public institution should formulated an annual plan and final accounts for off-budget funds, and the quarterly report should be turned over level by level up to the Ministry of Finance. The Notice further clarified the principles of using off-budget funds. Off-budget funds should be earmarked for specific purposes: the basic depreciation fund should be applied to the renovation and transformation of fixed assets and must not be diverted to capital construction; the employee benefit, incentive, and wage growth funds must be collected before using, and the off-budget funds earmarked for developing production and businesses could not be used to issue bonuses, allowances, and benefits in kind. After that, the State Administration of Commodity Prices and the Ministry of Finance issued the Notice on Strengthening the Management of Administrative and Public Service Charges. The Notice defined the concept, principles, and procedures of examination and approval of administrative and public service charges as well as the division, management, and supervision of the corresponding approval authority. In 1989, the State Planning Committee, the People’s Bank of China, the Ministry of Finance, and the State Auditing Administration jointly released the Supplementary Notice of Further Strengthening the Management of Self-Raised Funds for Capital Construction, which stipulated the approval procedures, capital sources, and the division of labor among the competent departments. In addition to that, governments of provinces, municipalities, and autonomous regions also formulated a series of concrete measures in accordance with the above regulations. In October 1991, the State Council promulgated the Regulations on the Management of the State Budget. This document divided the existing dual budget system into a regular budget and a capital budget, and specified the basic principles of budgeting, the authority of budget management, the scope of budgetary revenues and expenditures, budget preparation, the implementation and supervision of the

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budget plan, budget adjustment, final accounts, and related legal liabilities. This marked an advance of the Chinese government in the field of budgeting. However, since the Regulations was an administrative statute of the State Council, it could only govern the budget management power of local governments, competent departments, and administrative and public institutions, but could not be applied to regulate the budget review and oversight duties of the National People’s Congress (NPC) and its standing committee. As a result, its restrictive effect over budget review was lessened to a certain degree, and the problem of weak budget management was not solved fundamentally. Moreover, this set of Regulations had been formulated before the sanction of the socialist market economy in the 14th National Congress of the CPC, so the implementation of most provisions was still affected by the planned economic system. During this period, as China sought to open up itself to the outside world, enliven its economy, and reform its economic system, its budget management system was improved to a certain extent. On the basis of adjusting the division of financial sources and power between central and local governments, the state promoted the contract management responsibility system (chengbao jingying zeren zhi 承包經營責任制), initially confirmed the distribution relationship between the state and enterprises, and reformed the financial management system in administrative and public institutions. In addition to that, the number and size of off-budget funds increased rapidly during this period. In 1986, China’s off-budget funds only recorded CNY173.73 billion, but it soared to CNY385.49 billion in 1992, equivalent to 110.67% of the budgetary revenue of the same year, and its growth rate exceeded those of the GDP and budgetary revenue of the same year.10 In other words, a considerate part of the increment in GDP was held by local governments, enterprises, competent departments, and administrative and public institutions in the form of off-budget funds, resulting in serious dispersion of capital. Among the various kinds of off-budget funds, the funds managed by administrative and public institutions grew the fastest. Meanwhile, cases of institutions turning budgetary funds into off-budget ones, diverting production funds to consumption, and taking public capital for private uses increased. Illegal “little coffers” of government authorities were pervasive. The so-called “little coffers” (xiao jinku 小金庫) referred to any form of funds embezzled or intercepted from revenues that should be turned over to the state but were privately kept without being listed in the books of the financial departments or included in budget management, against the national financial regulations or other related provisions.11 Major sources of little coffers included budgetary and off-budget funds embezzled or diverted in various names; sales revenue, operating and nonoperating incomes, and other revenues illegally retained by enterprises;

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profits from price differences by reselling at an exorbitant price; and penalties and confiscatory income misappropriated or intercepted by economic authorities and supervisory departments. Little coffers were extralegal income, nontax revenue which was covered in neither budgetary nor off-budget management. Also known as “unregulated fiscal funds”, little coffers were controlled and managed by levying authorities at their own will and were hardly subject to any laws. The funds mainly came from three channels — arbitrary collection of fees, arbitrary imposition of fees, and arbitrary raising of funds —usually in a variety of names and in disorder. Although such extra-legal income was distinguished from off-budget funds, it shared the same lack of financial supervision and management. Operated outside the fiscal system of the country, it upset the balance between fiscal revenue and expenditure, disrupted the normal order of the market economy, exacerbated social contradictions and the losses of national fiscal funds, weakened the country’s financial power, and abated the effects of macroeconomic control and regulation. Therefore, in order to radically clean up little coffers and abolish extralegal income, the Chinese government must start with reforming the fiscal system. After 1988, the size of off-budget funds was almost as large as that of budgetary funds. In quite a number of provinces and cities, off-budget revenue (or expenditure) exceeded that of budgetary revenue (or expenditure). That is why many also referred to off-budget funds as China’s “second budget.”

1993–present: Gradually standardized management of off-budget funds From 1993 to 1995 In 1993, the General Office of the CPC Central Committee and the General Office of the State Council circulated the Provisions on the Application of Budgetary Management to Administrative Charges and Penalty and Confiscatory Income, and included 83 types of administrative charges into the budget. In the same year, the reform of corporate financial and accounting systems excluded enterprises’ depreciation funds and retained after-tax profits from off-budget funds. The scope of off-budget funds was narrowed down to administrative and public service charges, funds, and surcharges stipulated by laws and regulations; administrative and public service charges approved by the State Council, provincial governments, and their subordinate fiscal and planning (price control) departments; funds and surcharges approved and established by the State Council and the Ministry of Finance; funds turned over to relevant competent governmental departments by their subordinate units; self-raised and collected funds of township governments

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used for their own expenditure; and other fiscal funds not included in budgetary management. Moreover, before a separate budgetary system for social security funds was formulated, social security funds were also managed according to the management system of off-budget funds. In March 1994, the Budget Law of the People’s Republic of China was passed in the Second Session of the Eighth National People’s Congress, and it was enacted on January 1, 1995. This was the first separate statue on the budget since the founding of New China, and the enactment of the law marked a brand new stage of China’s budget system under the rule of law. In November of the following year, Premier Li Peng signed State Council Order No. 186 to issue the Regulations for the Implementation of the Budget Law of the People’s Republic of China. The Regulations came into effect upon its promulgation. All these were major advances made by China in the process of promoting the rule of law in budget management. After the introduction of the Budget Law and the adjustments in the scope of off-budget funds, the size of off-budget funds was reduced to a certain extent. In 1993, the total off-budget funds amounted to CNY143.25 billion, CNY242.2 billion less than the previous year, and its percentage in comparison with the budgetary revenue also plummeted from 110.67% to 32.94%. After that, off-budget funds displayed rigid growth and reached CNY389.33 billion in 1996, exceeding the peak amount before the last adjustment of the scope of off-budget funds.12

From 1996 to 2001 To further strengthen the management of off-budget funds, the State Council promulgated the Decisions on Strengthening the Administration of Off-Budget Funds in July 1996. The Decisions redefined the coverage of off-budget funds and included 13 kinds of government funds or charges, which were collected by virtue of the authority of governments and which were of a quasi-tax nature, into budgetary management as regular local fiscal revenues for dedicated uses.13 It also required strictly controlling the size of administrative and public service charges and governmental funds, while unauthorized collection of fees and establishment of funds would be deemed illegal and penalized. Moreover, the Decisions pointed out that “off-budget funds [were] the country’s fiscal funds and should be managed through the two lines of revenue and expenditure (shouzhi liang tiao xian 收支兩條線).” Since then, the separate management between off-budget revenue and expenditure was gradually confirmed. This management approach required the detachment between the nontax revenues (such as administrative and public service charges, and penalty and confiscatory income) and expenditures of relevant departments. Revenue of

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government departments had to be turned over to the state treasury and could not be retained or used for their own expenses. The funds assigned by the Ministry of Finance to these departments for expenditure could not be linked to their revenue but had to be decided based on the demands of each department for fulfilling their duties. The key of intensifying the reform of the separate management of revenue and expenditure was to gradually place all fiscal funds under government budget management in accordance with the requirements of public management, so as to leave no fiscal revenue or spending out of the government budget or public supervision. The main aim of this document was to determine the management scope of public finances, which was in essence to standardize the scope of governmental activities. From the perspective of revenue, this reform intended to divorce capital collection from payment, regulate the collection of off-budget revenue, and reduce government funds tied up by governmental departments or administrative and public institutions. Lawful and legitimate revenues were to be incorporated into the government budget or managed under dedicated accounts and no longer collected by governmental departments or administrative and public institutions for their own expenditure. From the perspective of expenditure, this reform detached expenditure from revenue, so that the income from charges, penalties, and confiscation turned over by collecting authorities were no longer linked up with their expenditure. The ultimate goal of this reform was to prepare a consolidate government budget plan and gradually reduce and eliminate offbudget funds. The Decisions released in 1996 represented another large-scale adjustment in the scope of off-budget funds since 1993. In1998, Premier Zhu Rongji announced an off-budget funds cleanup and rectification scheme. The scheme required banning apparently unreasonable charges, substituting taxes for charges that must be kept, separating public service fees from governmental administrative fees, and strictly regulating the fees collected by intermediaries. Only a small number of public service charges were continued and charges that could be neither abolished nor transformed were to be kept in the name of government fees.14 After several rounds of adjustments, in 1997, the national off-budget revenue was reported at CNY282.6 billion, CNY106.7 billion less from a year earlier. However, similar to the situations of the previous adjustment, the figure rebounded to approximately CNY382.6 billion in 2000.15 In view of this situation, the Ministry of Finance and the People’s Bank of China issued the Notice on the Pilot Reform of the Fiscal Treasury Management System in March 2001. In September, Minister of Finance Xiang Huaicheng convened a regional fiscal head work conference to study further steps for the separation of fiscal revenue and expenditure in the hope of reinforcing fiscal management work.

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Since 2002 At the end of 2001, the General Office of the State Council circulated the Notice of the Opinions of the Ministry of Finance on Deepening Reform for Separating Revenue and Expenditure and Further Strengthening Financial Management and decided to conduct a corresponding pilot project in selected units. The reform aimed to apply the four measures of “cleanup, transformation, substitution, and retention” (yi qing, er zhuan, san gai, si liu 一清，二轉，三改，四留) to administrative and public service charges and governmental funds of various kinds based on their different situations in order to standardize the management of off-budget funds. Specifically, “cleanup” referred to the abolition of illegal and unreasonable funds and charges among all existing administrative and public service charges and funds in accordance with the requirements of transforming the functions of governments and establishing a public finance framework under the socialist market economy. “Transformation” meant that the charges that could not embody the functions of governments and could be formed in market competition, such as road tolls, bridge tolls, technology promotion expenses, and technology transfer fees, would be transformed into operating income and taxed accordingly, in response to the requirement of separating government functions from enterprise management. By “substitution,” it meant substituting taxation for some of the charges and revenues that could reflect governmental functions and that bore the nature of taxes, in accordance with the requirement of optimizing the taxation structure. Finally, “retention” suggested that a small number of charges and government funds which complied with international practices would be retained. For the fees levied for the purpose of providing specific public management services and rational charges that could not be replaced by taxes, they would be incorporated in budget management as “nontax revenues” under recurring revenues, following the budget principles of unity and integrity as well as international practices. Collection work would be organized by tax departments or competent authorities and tax revenues would be directly sent to treasuries or recorded in dedicated financial accounts. Expenditures would be arranged by respective governmental departments in order to form a unified and complete government fiscal system. The charging items and the standards laid down by the central and provincial governments must be strictly enforced, and the state would promulgate annually to the public the list of chargeable items. The governments and collecting authorities should take precautions against the arbitrary collection of charges, reinforce supervision from fiscal authorities, price control, and auditing departments and the public, and investigate and punish violations of laws and regulations.

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In January 2002, the Ministry of Finance and the People’s Bank of China jointly issued a notice to integrate the revenues from all the charges of public security departments (excluding those from their affiliated colleges and secondary technical schools) into the budget plan and also stipulate that these revenues should be turned over to the state treasury. In April, Vice Minister of the Ministry of Finance Xiao Jie said in the national fiscal and treasury work conference that the Ministry of Finance would further deepen and improve the reform of fiscal and treasury management, increase the number of pilot departments for the reform of treasury payment management, and launch a new pilot reform of the collection and management of off-budget funds in a group of selected central governmental departments in the context of the reform of the separate management of fiscal revenue and expenditure. On May 20, 2002, the Ministry of Finance issued a notice which announced 31 types of chargeable governmental funds that should be continued to be collected. Among them, 26 funds were established in accordance with laws, national administrative statutes, or documents of the CPC Central committee and the State Council, or under the approval of the Ministry of Finance together with competent authorities, with their objects, scope, and standards of collection explicitly stipulated. The rest 5 funds were expected to be replaced by the fuel or agricultural tax. The goal of this adjustment was to build a public fiscal revenue system with tax revenue as the core and a few standardized charges as a supplement in order to adapt to the requirements of the development of a socialist market economy. In July 2004, the Ministry of Finance issued the Notice on Strengthening the Management of Government Nontax Revenue, which marked a new era of nontax revenue management for off-budget funds, meaning that off-budget funds would be gradually included in the budget. Since 2004, government revenue has been divided into tax revenue, nontax revenue, and debts. Before that, nontax revenue included budgetary nontax revenues, extrabudgetary nontax revenues, and the charges, funds, and requested donations of governmental departments that were not covered in the management of the fiscal system. The management of nontax revenue was in a mess. The Notice clearly defined the management scope of government nontax revenue: administrative and public service charges, government funds, income from the compensable use of state-owned resources and assets, operating income from state-owned capital, public welfare funds from lottery, penalty and confiscatory income, income from donations accepted in the name of governments, revenue collected from the subordinate units of administrative and public institutions, and interest revenue generated from governmental fiscal funds. Social security funds and housing provident funds were not listed in the management scope of government nontax revenue.

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In February 2008, the Ministry of Finance released the Notice on Further Strengthening the Management of Budget Enforcement and put forward strict requirements on the budget management work of government fiscal departments and budgeting authorities at all levels. The document called for completely raising the standards of a series of budget management work including budget preparation, budget enforcement, and budget execution analysis. Efforts were to be made to enhance the validity and accuracy of budget preparation, deepen the reform of centralized treasury payments, improve the budget enforcement management mechanism, strictly control the enforcement of the government procurement budget, strengthen the analysis of budget execution, and boost fiscal informatization. In November of the same year, the Ministry of Finance and the Development and Reform Commission published a joint announcement which stipulated that 100 administrative and public service charges would be uniformly abolished throughout the country with collection ceased from January 1, 2009. After a series of budget reforms, in March 2010, the Budgetary Affairs Commission of the NPC Standing Committee and the Ministry of Finance together with other departments concerned put forward proposed revisions to the Budget Law. The core of the revisions was to attain three goals: to enhance the integrity of budget preparation, regulate the execution of the budget, and improve the solemnity of budget supervision. To enhance the integrity of budget preparation, the proposal explicitly stated that all government revenues and expenditures should be included in the budget plan. If the new budget law can be formally put into effect,16 this will mean off-budget funds which have existed for a long time in China will become history.

Historical Evaluation of Off-Budget Funds In the press conference after the NPC and Chinese People’s Political Consultative Congress (CPPCC) of 2008, Chinese Premier Wen Jiabao pointed out, “The fiscal history of a country is astonishing. If you read it, what you will learn about will be not only economic development but also the social structure and the level of equity and justice.” In light of this, the anticipated legal abolition of the off-budget funds system which has lasted for over 60 years will indeed be a revolutionary event in the history of China’s public finance and budgeting. Throughout the history of the emergence and development of off-budget funds, it should be admitted that off-budget funds played a very active and undeniable role in China’s economic development. But along with the adjustments in the distribution relationship between the state and state-owned enterprises, the continuous expansion of government functions, and the growing contradictions

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between fiscal revenue and expenditure and between centralized taxation power and decentralized administrative power, the rapid growth of off-budget funds was accompanied by the exposure of more and more problems.

Historical achievements of off-budget funds From the perspective of the process of China’s economic development, off-budget funds were an inevitable result of decentralization reforms to move away from the highly centralized planned economic system, and they had exerted certain positive effects on the country. First, they helped solve the financial difficulties of central and local governments to a certain extent. For instance, in the early days of New China, to ensure the victory of the Korean War and lessen people’s burdens, government agencies, military units, schools, and administrative and public institutions conducted production activities and established “minor public treasuries.” As a prototype of off-budget funds, these minor public treasuries alleviated the financial difficulties of local governments and administrative and public institutions at a very early stage of New China. Moreover, before the launch of the tax sharing reform, the central government collected “energy and transportation funds” in the 1980s and “budget regulation funds” in 1989. Although these were extraordinary measures adopted for the purpose of maintaining the normal functioning of the central fiscal organ and they reflected a big problem in the fiscal relationship between central and local governments, off-budget funds did undeniably play an important role in raising funds for the central government. Second, off-budget funds aroused the incentive of local governments, governmental departments, enterprises, and public institutions, for their growth was much faster than that of budgetary funds. In fact, off-budget funds were an important source of economic vitality, which was especially obvious in the early stage of China’s economic reform after the launch of the Reform and Opening Up policy. This was equivalent to opening up possibilities for the progressive reform of the traditional economic system, which offered ample room for subsequent reforms in various other aspects, expanded the financial power of local governments, and aroused the enthusiasm of local governments in promoting financial management and developing the local economy. Stimulated by the principle of “more pay for more work done,” the economies of Guangdong, Zhejiang, and other coastal provinces were rapidly booming. Third, the permissible existence of off-budget funds provided a comparatively free and stable market financing environment for local governments, government departments, enterprises, and public institutions. This was beneficial for them to

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promote production, construction, and business development in a flexible way based on local conditions. For example, starting from 1954, the state allowed local governments to collect industrial and commercial surtaxes as local self-financed funds for the maintenance of urban public utilities, and permitted competent authorities to incorporate part of the miscellaneous revenue into off-budget funds under separate management to finance their own expenditure. It also demanded enterprises to set up incentive funds, welfare funds, and funds for major overhauls as enterprise special funds managed outside of the budget. Moreover, in July 1979, a pilot reform was launched to give more authority to enterprises; in January 1980, the system of profit retention for enterprises was promoted, allowing for the establishment of production development funds, employee welfare funds, and bonus funds; and in 1981, the systems of profit retention and full responsibility for profits and losses were implemented in multiple forms in state-owned industrial and transport enterprises and competent authorities based on their different situations. In 1983 and 1984, the central government conducted two reforms to substitute taxation for profit delivery in state-owned enterprises. In the first reform, it was stipulated that large and medium-sized state-owned enterprises which were profitable had to turn over an income tax equivalent to 55% of their realized profits. The after-tax profits of enterprises were to be divided between the state and the enterprises based on a ratio approved by the state. The profits retained by the enterprises should be used for developing production, improving employees’ collective benefits, and giving out bonuses. All these arrangements undoubtedly created space for the future development of local governments, government departments, enterprises, and public institutions. Fourth, off-budget funds relieved the pressure on government fiscal departments and solved the problem of overly centralized financial burdens, which enabled qualified public institutions to gradually implement enterprise-style management. Since 1980, government organs and public institutions had been asked to be responsible for any deficits or surpluses arising from completing their designated budgetary duties. Moreover, educational surcharges, vehicle purchase surcharges, and other administrative and public service charges were imposed. At the same time, public institutions were allowed to carry out diverse operations and paid services to increase their income. They were also encouraged to transform their financing method from being fully government funded to government-institution jointly funded and then to completely self-funded. For institutions which had comparatively steady revenue and expenditure, enterprise-style management was introduced. Fifth, the off-budget funds system basically guaranteed enough funds for the nation’s priority spending and ensured the normal operation of government

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agencies and various undertakings. Off-budget funds were earmarked for specific uses and managed under separate accounts, which facilitated the financing of key projects. For example, to ensure the regeneration of cutover lands, the state made plans for encouraging afforestation by state-run and collectively owned forestry companies, constantly expanded forest resources, and established a forestry cultivation funding system in accordance with the principle of preserving forestry resources by afforestation. During the First Five-Year Plan period (1953–1957), the central government made some provisions for forestry cultivation funds. In May 1972, the Ministry of Agriculture and Forestry and the Ministry of Finance officially released the Interim Measures for the Management of Forestry Funds, which clearly specified the scope of and standards for fund collection and the direction for fund use. In June 1980, the Trial Measures for the Establishment of School Funds and the Incentive System for Higher Education Institutions was promulgated. It stipulated that income from school-run factories, farms, and hotels should be retained by the schools for financing their own expenditure; income from the factories and farms built by primary and secondary schools during the educational reform should not be included in the budget and should be managed as off-budget funds for improving school conditions and the production conditions of school-run factories and farms, purchasing books, teaching apparatus, audio-visual education equipment, and hygienic facilities, and increasing the collective benefits and incentives for teachers, students, staff members and workers. These provisions played a vital role in making up for the deficiency in educational funds.

Drawbacks of off-budget funds The large amounts of off-budget funds, in fact, hindered the movement of the fiscal system from development-oriented finance towards public spending– oriented finance. Moreover, the fact that large amounts of funds lay outside fiscal management posed a massive impact on the healthy development of the national economy, leading to the imbalance of the national income distribution pattern and the disruption of the distribution order. This increased the difficulty of reform. Over time, the shortcomings of off-budget funds became increasingly prominent. First, off-budget funds further aggravated the problems of developmentoriented finance and “staff-based finance.” From the perspective of the structure of off-budget funds, off-budget funds became an important source of funding for local infrastructure construction and other types of development spending. Due to the absence of general scientific management principles and performance targets, some off-budget funds were invested in projects with quick returns yet short-term benefits. The phenomena of duplicative and blind development were

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very common, and they became major incentives for the expansion of fixed-asset investment and disturbed the normal order of the national economy. In 1998, the central government proposed the transition from development-oriented finance to public spending–oriented finance, yet the share of public spending did not rise but dropped. Taking 2005 as an example, the total government revenue was CNY3.16 trillion, the expenditure on economic construction was CNY931.7 billion, accounting for 29.4% of the fiscal revenue, and the expenditure on administrative costs was CNY651.23 billion, making up 20.58% of the fiscal revenue. Over the half of the government revenue was used to finance construction and administrative operations, and the expenditures on public undertakings and education only comprised 28.3% of the fiscal revenue.17 Moreover, many government departments implemented the separate management of revenue and expenditure reform on multiple charges and fines for their own benefits and put into place a reward system for excess collection of fees, thus forming a vicious circle of “collecting fees to sustain overstaffing.”18 Second, off-budget funds bred government waste and fiscal corruption. As offbudget funds were free from the supervision of the NPC, local governments could easily transfer budgetary resources outside the budget and directly allocate them to government departments at all levels without any kinds of fund management. In 1985, China launched the nationwide campaign of “finance and commodity price examination” in the hope of cleaning up the off-budget funds embezzled and intercepted by administrative organs, enterprises, and public institutions at various levels. By 1997, illegal funds worth CNY204.4 billion had been found out and CNY133.1 billion was turned in.19 It was apparent that due to the lack of effective constraint and management mechanisms, the use of off-budget funds gave rise to the double expansion of investment and consumption in China and violations of local governments. Consequently, off-budget funds became an important economic cause for all kinds of corruption. They broke the unity and integrity of the national budget, eroded the tax base, left a lot of governmental financial resources which should have been covered in the budget plan outside the budget, and shook the steady growth of governments’ endogenous financial resources. That was why some people ridiculed off-budget expenditure as a basket which hid all kinds of under-the-table expenditure from embezzlement and illegal expenses to spending on public receptions, vehicles and overseas trips (collectively known as “the three public consumptions”; san gong xiaofei 三公消費), and unofficial employee benefits and year-end bonuses. Third, off-budget funds increased regional financial differences and expanded the income gap. Government finance is supposed to have an income redistribution function that would narrow the financial differences between different social

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classes, sectors and regions. But off-budget funds exerted a negative impact on economic and social disparity and income inequity, disrupting the distribution relationships between central and local governments, between governments and enterprises, and between the state and individuals. Take the fiscal revenues of China’s local governments in 2004 as an example. In that year, local budgetary revenues totaled CNY1189.34 billion, and adding the CNY800 billion (estimated) of transferred payment from the central government, CNY432.33 billion of off-budget revenue, and CNY615.06 billion (estimated) of fiscal revenue from land, the total disposable income of local governments was CNY3,036.73 billion, 3.85 times of the expenditure of the central government and 22.19% of GDP. Among the disposable financial resources of local governments, off-budget funds and revenue from land took up 34.5%, which was not included in budget management. Moreover, the lower the administrative level of a government was, the more dependent it was on off-budget and land revenues. Therefore, we can see that when land income became the largest source of off-budget revenue for local governments, because rent was positively correlated to the regional economic development level, offbudget funds further expanded the regional inequity.20 In addition to that, from the perspective of distribution relationships, the expansion of off-budget funds broke the integrity of the national budget and lowered the fixed income of the central government by growing local government revenues. Fines, charges, and requested donations under numerous names added to the burdens of enterprises, upset the economic order, and harmed fair competition. Pegging off-budget revenue to offbudget expenditure crowded out budgetary revenue, and due to the difference in the profitability of different units, the imbalance in income distribution among different industries and government units was constantly aggravated.21 Fourth, off-budget funds dispersed the financial resources of governments, hid governments’ endogenous financial resources, aggravated financial difficulties, and weakened governments’ ability to coordinate and control the macroeconomy and social development. The direct consequence of the rapid growth of off-budget funds was the hiding of governments’ endogenous financial resources, which reduced budgetary revenue, eroded the tax base, and expedited the decline of the status of the formal fiscal system. It also created an undesirable alternative for the tax effort of local governments, increased the difficulties in building a sound tax revenue system, and dispersed financial resources. The decentralization of financial resources made it difficult for the state fiscal authority to raise enough funds to support the development of basic industries and the undertakings of science, education, culture and public health as well as impeded the growth of budgetary revenue and financial resources, weakened the adjustment capacity of the economic structure, hindered the implementation of national industrial policies, and harmed

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the coordinated development of the national economy. Besides that, huge sums of off-budget funds were at the arbitrary disposal of governments and administrative and public institutions of various levels, heavily subject to the influence of local interests and hence largely inefficient. At the same time, the decentralization of financial resources exacerbated the difficulty of balancing the fiscal budget, which resulted in consecutive years of budget deficits while surpluses were recorded for off-budget funds. This, to a certain extent, held back the development of the national economy as a whole and the progress of economic transformation. Fifth, the expansion of off-budget funds gave rise to runaway consumption of social groups. The feature of decentralized management and pursuit of shortterm returns typical of off-budget funds meant that the majority of the funds were diverted to consumption. The use of off-budget funds amplified the irrational consumption of social groups and individuals. The purchasing power of social groups was an important component of consumption funds. The overexpansion of this purchasing power would not only cause the excessive growth of consumption funds and increase fiscal burdens, but would also add to the difficulty for consumers to purchase commodities that fell short of supply in times of limited resources, damage the relationship between the government and the public, and act against ideological and ethical progress. According to the statistics from the National Bureau of Statistics of China, in the second half of 1984, due to the rapid expansion of off-budget funds, the group purchasing power of 1984 and 1985 increased by 26.5% and 26.3%, respectively, compared to the previous year. The growth rates were far higher than those of the gross industrial output value of the two years, which were 14% and 18%, respectively. This played a substantial role in the serious inflation and the failure of the market forces in the ensuing time.22

Theoretical Discovery of Off-Budget Funds In history, the creation of the public finance system overlapped with that of the budget system; it was the budget system that contributed to the development of public finance operations. Taxpayers supervise government checks and balances through a representative body, such that governments must prepare a budget for the approval of the representative body before putting it into practice. The representative body makes resolutions and executes oversight in the interests of taxpayers, which gives the government budget the political significance of reflecting the will of taxpayers. The budget system not only keeps tight control over fiscal activities but also makes the most effective tool for guiding, supervising, and criticizing all administrative activities. It relies on legal procedures to prevent government financial activities from deviating from the interests of taxpayers, and

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protects private property rights against infringement resulting from the expansion of government power. It should be said that the development and reform of the budget system are always closely related to the transformation of the fiscal system, and are even inseparable from the process of a country’s economic development. To look back at history, for China, even under the fusion of government functions and enterprise management as well as the centralized control over government revenues and expenditures, it was impossible for the state fiscal department to perform absolutely centralized fiscal management in handling its relationship with enterprises and public institutions. It had to not only allocate a certain amount of working capital to enterprises and public institutions, but also give them certain rights to use capital in order to arouse their incentive. Internationally speaking, the former Soviet Union and the Eastern European socialist countries which practiced a highly planned economy all had off-budget funds, which did not exist in Western market economies then. Thus it can be seen that off-budget funds are a product of the highly planned economy and the two often go together. The planned economy is the basis for the existence of off-budget funds. The growth and decline of off-budget funds thus reflect, to a certain extent, the progress of the reform of China’s economic system. Therefore, it is not wise to analyze the growth of off-budget funds in isolation. It will be much more realistic to dissect their changes in accordance with the economic environment on which they depended to survive and other related factors.

Olson’s dilemma and public choice theory Judging from the birth and development of off-budget funds, although they have played a very important role in China, the decentralized fiscal budget system appeared increasingly incompatible with the requirements of the socialist market economy. Therefore, it is a must to unify government budgeting. The budget can be regarded as a public product which cannot be provided by individuals. The reason for the inadequacy of the budget is the absence of selective incentives. That is to say, even though everyone realizes the necessity for public goods, the lack of extra benefits for the providers renders the supply of public goods not in place. James M. Olson elaborates on this phenomenon by stating that individuals often act out of their personal interests rather than collective, public interests, and rational and self-interested individuals will not act in the group interest.23 The “logic of collective action” revealed by Olson in fact explains the “dilemma of collective action,” which shall be called “Olson’s dilemma” here. The differences in supply under the selective incentive framework show that even

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in countries with identical demand for public goods the supply of the goods is probably different. Public choice theory believes that politicians in political markets usually act out of maximum self-interest, which leads to government failure. Although China has long recognized the irrationality of off-budget funds, the progress of reforming such a system has been slow, and this can be attributed to the lack of cooperation among local governments. In line with the rationality of economic man, local governments have worried about the loss of their own benefits after the correction of off-budget funds, while off-budget funds can create rent-seeking opportunities for local bureaucrats. Their worry comes from the fact that without constraints from the constitution and relevant laws, the central government, too, has the free rein to formulate and adjust fiscal policies and systems in its own interests. It was this self-regarding tendency that gave rise to a distrust of the central government’s promises on the part of local governments, which responded by opportunism as expressed in the transfer of budgetary revenues into off-budget ones. At the same time, the decentralization of power entitled local governments to the rights to obtain off-budget funds. In fact, to stimulate local economic growth and raise more funds for developing services, local officials inevitably resorted to off-budget funds.24 Logically, local bureaucrats and politicians would resist external attempts to correct off-budget funds. To the fundamental solution to this tension would be to implement selective incentives on local government in fulfilment of the rational economic man assumption, that is, to achieve unified budgeting under the premise of reasonable decentralization. In terms of the relationship between central and local governments, theoretically, a balance should be struck between centralization and decentralization according to the respective ratios between marginal costs and revenues in centralization and decentralization. Only when the marginal revenue of either centralization or decentralization equals their marginal cost can partial economic equilibrium be achieved. And only when partial equilibrium is realized under both centralization and decentralization, with their respective marginal revenues and marginal costs equalized, will the public equilibrium of centralization and decentralization be achieved. As centralization takes an active position in the relationship between centralization and decentralization, it is necessary to follow the principle of “decentralization sovereignty.”25 That is to say, priority should be given to the needs, choices, and values of decentralization, allowing the needs of decentralization to go before the needs of centralization and centralization to serve decentralization. Administrative and financial power should be divided between central and local governments in accordance with this principle. In view of this, to provide selective

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incentives for local governments to pursue the decentralization of power is an endogenous demand of the market economy.26 From the perspective of China’s centralized fiscal system, local governments play a dual role. On the one hand, they are tax collectors who impose taxes on the taxpayers (mainly state-owned enterprises and collectively owned enterprises) within their own jurisdiction. On the other hand, local governments are also taxpayers who have to turn a certain proportion of the taxes collected within their jurisdictions over to the central government. As tax collectors, local governments, like the central government, want to collect as much tax as possible while as taxpayers, they strive to expand the share of revenue they can retain in their own pocket. The central government tries to concentrate financial resources on undertakings that are vital to the national economy and people’s livelihoods, whereas local governments wish to optimize local benefits by reducing their contribution to the central fiscal department. This is the primary cause for the power struggle between central and local governments.27 Therefore, only by giving the most effective incentives to local governments can their worries about the regulation of off-budget funds be removed. Only through imposing effective supervision on local governments and improving the openness and transparency of local budgets while introducing the public choice mechanism to local fiscal systems can China walk out of Olson’s dilemma and truly regulate funds that have long fallen outside the government budget.

The reform of the economic system and the growth of off-budget funds The economic system reform launched in 1978 created possibilities for the release of productive forces and brought about the initial booming of the Chinese economy. As the development of urban and rural economies gradually strengthened China’s economic power, it also provided an economic basis for the growth of off-budget funds.

Reform of decentralization and tax reduction in the fiscal system The tax reform characterized by tax and profit concessions in the 1970s ushered in the era of Reforming and Opening Up. Since then, the own funds of enterprises had rapidly increased. In the traditional economic system, state-owned enterprises were appendages of governments. They had no autonomy in production and management but had to act according to government plans. However, with the continuous advance of the reform, enterprises were allowed to partially, and later

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totally retain the depreciation funds for simple reproduction, which had been totally turned over to the central government, so long as they acted as independent commodity producers. At the same time, the policy regarding after-tax profits evolved from an enterprise funds approach to profit retention (lirun liucheng 利潤 留成), profit retention after income tax, and then profit contract (lirun chengbao 利 潤承包),28 owing to which state-owned enterprises not only gained the financial capacity to give out employee bonuses and benefits, but also were equipped with a self-development ability. The state-owned enterprise reform was the main reason for the vigorous growth of budgetary funds, while the growth of off-budget funds was a result of the Reform and Opening Up policy and economic development. This, to a certain extent, reflected the path of changes of China’s economic system in different periods and manifested the characteristics of the coexistence of various economic sectors and the difference in the interests of different economic players at the primary stage of socialism. However, it is undeniable that the state’s practice of delegating greater power and transferring more profits to state-owned enterprises led to a constant decline of the proportion of budgetary revenue in total national revenue. Budgetary revenue could no longer satisfy governments’ needs to expand their functions, and the tension between state revenue and expenditure was exacerbated. Moreover, with the development of the economy, the functions of the government were also expanding, but some inappropriate functions, such as subsidizing large loss-making state enterprises and competent authorities’ direct intervention in enterprises, were not eliminated. Rugged relationships in income distribution and the expansion of government functions created too many demands for budgetary revenue and formed external pressure for the formation of large off-budget funds in the face of the slow growth and short supply of budgetary revenue. Moreover, this situation paved the way for the charging of service and nonservice fees and the establishment of earmarked funds.

Fiscal decentralization reform In 1994, China introduced the tax sharing system for fiscal decentralization. In 2003, the Decision of the Central Committee of the Communist Party of China on Some Issues Concerning the Improvement of the Socialist Market Economy further pointed out that under unified tax policies, the state would grant local governments an appropriate amount of tax administrative power. China, same as many other countries in the world, experienced gradual decentralization of fiscal power, but China’s fiscal reform showed a strong peculiarity, namely an incompatibility between the reform of the economic system and the reform of the government operation mechanism.

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The decentralization of power was widely implemented in China’s fiscal system while the government structure continued to maintain a typical centralized system with a top-down management approach where governments at the same level were granted the same amount of administrative power. The economic reform was carried out under the background of fiscal decentralization vis-à-vis overly concentrated government power, thus giving rise to the contradiction between the high vertical centralization and high horizontal decentralization of fiscal power.29 In the highly vertically centralized system of China, core leaders of local governments were appointed by governments at a higher level, and local governments only focused on the administrative orders from their superior governments but neglected the requirements of local residents. As transfer payments, such as revenues turned over to the central government or subsidies granted to local governments, in the budget were unbalanced and uneven, local governments no longer placed their hopes on the transfer payments of budgetary funds but relied on themselves to expand offbudget funds and nonregulated funds in order to fulfil their functions.30 Bird, Ebel and Wallich observe that in most transition economies, the rights and responsibilities of local governments were seriously unbalanced, and the central government shifted expenditure responsibilities onto subnational governments without giving them corresponding amounts of fiscal revenue as a guarantee.31 And it was exactly the way China’s fiscal system worked: the division of fiscal revenues was clear whereas the division of expenditure responsibilities was comparatively vague. Coinciding with the centralization of government power and the upward aggrandizement of fiscal power was the decentralization of administrative power. Entering the 1980s, the fiscal system as characterized by the division of revenues and expenditures between central and local governments broke up the connection between fiscal power and administrative power. This arrangement for the first time granted local governments some form of fiscal autonomy, but while hardening fiscal constraints, it in fact led to the localization of government responsibilities. Under the planned economy, local governments acting as agents of the central government used to provide public services and receive money from the central government through the revenue sharing system; however, after the 1980s, expenditure responsibilities were divorced from the revenue sharing system, and local governments became responsible for raising funds to provide public services. Although the tax sharing reform in 1994 adjusted the revenue distribution pattern, it failed to make changes to expenditure responsibilities, and the budget pressure on local governments was increasingly building up. The vague division of expenditure responsibilities resulted in the localization of expenditure responsibilities de facto, whose direct consequence was the financial difficulties faced by governments at the grassroots level.32 After entering the 1990s, local governments even assumed

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most of the country’s fiscal expenditure, shouldering around 70% of the national budgetary expenditure.

Summary Off-budget funds arose in response to the highly centralized planned economy. The soil of the planned economy had nurtured the growth of off-budget funds, and with the advance of China’s economic reform, off-budget funds continued to expand. While off-budget funds played an important role in history, many acute problems were exposed. Throughout the history of New China, although multiple reforms were introduced to tackle the issue of off-budget funds, it was hard to avoid the vicious circle of reduction, expansion, further reduction, and reexpansion. In many cases, off-budget funds not only did not decrease but increased. Undeniably, China’s reforms on off-budget funds also fell into the vicious circle of the “law of Huang Zongxi,”33 that is, following the pattern of tax reforms aiming to reduce farmers’ burdens ending up exacerbating their burdens. A small step in the budget system will mean a giant leap in political modernization. A truly competent government must be a government with a unified and transparent budget system. With the implementation of strict control and management over — and eventually elimination — off-budget funds, the further improvement of China’s socialist market economy, the separation of government administration and enterprise operations, the establishment of a standardized revenue mechanism, and the formation of a government allocation pattern, offbudget funds are completing its historical mission and will soon be totally phased out from the stage of history after a long process of development. But there is still a long way to go for the Chinese government to establish a unified and open budget system and there are still many challenges in front of China. China needs to not only reinforce budget supervision but also improve the centralization and unification of the budget system.

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Chapter

Overall Balance

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The Raising of the Concept of Overall Balance In the early days of New China, the government faced the challenge of economic restructuring. The eight-year War of Resistance against Japan and the three-year Civil War brought to China shortages of materials, market stagnation, fiscal deficits, and serious inflation. In response to the vision of socialist transformation, the Chinese government, in 1950, adopted various measures to combat economic difficulties in hopes of rapidly restoring production and fighting inflation. The specific measures included: advocating equal stress on resource conservation and production, issuing People’s Victory Parity Bonds, unifying economic and financial work, and implementing unified management of fiscal funds, material distribution, and cash. All these measures paved the way for quickly dampening inflation, and restoring and developing the national economy. The practice of unifying the management of fiscal and economic work made the builders of New China aware of the significance of the fiscal balance in the national economy, and the state leaders started to consider finance, credit, and materials as an interrelated whole in arrangements, which gave an initial shape to an “overall balance” (zonghe pingheng 綜合平衡) in finance and credit. As the operation of the Chinese economy got on track, Chinese economic theorists gradually put forward the idea of the balanced development of the national economy. Luo Zhongyan was a pioneer in this regard.1 As early as 1951, he proposed consciously striking a balance between agriculture and industry, between the production of capital goods and that of consumer goods, between the production and circulation of goods, and between accumulation and consumption. Ma Yinchu was the first to explicitly bring up the concept and theory of “overall balance.” In 1956, he proposed the theory of overall balance based on the assumption that everything is interrelated with each other (which he termed “tuan tuan zhuan” 團團轉, or “circulating”).2 According to Ma, all spheres of the national economy constitute an integrated whole, and in this process, the law of proportional development plays an important part. In 1957, Chen Yun summed up the experience and lessons learned in the fiscal and economic work in 1953 and 1956, and suggested that the scale of economic construction must comply with the national capacity.3 He also listed several prerequisites for maintaining economic stability. They were: (1) The government must bring a balance to both the fiscal budget and credit funds, or better still, a slight surplus; (2) materials should be distributed in a reasonable way, and the distribution of raw materials should first address the minimal requirement of the production sector for basic necessities and then the demand from the production of capital goods, while the rest should be

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invested in capital construction; (3) the rise of people’s purchasing power must agree with the supply of consumable goods and materials; (4) to balance the capital construction and financial capacity of the country, it is necessary to look at the figures of both the current year and the preceding and following years. At the same time, Chen also pointed out that as the agricultural economy took the lion’s share in China, agriculture had a large restrictive force on the scale of economic construction.4 Since then, the topic of overall balance in finance, credit, and materials has been widely studied in the theoretical field. This marked the entering of overall balance into the agenda of economic theory study as a topic of enormous practical and theoretical significance. Liang Wensen proposed three basic principles for achieving this overall balance.5 (1) The purchasing power of money created by fiscal expenditure and credit supply should be balanced with the supply of materials in aggregates. (2) Under the premise of the first principle, a balance in terms of composition between the same two areas should also be maintained. (3) The fiscal budget, credit funds, and material supply should be balanced among different regions. Ge Zhida went on to map out the relationships between three types of balances: the fiscal balance is the precondition for the material balance and the credit balance; the credit balance is an overall reflection of the fiscal balance and the credit balance; and the material balance is the basis of the fiscal balance and the credit balance.6 After the convening of the Third Plenary Session of the 11th Central Committee of the CPC in 1978, China’s economic work was fully restored and furthered. The study of overall balance among scholars continued to thrive. Huang Da published Introduction to the Overall Fiscal-Credit Balance in 1984, which established a comprehensive and systematic framework for the theoretical analysis of the “three balances” (san ping 三平; i.e., fiscal, credit, and material balances). This work pushed the study of the three balances to a new height and became a classic in this regard. Then, with the continuous expansion of external economic interaction, balance of payments (BoP) gradually became an important factor in economic stabilization, thereby taking on a vital role in the overall balance theory. In 1985, Chen Yun added the foreign exchange balance to his three balances theory to make it a theory of “four balances” (si ping 四平). Following that, the balance in foreign exchange payments was brought to the theoretical foreground. In 1994, Zhou Shengye wrote a book named Financial Operation under the Context of Opening Up to the Outside World to conduct an in-depth analysis on the influence of foreign exchange on the supply and demand of materials as well as money supply. This work has made an outstanding contribution to the development of balance theory.

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Economic Background for the Raising of the Overall Balance Theory In 1953, China started to implement its First Five-Year Plan, and since then, the country entered into a period of massive economic recovery and construction. Due to the lack of experience in economic construction, the scale of capital construction was found to be too large: In the presence of only a 21.3% growth in fiscal revenue over the preceding year, the budgetary expenditure for capital construction rose by 50.7%, with 60% of the newly increased revenue being invested in capital construction. To maintain a fiscal balance, the government had to supplement fiscal expenditure with surplus money from the preceding fiscal years. Since surplus funds were saved in banks and constituted a source of credit funds but the government failed to take into consideration the credit plan when making use of its surplus, a credit crunch was triggered, along with a decline in commercial inventories. Moreover, this also weakened the control of state-owned enterprises on the market and brought difficulties to the execution of the national economic plan. In view of this situation, the central government issued the urgent directive of “increasing production and income, practicing economy, reducing expenditure, and balancing the national budget” (zengjia shengchan, zengjia shouru, lixing jieyue, jinsuo zhichu, pingheng guojia yusuan 增加生產，增加收入，厲行節 約，緊縮支出，平衡國家預算). After much effort, the annual budget plan was in the end implemented with generally balanced revenue and expenditure, with a slight surplus of CNY274 million (Table 4.1). Previous surpluses were not touched, and fiscal savings in banks and commercial inventories increased. This incident brought about an increased realization of the connections between fiscal deposits, credit funds, and commercial inventories, while general understanding towards the overall fiscal-credit balance was further advanced. In 1956, capital construction was oversized, wages grew at an excessively fast speed, and agricultural loans rose too high. While formulating a high capital construction target, the government forgot to reduce the loan size, which generated a huge fiscal deficit of CNY1.83 billion (Table 4.1). In order to make up for the fiscal gap, apart from making use of the CNY1.01-trillion surplus from the previous year, the central government also drew on the CNY504 million left over at the end of the fiscal year 1945 which was saved in banks as reserves. Besides that, local governments also contributed CNY135 million from the circulating funds allocated by the central government in the preceding years. The remaining deficit of CNY180 million was solved by bank overdrafts. However, the use of the cumulative fiscal surplus from preceding years created a deficit in credit funds. Both means of

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Table 4.1

Fiscal revenue and expenditure between 1953 and 1963 (CNY100 million)

Year

Fiscal revenue

Fiscal expenditure

1953

222.86

220.12

Balance 2.74

1954

262.37

246.32

16.05

1955

272.03

269.29

2.74

1956

287.43

305.74

–18.31

1957

310.19

304.21

5.98

1958

387.60

409.40

–21.80

1959

487.12

552.86

–65.74

1960

572.29

654.14

–81.85

1961

356.06

367.02

–10.96

1962

313.55

305.25

8.30

1963

342.25

339.63

2.62

Source: General Planning Department of the Ministry of Finance, China Finance Statistics 1950–1991.

production and means of livelihood were in short supply, commercial inventories fell, the money in circulation exceeded regular demand, and market prices faced upward pressure. This experience brought the then decision-makers into full awareness of the inner connections between finance and credit. Starting from 1958, China embarked on the Great Leap Forward campaign. During those years, the size of the economy and overall balance were overlooked in economic construction, with blind pursuit of high speed and high targets. A large number of capital construction projects were carried out irrespective of the national financial and physical capacity. Overambitious targets in the budget plan resulted in high fiscal revenue and expenditure as well as large savings and loans at banks, which ultimately jeopardized the proportional balance of the national economy and led to a dramatic drop in economic benefits. This was reflected by a massive deficit in the budget: the fiscal deficit was CNY2.18 billion in 1958 but surged to CNY6.57 billion in 1959 (Table 4.1). Moreover, banks underwent credit inflation and a sharp rise in money supply. The amount of money in circulation in 1961 was 2.4 times more than that in 1957. Eventually, rising prices and tight supply of materials collectively gave rise to the longest period of severe inflation since the founding of New China. This economic setback provided a negative example of the significance of an overall balance in the sustainable and steady growth of the national economy. After the economic adjustments in 1960 and 1961, the macroeconomy took a turn for the better.

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But the outbreak of the Great Cultural Revolution in 1966 once again disrupted the development of the Chinese economy. During the ensuing decade, the national economy was seriously damaged. Under the guidance of “leftist” ideology, the theory of overall balance was criticized as erroneous and the pursuit of balance was blamed as leftist and too conservative. Due to the stagnation of production during this period, the fiscal revenue totaled CNY722.53 billion and the fiscal expenditure CNY724.42 billion, coming down to a deficit of CNY1.89 billion. This was a false balance in book values, for the country was in serious financial difficulties. Credit inflation and tight supply of materials coexisted, which were reflected in long-term suppressed inflation. Since the birth of New China, decision-making mistakes frequently appeared during economic construction, resulting in scarcity in materials, credit expansion, rising prices, and impeded economic development. It was against such a backdrop that the theory of overall balance was raised and gradually developed.

Main Content of the Overall Balance Theory Under China’s planned economic system, the theory of overall balance served as the theoretical guide for maintaining the smooth operation of the national economy and an important guideline for formulating and implementing various plans. It not only played an active part in macroeconomic decision-making, but also reflected the inevitability of economic activities. It has been considered a contribution made by Chinese scholars to financial theory. The expansion of the overall balance theory from three balances to four balances indicates a beginning integration of the influence of the international economy on the balanced development of the domestic economy into the analysis of macroeconomic equilibrium. However, it is widely believed among economic theorists that the three balances remain the cores and keys of the four balances.

Fiscal balance as key A fiscal balance requires that fiscal revenue be slightly larger than fiscal expenditure in a fiscal year. Among fiscal, credit, and material balances, the fiscal balance is considered to be the key. In the era of the planned economy, China practiced a highly centralized capital management system for a long time, and fiscal revenue took up an overwhelming proportion in the national income. Therefore, fiscal performance was of great significance to the capital circulation and money supply of the whole society. If a fiscal balance was achieved, no excessive money supply would be caused by fiscal deficits, hence a precondition for a credit balance. At

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the same time, a fiscal surplus, as a source of credit funds, would be beneficial to lessening the pressure to increase money supply as resulting from the expansion of credit. Under the system of unified management of bank funds, banks’ funding sources were narrow and sizes of deposits small. If demand for loans was larger than the pool of credit funds, banks would have to turn to the government, which would either draw on previous surpluses or allocate a sum of credit funds, for help. In this sense, to achieve a fiscal balance demanded that the fiscal authority consider not only fiscal performance, but also the balance in credit funds. That is to say, when banks were unable to strike a balance between the sources and uses of credit funds, a fiscal balance could only be maintained after an extra portion of funds was allocated to fill the credit balance deficit. Otherwise, despite the balancing of fiscal revenue and expenditure, the imbalance in credit funds would lead to an overall imbalance. In conclusion, a fiscal balance is the key in the three balances, and it exerts an influence on the national economy through affecting the three balances.

Credit balance as overall reflection As Zhou and Hou note, a credit imbalance is not a gap in book values between the sources and lending of credit funds, but the difference between the regular sources (i.e., excluding additional allocations) and lending of credit funds.7 A credit imbalance boils down to an imbalance between the supply and demand of materials. A credit balance is considered to be an “overall reflection” of the three balances. In those days, banks were merely a cashier of the fiscal authority with a very limited business scope. They were only responsible for making loans to state-owned enterprises to fulfil their provisional and seasonal demand for extra working capital. Moreover, since the government carried out unified management of fiscal funds, deposits in banks mainly came from fiscal savings and social idle funds that could be absorbed by banks were minimal. Therefore, if there was a gap between the sources and uses of credit funds which fiscal funds were unable to fill, the government would have to increase the money in circulation without a material basis, which would give rise to an imbalance between the supply and demand of materials. It is in this sense that a credit balance is an overall reflection of the fiscal and material balances. As a credit imbalance essentially means that the amount of money in circulation outstrips the value of materials available, the solution will be to cut down on excessive spending, and since expenditure by individuals and enterprises are usually made to meet either personal consumption demand or regular production demand, the problem has to be solved by reducing government spending. Thus, there was the saying, “Where a gap exists in credit funds, rescue is to come from fiscal funds.”8 Because bank funds must be balanced

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in the accounting books, unlike a fiscal balance, a credit balance cannot be observed from a difference in book values (which is nonexistent). In the particular period in history when people had little knowledge about the credit balance and even the balance between the supply and demand of money, the increase in cash supply was approximated as the key indicator for a credit imbalance; that is, credit difference = loans – deposits = cash issuance. In current understanding, however, this view seems problematic. The primary reason is that the issuance of additional cash cannot fully reflect the excessive or insufficient supply of money resulting from a credit imbalance. Because cash is only a component of money supply, a large increase in deposit money will not be reflected in cash supply. Moreover, an increase in cash supply does not necessarily mean that the additional amount is excessive, for economic growth also requires the issuance of more cash. A credit balance is in essence the pursuit of a theoretical balance between the supply and demand of money, just that during the period of the planned economy, the adjustment of money supply mainly hinged on direct regulation through consolidated credit plans, and the classification of money supply (into M0, M1, and M2) had not been developed,9 which was why the credit balance was studied instead of the money balance. In those days, the former was more observable and feasible to study.

Material balance as basis A material balance refers to the balance between the supply and demand of commodities, and it is considered the basis among the three balances. During the period of the planned economy, materials were mainly distributed in kind, and supply and demand were executed strictly in accordance with state plans. Under such a circumstance, as long as the quotas for material rations were obtained, it would not be difficult to acquire necessary funding, whether from fiscal appropriations or from bank loans. The fiscal budget and credit schemes of the central government were made largely based on such a material distribution plan. As long as the supply and demand of materials were balanced, there would be a sound basis for the fiscal and credit balances. According to Huang, at that time, a precondition for market equilibrium was to maintain necessary inventories in state-owned enterprises, while a premise for maintaining commercial inventories was to withdraw a portion of money supply from circulation in the form of fiscal savings.10 Material supply and demand in a broad sense should include the supply and demand of both means of consumption and means of production. But at that time, the means of production were not considered commodities; therefore the focus of the material balance was given to the balance in consumer goods and

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some agricultural capital goods. The supply of materials was mainly determined by production in agricultural, light, and heavy industries, while demand was represented by the current purchasing power formed by capital supply from the treasury and banks within a certain period of time. Hence, a material balance in discussion is equivalent to what is now understood as a balance between aggregate social supply and demand. This balance includes not only a balance in aggregates, but also a balance in structure and among different regions. But the balance in aggregates takes a dominant place.

Foreign exchange balance as supplement The policy of Reform and Opening Up greatly boosted the development of foreign trade, as a result of which foreign exchange payments increased by a big margin. External economic activities and the balance in foreign exchange payments began to have a direct bearing on the fiscal and credit balances as well as the operation of the entire national economy. Therefore, the impact of foreign exchange on the fiscal and credit balances must be taken into account and financial support had to be rendered to achieve an internal balance in foreign exchange. In 1985, the idea of foreign exchange balance was introduced into the analysis of macroeconomic equilibrium. The theory has it that due to the special impact of foreign exchange payments on supply and demand in the domestic market, foreign exchange can make a powerful economic lever for regulating the domestic macroeconomy, and thus plays an irreplaceable role in maintaining a balance between aggregate social supply and demand, compared to fiscal and credit funds. In view of this, the government must make overall arrangements for foreign exchange payments as well as imports and exports in order to avoid a massive favorable BoP and giant foreign reserves, and also prevent excessive exports regardless of domestic supply capacity, which would lead to a domestic imbalance between money and commodities. Apart from that, the government can also use part of its foreign reserves to import some goods to ease pressure in the domestic market when it is highly strained or when reform of the economic system or the price system demands a relatively relaxed environment. Moreover, as the financial activities in the respects of government finance, credit, and foreign exchange are carried out in the form of money, with the presence of commodity-money relations, these financial activities will reflect and bring about changes in the supply and demand of capital and consumer goods. Thus, it is necessary to balance the monetary incomes and expenditures of the fiscal budget, credit, and foreign exchange with the supply and demand of materials. Neither excessive money supply nor excessive material supply should be tolerated.

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Overall, the four balances imply a balance in two aspects: First is the overall quantitative balance in the fiscal budget, credit, foreign exchange, and materials; that is, the aggregate monetary purchasing power formed by fiscal, credit, and foreign exchange activities should be on a par with the aggregate supply of materials. Second is the overall structural balance in the fiscal budget, credit, foreign exchange, and materials, which means that monetary demand from capital and consumer goods during fiscal, credit, and foreign exchange activities must comply with the supply of the respective goods in kind.

Institutional Bases for the Realization of the Overall Balance in the Planned Economy Era The three balances theory was raised against the backdrop of a planned economy, where an inherent principle is centralized planning. That is to say, a unified plan was implemented across the whole country, and major financial and material resources were at the disposal of the state, with centralized management over fiscal revenues and expenditures, bank deposits and loans, and goods purchase and distribution. Under such a highly centralized economic management scheme, the government imposed direct control over the quantity and prices in economic activities rather than relied on the market mechanism with indirect government regulation. To understand how the overall balance was realized at that time, we have to first review some specific institutional arrangements and their economic significance under the planned economy.

Fiscal balance as key under “large treasury, small banking” It is said that the treasury and banks are the two moneybags of socialist countries.11 Under the planned management system of unified control over fiscal revenues and expenditures, the fiscal system played a dominant role while the financial system was supplementary. A major part of the national income was distributed through the national budget. Thus, a monetary balance was a prerequisite to realizing a material balance. Moreover, as the fiscal budget was the main channel for capital distribution, a credit balance depended on a fiscal balance. In this way, the fiscal balance occupied the key position, such that to achieve the overall fiscal, credit, and material balance, the government had to first realize a fiscal balance. Consequently, the central government gave priority to the fiscal balance in its macroeconomic regulation and control. As long as fiscal revenue and expenditure were balanced, the credit and material balances could basically be attained. As a result, the national

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economy would also be balanced in general, and money circulation would be stabilized. Table 4.2 reviews the historical share of fiscal revenue in national income, and it can be found that the revenue share between 1953 and 1978 averaged 34.3%, and the corresponding growth elasticity (fiscal revenue growth / national income growth) was 1.111. These figures indicate that fiscal revenue occupied the lion’s share in the national income and the growth of the former was faster than that of the latter. After 1979, however, with the progress of the reform of the economic system, the proportion of fiscal revenue in national income decreased year by year and reached 25.4% in 1982. The growth elasticity also declined over the years from above 1 to below 1, which implies that fiscal revenue grew slower than national income. In contrast, the share of bank deposits in national income surged to 12% in 1984 from 2.3% in 1978. Table 4.2

Year

Fiscal revenue share of national income and growth elasticity Ratio (%)

Elasticity*

Mean

Difference

Mean

Difference

1953–1978

34.3

—

1.111

—

1979–1982

27.3

–7.0

0.067

–1.044

1983–1988

25.1

–2.2

0.606

0.539

Source: Chen, Public Finance, 194. * Elasticity is the ratio of fiscal revenue growth to national income growth.

Zeng questions whether the credit balance deficit is always ultimately filled by fiscal funds.12 In recent years, the government has been running a budget deficit, so there is no money in the treasury to make up the credit balance deficit. On the contrary, the difference between fiscal revenue and expenditure has to be offset by bank credit. Apparently, the reform of the economic system has diversified market players and shaped the pattern of national income distribution in favor of the household sector, which significantly enhances the role of bank credit in the national economy, making it the main channel for raising and distributing funds. The system of “large treasury, small banking” has been gradually reversed to “small treasury, large banking,” changing the status and functions of the credit balance in the overall balance of the macroeconomy. Thus, the realization of the macroeconomic balance has been growing less dependent on the fiscal balance.

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Credit balance as overall reflection under unified banking and unitary indirect financing The gist of the credit balance is to purse the balance between the supply and demand of money. Under the modern market economy, there are many factors that will affect the monetary balance, and the realization of this balance requires moves from both the supply and demand sides. It is subject to not only the central bank but also the behaviors of commercial banks, enterprises, individuals, and other market players. In contrast, when China was under the traditional planned economic system, a multilayered financial market was not established and the market was short of diverse financing channels, investors, and financiers. Moreover, the banking system was under unified management with only one bank throughout the country: the PBC. Deposits and loans were managed in a centralized manner, and bank credits were the only capital source for enterprises in addition to fiscal appropriations. Accordingly, changes in the supply and demand of money were entirely reflected in the credit funds. As such, under the planned economy mechanism, the complex problem of monetary balance was simplified into one of credit balance. The supply and demand of credit would be affected by consolidated credit plans as well as the behaviors of the fiscal organs. These factors made the credit balance rather than the monetary balance an overall reflection of the three balances. However, with the continuous reform of the economic system, the diversification of financing subjects and methods, the market-oriented reform of the banking system, and the establishment of the central bank as an indirect regulation mechanism, concerns over the credit balance have gradually shifted towards the monetary balance.

Material balance on the premise of quantity control and price planning Through the above analysis, we know that the government’s management of capital flows under the planned economy primarily depended on the fiscal balance supplemented by the credit balance. As for material supply, it was managed through quality control and price planning. Since 1953, China implemented a planned economy where enterprises planned their sales based on production, and production plans as well as product prices were devised by the government. In the commercial sector, the government imposed the measure of “production according to state orders and centralized acquisition and marketing” (jiagong dinghuo, tonggou

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baoxiao 加工訂貨，統購包銷) for most industrial products while “centralized acquisition and distribution” (tonggou tongxiao 統購統銷) for agricultural products. Specifically, for the industrial sector, its products must be acquired by specialized agencies and producers were not allowed to sell their products to other dealers without permission. Those agencies would find a central market for the products but deals with resellers were not permitted. For the agricultural sector, in October 1953, the Chinese government adopted a policy of planned acquisition and supply of major agricultural products like grain. Later, this policy was expanded to cover cotton, gauze, and cooking oil. At that time, apart from implementing direct control over the quantity of industrial and agricultural products, the government also adjusted and balanced material supply via the means of price. Yet, since the introduction of the Reform and Opening Up policy, the material supply mechanism has gradually given way to a market circulation mechanism and planned prices have been replaced by market prices, along with changes in the management of industrial and agricultural products. The government no longer directly adjusts the supply and demand of materials; instead, it exerts its influence through indirect control over the market.

Theoretical Significance of the Overall Balance Theory The three balances theory reflects the exploration of the Chinese economic theoretical field on macroeconomic equilibrium, and it is applicable to the macroeconomic regulation and control in the era of the planned economy. Despite some historical limitations, the idea of macroeconomic balance as manifested by this theory remains a source of inspiration for research of the operation of the economy in both practical and theoretical aspects today. The relationships between different macroeconomic variables, such as that between the fiscal and banking systems, between money supply and demand and social supply and demand aggregates, and between foreign exchange and money supply, which are revealed in the three balances, and the extended four balances theory, are of profound theoretical significance. In view of this, Huang incisively points out that the word “balance” in the theory should be understood as coordination and adjustment in a dynamic process and “overall balance” with a focus on the interactions between all economic sectors and their surrounding environment and also the close connection between each sector. Balance and overall balance should be regarded as not only a method for observing an objective process but also the inner laws of the objective process itself. Under the market economy, overall balance should also provide a theoretical summary of the objective economic process.13

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Fiscal Balance: A pivotal factor affecting money supply The fiscal balance is believed to be the key among the three balances. Although this was related to the emphasis on the fiscal system as necessitated by the planned economy during that particular historical stage, the fiscal balance does still play an indispensable role in capital flows under a market economy. To examine the mechanism of money supply, it is inevitable to study fiscal revenue and expenditure. Whether a fiscal balance is achieved will exert a profound influence on money supply, so the theory of fiscal balance is of immense significance to the realization of balanced money supply and demand. Ma records former Minister of Finance Xiang Huaicheng’s view of the fiscal balance concept in his Interviews with the Ministers of the People’s Republic of China:14 Ma Guochuan: You have engaged in fiscal work for 50 years. Could you please summarize your views of fiscal management? … Xiang Huaicheng: Is a fiscal balance or imbalance more favorable [to the national economy]? Although at the moment no one applauds the fiscal imbalance, the country has recorded a deficit for decades. There is also theoretical evidence saying this is exactly what Western countries have been doing: has not the U.S. always run a fiscal deficit? But I think as far as fiscal management is concerned, we should insist on a balance. By insisting on a balance, it does not mean that a balance must be pursued every year. In the process of development, imbalances are allowed, and this is normal. But if we hold a fiscal mentality that heralds imbalances, thinking that the fiscal budget does not have to be balanced, it will be dangerous. Although Obama proposed a deficit of USD1,800 billion, he has designed measures to cut deficits within a few years. So for fiscal management, it is necessary to insist on the concept of balance. This is not to say an absolute balance, but a mentality in favor of the concept of balance, the development concept of an overall fiscal-credit balance. A fiscal balance is an ideal condition for achieving a monetary balance. Naturally, a fiscal balance should be maintained not just for the sake of the treasury but also the ultimate realization of market and monetary equilibrium, for seeking balanced and sustainable development in a dynamic environment. In the actual operation of the world economy, it is common to see fiscal deficits. In these cases, the different measures adopted by governments to make up for the differences will determine the extent to which deficits influence money supply. According

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to Sargent and Wallace, if the budget deficit is continuous, governments have no choice but to increase the supply of base money, which will bring about inflation.15 Haan and Zelhorst argue that in a fiscal policy–dominated regime, the monetary authority will finance deficits under the pressure of the government and money supply by the central bank is a function of fiscal policy; in developing and transition countries, as a result of underdeveloped financial markets, the dependence of the central bank, and imperfect taxation systems, governments are more inclined to finance deficits through creating more money.16 The research of Thoma indicates that even when the central bank enjoys enough independence, deficit spending can still have an effect on money supply through influencing economic growth, interest rates, and commodity prices.17 Turnovsky maintains that when there is a time lag in macroeconomic policy, due to the presence of unexpected inflation, a decrease in the real value of interest on debts will imply an increase in government income, giving the government the incentive to finance its budget deficit with seigniorage.18 Therefore, the coordination between fiscal and monetary policy is an important ingredient of realizing the monetary balance, and this has received a lot of attention from macroeconomic decision-makers.

Intrinsic link between the monetary balance and balanced aggregate social supply and demand The core idea of the three balances theory is to realize mutual adaptation and coordination between capital flows and material supply on the basis of the fiscalcredit balance. In theory, this is to balance money supply and demand with aggregate social supply and demand on a macroeconomic level. Based on the IS-LM model, Hicks built a theoretical framework to explain the interaction between the product market and the monetary market and their effect on the level of national income and the interest rate.19 Its purpose was to link the monetary economy and the physical economy together and to break the neoclassical dichotomy of the physical and monetary sides of the economy. This offered an important tool for modern macroeconomic analysis. Huang creatively presented a simple graph about the relationship between market supply and demand and money supply and demand (Fig. 4.1). He also gave the following conclusions: (1) Aggregate supply determines the demand for money, but the same amount of aggregate supply may create disproportionate levels of demand for money. (2) Money demand induces money supply, but the two are by no means of equal amounts. (3) Money supply becomes a vehicle of aggregate demand, and the amount of money supply may generate relatively large or small

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aggregate demand. (4) Large aggregate demand is likely to promote an increase in aggregate supply under certain circumstances, but the difference between the two will not be totally eliminated, and with small aggregate demand, aggregate supply will not be fully used. (5) The difference between aggregate supply and demand can be adjusted through contractionary or expansionary policy, but to simply control demand will not ensure equilibrium. The relationship between aggregate social supply and demand corresponds to that of the supply and demand of money in circulation, and in fact, money in circulation and bank reserves are constantly substituting for each other. This implies that the amount of bank reserves also has an impact on market equilibrium. Chinese scholars have revealed the relationship between capital flows and material flows in macroeconomic operation under the planned economic regime through the three balances theory. While the means of achieving a macroeconomic balance are not the same under different economic systems, the core ideas should be alike. Fig. 4.1

Relationship between market supply and demand and monetary supply and demand AS

AD

Md

Ms

Source: Huang, Economics of Money and Banking, 316. Note: Ms, Md, AS, and AD represent money supply, money demand, market supply, and market demand, respectively.

Significance of foreign exchange payments to internal equilibrium The theory of four balances emphasizes the significance of balancing foreign exchange receipts and disbursements. This is, undoubtedly, of a great help to the Chinese economy, which is constantly merging into world economic development, in its process to balanced development. For countries participating in economic globalization, their connections with external economies are of paramount importance to the operation of the domestic economy. The great impact is reflected in the fact that while economic globalization does provide an economy with many favorable conditions that will not exist under a closed environment, it also brings with it some shocks to domestic economic stability and development.

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The classic IS-LM framework originally developed to describe a closed economy has been expanded to tackle an open economy with the addition of two basic open variables: foreign trade (imports and exports) and international capital flows. Precisely, the BoP has been incorporated into the IS-LM model of a closed economy to form the IS-LM-BoP model under an open economy. By using this model and taking into account different exchange rate regimes, interest rate systems, and degrees of capital openness, we will be able to obtain corresponding macroeconomic policy options. The monetary theory of balance of payments stresses the changes brought about by a balance of payments deficit or surplus to the money stock. Those changes will have at least a short-term impact on economic behaviors.20 James Edward Meade overcame the limitations of solely focusing on the trade or current account in preceding research, and expanded the balance of payments theory to an overall balance that includes international capital movements.21 In addition to that, he also built a model between economic policy means and policy objectives by integrating Keynesian theory with neoclassical theory, with which he analyzed the policy mix for achieving both internal and external equilibrium and the issue of international economic cooperation. Among the policy mixes to attain internal and external equilibrium, Mundell’s proposal of fiscal and monetary policy mix and Swan’s combination of expenditure and exchange rate policies are the most influential. According to Mundell, as fiscal and monetary policies each have their comparative advantages in coordinating domestic and foreign equilibrium, governments should use fiscal policy to regulate internal equilibrium while monetary policy to attain external equilibrium.22 Swan demonstrates how expenditure-switching and -reducing polices can be used to achieve simultaneous internal and external equilibrium.23 He believes that expenditure reducing policy can effectively affect the level of domestic spending, and changes in real exchange rates will significantly influence the balance of payments. Therefore, Swan advocates the use of expenditure-reducing policy to achieve domestic equilibrium and expenditure-switching policy to realize external equilibrium. The theoretical analyses and policy suggestions of Mundell and Swan offer an important reference to the selection of macroeconomic regulation models under an open economy. With the furthering of economic globalization and the improvement of economic openness in China, changes in economic conditions, transfers of international economic fluctuations, and speculative shocks of hot money are likely to create a conflict between internal and external equilibrium. A macroeconomic regulation model which solely focuses on domestic macroeconomic equilibrium will be exposed to shocks from ways of economic operation under the open economic environment. Governments’ efforts on macroeconomic regulation should not only

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be devoted to realizing domestic economic equilibrium and stability, but also take into account the need of striving for external equilibrium. This is also an important insight gleaned from the overall balance theory.

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Chapter

Polyandry

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Definition In the economic history of China, “polyandry” (yi nü er jia 一女二嫁) is used to describe the duplicate application of the fiscal surplus from the previous year to both fiscal expenditure and bank credit of the current year occurring in the 1950s. The proposal of this term intended to point out the irrationality of such a practice, implying that the fiscal surplus from the previous year could not be used anymore by the government under normal circumstances because it had been lent out by banks to other purposes. Otherwise it would be similar to marrying a girl twice to two different men, which is unacceptable. Later, the practices of lending a sum of money twice to two different borrowers by banks or “granting real loans on fictitious deposits” (xu cun shi dai 虛存實貸) — that is, where the deposits had no material basis in commodities — were also labelled as “polyandry.”1

Background In the early days of New China, due to the lack of experience in fiscal and economic work, the Chinese government fumbled its way in practice. During the period of national economic recovery, it was a common practice for the fiscal surplus from the previous year to be listed in the budget of the current year. At the beginning, as the budget preparation skills of the fiscal authority were low and the estimates for economic development were not accurate, revenue and expenditure were both underestimated. But as the government could usually manage to end the fiscal year with a surplus, no problem occurred. And after three years of constant efforts, by the end of 1952, the Chinese fiscal and economic situations had fundamentally turned for the better and the national economy had been fully recovered. Especially in 1952, the agriculture industry reaped a bountiful harvest and the grain output hit an all-time high. Benefiting from this, fiscal revenue exceeded fiscal expenditure with a surplus of CNY773 million and a cumulative surplus of CNY3 billion. Starting from 1953, China entered the period of the First Five-Year Plan. As China’s economic and financial conditions fundamentally picked up, rash ambition started to soar in the government, causing it to eagerly expand the budget. At the same time, due to the lack of experience, the Ministry of Finance included the fiscal surplus from the preceding fiscal year that had been earmarked as credit funds into the budgetary revenue of 1953, for the use of offsetting the expenditure of the current year. As a result, the budgetary expenditure was enlarged, so was the budget size. At that time, only the Soviet expert Kutuzov (who was later appointed Deputy Minister of Finance of the Soviet Union) had warned the Chinese fiscal

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authority against the employment of the fiscal surplus from the preceding year. Worse still, in ignorance of the potential harm of diverting the fiscal surplus to other uses and assured by its own past experience, the Chinese fiscal authority did not take the expert’s advice.2 In that year, the gross output of industry and agriculture grew by 21.3% while the budget for capital construction rose 50% from a year earlier, which resulted in an imbalance between production and demand and created a tension in the supply of the means of production and livelihood. As Song remarks, “during the implementation of the budget plan, a deficit was reported in January, and in July 1953, the cumulative fiscal deficit amounted to CNY1.07 billion. After a fiscal deficit appeared, the fiscal surplus of the previous year was dipped into and withdrawn from the deposits with the bank. This tightened credit funds, so banks had to rein in loans to the business sector, which forced the business sector to reduce inventory and thereby caused difficulty in commodity circulation.”3 Song further describes, “the business sector in different regions started to downsize inventories and cut down acquisition costs in order to squeeze money out to repay bank loans. This was the so-called ‘commercial runs,’ which caused an artificial tension in the market for some time.”4 The fiscal deficit, the bank credit gap, and the reduced inventory of the business sector impeded the normal operation of the national economy. Such was the small “rash advance” (xiao maojin 小冒進) at the start of the First Five-Year Plan period.5 In response to the emerging problems, in August 1953, the Central Committee of the CPC issued an Urgent Circular Regarding Increasing Production, Rising Income, Practicing Economy, Curtailing Expenditure, and Balancing the National Budget, and took effective measures to address the problems. Thanks to these efforts, by the end of 1953, not only did the fiscal surplus of CNY3 billion from the previous year remain unused, but the fiscal revenue was also slightly larger than the expenditure. This played an active role in replenishing the credit funds of banks, consolidating confidence in the currency, and stabilizing market prices. From 1954 onward, the new item of “additional allocation of credit funds to banks” was listed in the national budget plan. This showed that while deposits fell short of loans in banks, the government’s support for bank credits had been transformed from being unconscious and unplanned to being conscious and planned.6 Can fiscal surpluses be diverted to other uses? This was a new question at that time. After some analysis, China’s fiscal authority soon learned that fiscal surpluses as treasury deposits saved in the state bank, whose credit operations had been transformed from supporting government expenditure to helping the state sector, especially state-operated commerce, were used as a source of credit funds by the state bank. In other words, these treasury savings had already been lent out to the

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business sector as working capital. Metaphorically speaking, the “daughter” had been married off. So if the fiscal authority intended to divert the same source of money to capital construction, it would be like marrying the same “daughter” twice to two different men; hence the error of “polyandry,” as it was often called, in 1953. Certainly, if material inventory was in excessive supply, fiscal surpluses might be moderately used, but at that time, such a premise did not exist.7 Wang comments that in those years, credit funds faced an acute shortage and own funds of banks were tight; therefore, the expansion of credit funds had to rely on the growth of fiscal deposits, including fiscal surpluses, in addition to absorbing deposits from industrial and commercial enterprises and savings of urban and rural households as well as necessary issuance of banknotes. Any employment of fiscal surpluses from the previous year by the government finance department, however, would definitely disturb the bank credit balance and force banks to call in loans made to industrial and commercial firms if not increase money supply. In Wang’s words, The fiscal surplus of CNY3 billion from the preceding fiscal year was 3.5 times that of the total savings deposits of banks and one seventh of the fiscal revenue in 1953. Once this was withdrawn, it would seriously impact the balance of bank credit funds and material supply, thus disrupting the normal operation of the entire national economy. Moreover, the fiscal surplus from the preceding year also included the investment for overdue construction projects and expenditures spanning over more than one fiscal year approved by the state, such as relief funds for natural disasters, funds for resident relocation from reservoir regions, and subsidies for flood control and small irritation projects. Such money had been designated for specific purposes and thus could not be transferred to other uses.8 The article “Li Xiannian’s Initial Management of New China Finances” gives us a brief account of the situation at that time.9 In 1953, problems brought by the employment of the fiscal surplus came to the attention of the central government. On September 8, 1953, Chen Yun, a member of the State Planning Commission, pointed out that the fiscal surplus from the previous year as listed in the budget revenues was a false figure, and if it was listed, additional expenditure for credit funds should also be included. Chen believed the inclusion of the fiscal surplus from the previous year in the current budget revenue was a mistake in budgeting.10 However, although Chen raised opposition to the practice, the problem was not solved completely. The divergence and dispute over whether the fiscal surplus from the preceding year could be listed in the budget plan of the following year still existed. At that time, there were two different views. Some, especially the local

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fiscal officials, reasoned that since the money belonged to the treasuries, there was no reason that it could not be used by the fiscal authorities. Others maintained that because the money from the fiscal surplus had been loaned out after being saved in banks, if the government insisted on spending the surplus, banks would suffer from a capital shortage, which would bring about serious ramifications. In the face such a controversy, Li Xiannian, the then Minister of Finance, organized the No. 5 Office of the State Council [i.e., the Office of Finance, Money and Commerce], the Ministry of Finance, and the People’s Bank of China to conduct a special research study on this issue. He also invited Soviet experts to introduce their experience in the prohibition against using the fiscal surplus. Having listened to both sides of the argument carefully and after serious consideration, Li decided that the latter opinion against dipping into the fiscal surplus was more reasonable, because the fiscal authorities and banks were using the same pool of money in implementing fiscal budget and credit plans, which phenomenon was later called “polyandry.” Back then, fiscal surpluses as savings in banks had been loaned out in the form of credit funds to commercial, foreign trade, industrial sectors to replenish their working capital, and most of the money had been turned into inventory in the forms of goods, grain, and commodities. If the fiscal authorities also had to use the same pool of money, banks would have to withdraw those loans, which would in effect necessitate additional working capital injections in the affected sectors, lest inventory and commodity supply should suffer. But augmenting the working capital, whether through expanding fiscal expenditure via deficit spending or issuing more money to compensate credit funds, would surely have an impact on market prices. In view of this, Li emphasized: The credit plan and the fiscal budget are two different forms of capital allocation by the state. While considering the fiscal balance, the balances of credit and cash must also be maintained to ensure the close coordination between the two areas. Therefore, if the fiscal surplus from the previous year is to be used, there must be an equal amount of credit funds or working capital for compensation, which will be equivalent to increasing the expenditure of the current year. This is meaningless. That is to say, using the fiscal surplus from the preceding year to solve the expenditure of the current year is out of the question.11 Li stressed once again that the fiscal surplus from the previous year must not be listed in the budgetary revenue of the current year during the meeting of the branch bank governors of People’s Bank of China in August 1954 and the provincial fiscal head meeting in October of the same year. From then on, fiscal surpluses must

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be treated as fiscal reserves, and while local governments were allowed to make use of part of the money, the size should be under strict control. In addition, fiscal surpluses from the preceding year could not be used until July of the following year, and the capital use plan must be turned over to the State Development Planning Commission and the Ministry of Finance for approval. Li pointed out: “What we can learn from the National Fiscal and Economic Conference of 1953 is that we must maintain a balance whether in fiscal budgets, credit plans, or cash plans. This year, fiscal revenue and expenditure have been balanced and considerably robust. The credit plan for the latter half of the year is also in balance.”12 He added that the balance of the cash plan should also be ensured as its imbalance would in turn disturb the fiscal budget balance and price stability,13 and proposed that portions of the fiscal surplus be allocated to increase the working capital of commercial and industrial businesses as well as banks’ credit funds. Later, under Li’s leadership, a system of solving the credit balance deficit with state budgetary funds was established, and the proposal of the state finance granting 30% of the working capital of state-owned enterprises as own capital was reported to Premier Zhou Enlai for approval. This proposal played a very important role in ensuring the capital turnover for normal operations in enterprises.14 Despite this, the controversy over the use of the fiscal surplus continued to exist, and this brought about another rash advance in China’s economic development in 1956. As the fiscal and economic situations went well in the first three years of the First Five-Year Plan, adventurism emerged in economic construction again, resulting in excessively rapid growth in the capital construction scale, total wages of workers and staff, and agricultural loans, which were then known as the “threepronged development” (san guan qi xia 三管齊下) strategy. The consequences were excesses in all three areas. First, the scale of capital construction was too large. Capital investments were on the rise, with the total amount rising 57.7% from a year earlier with around CNY1.5 billion more investments, accounting for 45.7% of the budgetary expenditure of that year. As the expansion speed of capital construction exceeded that of fiscal revenue, fiscal strains resulted. At the same time, the investment in capital construction grew faster than the means of production, leading to a short supply of the means of production, especially building materials and machinery. Many construction projects faced stagnation and benefits decreased. Also, the shortfall in steel supply compressed the production of the light industry, affecting the supply of consumer goods in the market. Second, wages of staff and workers grew too high. It was planned that a workforce of 840,000 would be absorbed into the labor market, but it turned out that as many as 5.51 million persons were employed. This, together with pay raises

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resulting from promotion, pushed the total wages up 37% from a year earlier. In the same year, the means of consumption saw a year-on-year growth of 20%, which was impressive but still behind the demand. Third, agricultural loans increased at an excessively fast rate. The budgetary loans for the agricultural industry were CNY1.12 billion, but the actual amount reached CNY2.03 billion, more than doubling the original plan. The loans to the handicraft industry and joint state-private enterprises also went far beyond the plan. The gap between the supply and demand of credit funds had to be solved by additional money issuance. By the end of 1956, the amount of money in circulation had risen by CNY1.69 billion over the previous year. With the above situations, in 1956, a massive fiscal deficit of CNY 1.83 billion appeared for the first time since the founding of New China. To make up for this deficit, the central government not only used CNY1.01 billion from the cumulative fiscal surplus but also ran up a bank overdraft and drew on budgetary circulating funds from local governments. This forced the central bank to increase money supply, which triggered market price fluctuations. These situations arouse the attention of central government leaders such as Zhou Enlai and Chen Yun, and after summing up the experience and lessons learned, Li Xiannian pointed out that to eradicate the deficit, the government must pull out all the stops to reduce fiscal expenditure.15 In the state conference convened on June 5, 1956, proposals for curbing impetuosity and rash advances, amending the national economic plan of 1956, and cutting investments in capital construction were put forward.

The Impact of “Polyandry” and Theoretical Conclusions In his reflections of his work with Chen Yen, Rong Zihe, the then Deputy Minister of Finance, recalled that after the fiscal surplus from the previous year was included in the current budget revenue, problems began to manifest themselves in the second quarter of 1956, and he reported this situation to Chen. On hearing Rong’s report, Chen questioned him in fury, “Why did you not listen to and carefully study the opinions of the Soviet experts?”16 After the summer finance conference of the same year, the Central Committee of the CPC issued the Urgent Circular Regarding Increasing Production, Rising Income, Practicing Economy, Curtailing Expenditure, and the Balancing National Budget, and adopted effective measures to solve the problem. Rong continued in his essay: Through this incident, I would never forget the teachings of Comrade Chen Yun. More importantly, apart from understanding this issue, my insights on

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fiscal work and its relationship with other aspects of economic work were also deepened, and I had a preliminary grasp of the need of an “overall balance.” Unfortunately, not everyone had understood this issue back then. At that time, most comrades were used to the practices of days of the Revolutionary Base Area and were subject to ideological constraints. They talked about government finances and banking separately in most cases and lacked the idea of an “overall balance.” Not until 1956 when a rash advance appeared again in China and Comrade Chen Yun put forward the idea of “three major balances” did people truly understand this issue.”17 Li summarizes the origin and development of the theory of the three balances:18 Based on the experience from the “rash advance” and “anti-rash advance” in 1956, Chen Yun delivered a report about the problems in fiscal and economic work in the meeting of the Party secretaries of provinces, municipalities, and autonomous regions on January 18, 1957. Chen came up with the principle that the scale of construction must comply with the country’s financial and material resources, adding that if the economic construction scale exceeded the national strength, it should be counted as a rash advance; and if the two agreed with each other, the economy would be stable. It was in this speech that Chen proposed the idea of maintaining balances in government finances, credit, and materials, and stressed the use of these “three balances” to evade the risks of the economic construction scale exceeding the national strength. According to Li, owing to the experience with the “rash advance” and the “antirash advance” during this period and Chen Yun’s advocacy, the theory of the three balances started to be accepted by the majority and taken seriously by economic scholars and professionals.19 Vice Premier Li Xiannian, who was in charge of national fiscal and trade work, gave a thorough explanation: What is the major lesson from the fiscal and financial work in 1956? According to our experience, that government finances, credit, and materials must be coordinated and balanced. Here, the balance in the supply and demand of goods and materials is the basis of the overall balance, and the fiscal balance the key. This is because both government finances and credit will eventually boil down to the availability of materials, and contradictions will eventually come down to whether the supply and demand of materials can be balanced. In our country, fiscal revenues, whether taxes or profits, are based on the production and circulation of materials, and every cent of the fiscal revenue represents a certain amount of materials. Social production is arranged mainly according to the state plan, and the majority of aggregate

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social products will be distributed through fiscal appropriations and bank credit. Therefore, as long as expenditures are arranged within the scope of regular revenues with neither fiscal deficits nor bank overdrafts, a balance in credit funds can basically be maintained. If government finances and credit are balanced, a balance between the supply and demand of materials can also be generally achieved. Prior to 1955, as fiscal revenue exceeded fiscal expenditure, we did not feel the tension in material supply. But in 1956, when a fiscal deficit appeared and money supply was increased considerably, there was a general short supply of materials. A fiscal imbalance will definitely give rise to market strains. We had talked about this a lot in the past, but only after 1956 did we gain a deep understanding of the truth. To ensure the coordination and balance in all three aspects — fiscal, credit, and material — is a rule that must be followed in the construction of the socialist economy. The questions as to how much revenue we gain, where our expenditures go to, and what the purposes of the spending are have to be decided within permissible conditions rather than based on wishful thinking. Moreover, under the law of supply and demand, we also cannot allow spontaneous price fluctuations and production adjustments for the purpose of automatically balancing themselves. Therefore, state plans and national budgets must make allowance for the balance in all three aspects (fiscal, credit, and material) to conform to the objective rules.”20 Obviously, Li Xiannian had completely accepted the idea of the three balances proposed by Chen Yun, and was guiding national fiscal and trade work according to this idea.21 Liu summarizes the essence of the overall balance theory:22 An overall balance in the national economy targets overall monetary income and expenditure, and to achieve an overall balance is to achieve a balance in currency circulation. In real economic life, monetary income and expenditure are at the same time currency circulation; thus monetary income and expenditure as a whole is equivalent to currency circulation in its entirety, and the objective of an overall balance is to ensure the normal circulation of currency. Marx’s theory of commodity circulation suggests that currency circulation is achieved through commodity circulation, by which it is determined and which it serves. The demand for currency in the national economy is determined by the demand for commodity circulation. Whether currency circulation functions normally is in the first place dependent on whether money supply meets the demand for commodity circulation. When money supply outstrips commodity demand, it will give rise to a short supply; but if the opposite is true, an oversupply will occur. This indicates that it is commodities rather than

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the currency itself that are used to test whether currency circulation is normal. From the perspective of fiscal and credit receipts and disbursements, fiscal and credit monetary income represents a certain amount of materials, while their expenditure will ultimately form social purchasing power. Therefore, the overall balance will boil down to the balance between the supply and demand of materials, and the balanced supply and demand of materials is a basic sign of an overall balance. Understandably, the core of an overall balance is a balance between the supply and demand of materials. Official Li Chengrui expressed in a 1991 essay that the 40-year experience since the founding of New China had repeatedly proven the correctness of Chen Yun’s theory on the balance of government finances, credit, foreign exchange, and materials. He termed this overall balance “one of the sharp ideological weapons” which ensured the sustainable, stable, and coordinated development of the national economy, and which played an important guiding role in several key periods of socialist construction. He pinpointed the application of the theory of the three balances in correcting the rash advance of 1956, through the campaign of expanding production and practicing economy, the reduction of investment in capital construction, and the suppression of the growth in social purchasing power. Observing that in 1957 fiscal revenue and expenditure were basically balanced with a slight surplus, banks’ credit plan was well implemented with the recovery of a considerable amount of circulating currency, and fiscal funds, credit funds, and materials were all allocated in conformity with reality, he concluded that the “three balances” were effective in eliminating the problems of tight supply and unstable prices. Production efficiency and economic benefits were improved remarkably. The year of 1957 became one of the years with the best economic indicators since the birth of New China. China’s First Five-Year Plan was successfully accomplished in 1957.23 Li Chengrui believed that the overall balance theory had undergone three tests at the time of his writing.24 It was first put to test during the Great Leap Forward and subsequent economic adjustment periods, and it proved to be efficacious in pushing forward the restructuring and upturn of the national economy in the first half of the 1960s. In January 1961, the central government officially implemented the principle of “adjustment, consolidation, replenishment and improvement,”25 which signified the transition from the Great Leap Forward to economic adjustment. During the period of economic adjustment, the government applied a series of theories formulated by Chen Yun, including the idea that economic construction must comply with the national strength and the theory of the three balances. The overall balance theory met the second challenge during the Great Cultural Revolution and following economic adjustment periods, but it played a

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powerful directive role in the course of adjustment and development. After the Third Plenary Session of the 11th Central Committee of the CPC, the government proposed the principle of “adjustment, reform, rectification, and improvement” in 1979 and revamped the economy based on the target of “two balances and one stability” (fiscal and credit balances and price stability).26 In 1982, it was stated in documents of the 12th National Congress of the CPC that the tasks of realizing the fundamental recovery of the fiscal and economic situations within five years were to significantly improve economic efficiency and to guarantee the basic balances in fiscal and credit funds as well as the basic stability of commodity prices. The concept of “two balances and one stability” was an embodiment of the overall fiscal, credit, and material balance theory. Under sweeping reforms and the efforts of opening up to the outside world, Chen’s three balances theory went through the third acid test, from the years of economic overheating between the latter half of 1984 and 1988 to the subsequent period of “rectification, improvement, and deepening reform” (zhili zhengdun, shenhua gaige 治理整頓，深化改革), and its role was reasserted by the CPC Central Committee. The theory put the national economy back on the track of sustainable, steady, and coordinated development. On March 23, 1991, Li Peng, on behalf of the State Council, delivered a report at the Fourth Meeting of the Seventh National People’s Congress, where he pointed out: “In the following decade, we should maintain the sustainable, steady, coordinated development of the national economy and avoid large economic turbulence. The top priority remains keeping the economic aggregates in balance, especially the respective balances in government finances, credit, foreign exchange, and materials, and an overall balance between them.” It can be seen from the Outlines of the Ten-Year Program and the Eighth Five-Year Plan passed in the Third and Fifth Plenary Sessions of the 13th CPC Central Committee and the Fourth Session of the Seventh National People’s Congress that the overall balance theory and related measures put forward by Chen in accordance with domestic conditions and national capacity continued to be regarded as the guideline. This proved that the theory was applicable to not only a society under a highly centralized planned system, but also to the new situations after the implementation of the Reform and Opening Up policy. Under the new situations, the shares of fiscal, credit and foreign exchange funds have been altered in distribution, the ratio between budgetary funds and extrabudgetary funds has been changed, and the planning method and economic operation mechanism have also undergone some changes. The specific applications of the four balances (adding the balance in foreign exchange) theory have also varied accordingly, but the basic principles have remained effective in guiding the current and future

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development of the national economy. It was noted in the documents of the 13th National Party Congress: To achieve stable development on the basis of increasing the efficiency of the national economy, we must strive to maintain a general balance between aggregate social demand and supply. The key to this task is to properly control the total volume of social fixed asset investment to make it agree with the national capacity, and reasonably manage the growth of daily consumption to make it compatible with the development of production. It is also necessary to reinforce and improve the overall balance of the national economy and maintain the respective balances in government finances, credit, foreign exchange, and materials, and a general balance between them. According to Li Chengrui, the overall balance theory is of great significance in the following aspects:27 1. The overall balance theory tackles the main contradiction in the proportional relationships of the national economy: the contradiction between aggregate supply and aggregate demand. In the sustainable, stable, and coordinated development of the national economy, coordination is the core. Only when demand and supply reach a balance in aggregates and composition can economic development become stable and sustainable. Economic restructuring should be premised on the general balance between aggregate supply and demand. As Chen repeatedly emphasized, development is at its fastest pace when it proceeds in proportion. 2. The theory also tackles the gist of the abovementioned contradiction. While the growth of production is infinite in the entire course of human development, for a particular stage in history, the development of production and the materials supplied by production are always finite. During China’s socialist construction when people were eager to get rid of economic backwardness, there was a lack of constraints on demand expansion in the economic mechanism. Consequently, the pursuit of quick results and overstretched economic construction became the most important facet of the supply-demand contradiction, as opposed to the problems of conservative thinking and underdevelopment. So the focus should be to search for effective restrictive measures to prevent investment and consumer demand from exceeding the national strength, that is, the country’s capacity for production and supply. The four balances theory provided the ground for measures to hold back hasty development.

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3. The theory helps contain demand expansion. The demand as discussed here refers to effective demand backed up by an ability to pay in the form of money. The capital held at the treasuries and banks does not constitute the majority of aggregate social supply, that is, aggregate final goods in society, but it does make up a large proportion of the net income created by the whole society, which gives it a decisive role in affecting demand. More importantly, only fiscal authorities and banks — through deficit spending and credit expansion — are able to create effective demand that is larger than the supply of materials. If the fiscal-credit balance is achieved and excessive money issuance is firmly prohibited, it will be possible to strike a balance between aggregate effective demand and aggregate material supply. In this sense, the fiscal authority and the central bank play a decisive role in balancing aggregate demand and supply. 4. The overall balance theory works closely with a series of other economic theories as prerequisites for each other. The overall balance in government finances, credit, foreign exchange, and materials works mainly in the field of distribution. In spite of its principal and decisive role in balancing between supply and demand, the overall balance is after all just one aspect of national economic operation, and if the whole economy is viewed as containing two parts, namely a material (physical and real) part and a monetary part, the four balances will all fall on the monetary side. The realization of the overall balance is inseparable from coordination with other policies, including other distribution means such as price policy, wage policy, and corporate profit distribution policy; overall national economic planning including the overall fiscal plan; industrial policies and optimized resource allocation; and reforms and economic management systems. Following the “sharp weapon” metaphor, the overall balance is best used in conjunction with other kinds of weapons. 5. The overall balance theory was born out of and has evolved along with the deepening of practical experience. Contrary to the comment that it was a product of the “product economy,” this theory was formed on the premise that the movement of money and materials are both interrelated and independent, that is, based on the existence of the commodity economy. It originated in the 1950s when the five economic sectors coexisted, and although China implemented a highly centralized planned system later on, the commodity economy still existed (despite its limited scale). This explained the practical significance of the theory during, for example, the economic adjustment in the early 1960s. Hence, its influence was certainly expanded during and after the formation of the planned commodity economy. It was true that new

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questions would arise in the application of the theory along with the changes in the economic situations. Questions that had been put forward included how to raise the share of fiscal revenue in national income and strengthen the government’s ability in macroeconomic regulation and control; how to balance the overall fiscal plan to facilitate fiscal-banking coordination, reinforce the management of budgetary funds, and tighten the control over off-budget funds; how to ensure the vitality of state-owned enterprises while strengthening the restraint mechanism on their default on loans; and how to better balance foreign exchange receipts and disbursements and properly increase foreign exchange reserves under the opening up policy. Wang concludes that during the period of planned economy, China’s economy was indeed balanced under the theoretical and economic management framework of an overall balance in government finances, credit, materials, and exports in the absence of the institutional basis for the coordination between fiscal-monetary policies. Such a macroeconomic regulation method, he argues, played a vital role in the planned economic period.28

Realistic Significance of the Overall Balance Theory Wang writes in his book named Review and Reflection of the 60-Year History of China’s Finance that “insisting on the overall balance was a basic financial management idea.”29 He adds that the overall balance in government finances, credit, and materials is a law of the development of a socialist economy. The contrasting experiences in the periods of the Great Leap Forward and the ensuing economic adjustment, in particular, further confirmed the significance of an overall balance. Deviating from the overall balance, economic development during the Great Leap Forward period ended up in a failure, while in the economic adjustment period, the economy took a turn for the better thanks to the reinstatement of the overall balance. The disproportions in economic relationships in the past were attributable to a violation against the overall balance principle. The theory of overall balance originated from practical experience and thus must have practical applications. As Wang explains, in the three balances theory, a fiscal balance refers to a balance between the part of national income that is held by the state treasury and the part that is distributed by the government, while a credit balance means a balance between the raising and use of capital by banks. A fiscal-credit balance reflects a balance in financial resources, which requires a balance in both total volume and structure. Fiscal and credit funds are interdependent and mutually restraining. A fiscal balance is the prerequisite for a credit balance whereas a credit

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balance is a reflection of a fiscal balance. The overall fiscal-credit balance is an important premise for the balance between material supply and demand. As the purchasing power created by fiscal and credit funds is an important component of social aggregate demand and the volume of material supply within a period of time is a constant or only changes slightly, fiscal expenditure and credit supply are the keys for the overall balance. If the two are too small, the speed of production will slow down; if the two are too large, there will be tension in material supply, which will trigger a price rise and a decline in social purchasing power. Clearly, keeping an overall fiscal, credit, and material balance is of enormous significance to the coordinated development of the national economy.30 Government fiscal departments and banks are two important sectors in the national economy. Fiscal and credit funds are two major levers regulating the macroeconomy. In the days of the planned economy, the size of investment in economic construction mainly hinged on state investment, and the state’s capacity to invest was determined by production. After the implementation of the policy of Reform and Opening Up, China’s economic system underwent dramatic changes and investors have become diversified. However, in the total investment of the national economy, state investment still occupies the lion’s share and fiscal policy always restricts the size and structure of other investments. Because of this, Chen Yun’s overall balance theory is still applicable.31 Fiscal revenue and expenditure and credit sources and uses remain the key indicators in reflecting and controlling currency circulation.32 Fundamentally speaking, the credit balance is a matter of currency circulation and the fiscal balance is pursued to stabilize the circulation of money and coordinate between demand and supply in the market. Therefore, the fiscal-credit overall balance is aimed ultimately at the stabilization of currency circulation and the coordination between supply and demand in the market, which are keys for the smooth running of reproduction and the realization of proportional relationships in the national economy.33 In China’s current macroeconomic regulation, the overall balance theory is still of great guiding significance. A review of Chen’s speech given at the meeting of the Party secretaries of provinces, municipalities, and autonomous regions in January 1957 will shed light on the choice of economic policies and measures for the present stage. Back then, Chen made the following important points:34 1. Both fiscal and credit funds must be kept in balance, better still with a slight surplus. As long as fiscal and credit funds are balanced, social purchasing power and material supply will also be in balance on the whole. 2. Materials should be distributed in a rational way and used in order of importance. The supply of raw materials must follow a certain order. In times of a short supply, the top priority should be to ensure the production

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of daily necessities, followed by that of the necessary means of production, with the remaining part devoted to capital construction. Production should precede capital construction, and the situation of the blind expansion of capital construction crowding out the production of daily necessities must be avoided. The scale of capital construction should be decided by the availability not of money but of raw materials. 3. The level of social purchasing power must be improved but the degree of improvement must comply with the size of consumable materials. 4. When judging the balance between the scale of capital construction and financial and physical capacities, the government should focus not only on the figures of the current year but also those of the preceding and succeeding years. Sharp rises and falls will incur a loss. 5. It should be noted that agriculture has a restrictive force on the scale of economic construction. In China, the agricultural economy takes a substantial share, and agricultural production is highly pertinent to fiscal revenue. Agricultural failures will affect the fiscal revenue, capital construction, and industrial production of the following year. Chen added that it was of absolute necessity to carefully study the proportional relationships in the national economy based on China’s current economic reality and past experience to avoid being trapped in a state of chaos caused by an economic imbalance. He stressed the importance of balancing the investments made in heavy, light, and agricultural industries; coal, electricity, transportation industries, and general industries; steel and machinery industries; military and civilian industries; large and small factories; advanced and backward technologies; and production facilities and daily facilities in economic construction. Noting that it was a must for economic construction in a large country like China to be stable, he showed a preference for slow but steady progress over hasty moves with a lot of errors, especially when dealing with the national economy.35 Compared to the past, China’s economic situations and social development have changed tremendously. The problems that need to be addressed are also quite different from before, so are the focus of macroeconomic regulation and control in economic operation and the ways, methods, and corresponding policies for macroeconomic management. Under these circumstances, the overall balance theory should still be effective and capable of offering valuable insights. First, in macroeconomic operation, it is of great significance to control the sizes of fiscal expenditure and credit supply in a scientific way and coordinate between fiscal and monetary policies. At the same time, it is also necessary to effectively control the total volume of capital and regulate the relationship between total

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social demand and supply to promote the continuous and steady operation of the economy. A question that deserves high attention is how to prevent inflation at a proper intensity and pace in the policy mix under a rise in both investments and credit supply. Second, the application of fiscal and monetary policies should take into account not only present but also future situations to maintain the sustainability of the healthy development of the economy. Especially after China has moved out of the impacts of the financial crisis and adopted a policy of expanding investment and credit scale, it is extremely important to consider the negative impacts of these policies and adjust their intensity and pace from the perspective of sustainable economic development. In the face of a growing fiscal deficit and debt scale, the government must make allowance for the national capacity, be alert to potential fiscal risks, and work out possible solutions to these risks. Third, it is of absolute necessity to pay attention to the rationalization of the economic structure. Growth with an optimized structure is sustained and steady growth, and development featuring coordination and cooperation is scientific development. A rational and scientific economic structure has always been an ideal state pursued by the Chinese government during its economic development, but for a long period of time, China has failed to address the structural imbalance in economic development, which has become a major obstacle in the healthy development of the Chinese economy and society. In view of this, improvements in the investment, industrial, and product structures and guidance for adjusting the demand structure should be the long-term focus of government policies. Fourth, the government must be committed to raising the income of households and improving people’s living standards. It is necessary to increase the income of residents and improve social purchasing power at all times. But as China is faced with different socioeconomic contradictions today, how to increase residents’ income has become an important question. In recent years, the income distribution pattern of China has changed greatly, and in the process of rapid economic growth, the income level of residents has also risen accordingly. Unfortunately, the share of residents’ disposable income in the national income distribution has not been significantly improved and even sees a decline. Therefore, adjusting the national income distribution pattern and properly increasing the income of residents are of the utmost importance to the sustainable economic growth of China, so that the fruits of reform can be shared by all and steady and health socioeconomic development can be ensured. The rise in household income can boost household consumption, which can in turn enhance the contribution rate of household consumption to economic growth. Yet in the process of encouraging the consumption of residents, the government

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must prevent the “crowding out” effect of current policies, and avoid the negative impacts of some irrational investments on consumption. In the past, one big contradiction was between the short supply of consumer goods and high demand, but now conflicts are caused by a certain degree of income shortages on the part of residents (which results in insufficient consumption), an irrational consumer goods structure (which inhibits the formation of effective consumer demand), or irrationalities in some other aspects such as the housing problem (which suppresses normal consumer demand). Therefore, it is necessary to increase the disposable income and spending power of residents, guide and adjust residents’ consumption scale and structure, facilitate the formation of the consumer market, and activate the driving force of household consumption for economic growth based on the present realities and by adjusting macroeconomic policies. Fifth, it is very important to develop the agricultural industry. The influence of agriculture on the whole national economy is likewise totally different from how it was in the past. But agriculture remains the basis of the national economy, and the importance of its status has never changed. Developing agriculture is of the utmost significance to the economy and society. The “three rural issues” (the issues concerning agriculture, rural areas, and rural residents) have been the focus of the Chinese government in recent years, and government authorities have adopted a series of policies and measures to promote the development of undertakings related to the “three rural issues.” Considering the current situations of China, it is of absolute necessity to place the “three rural issues” at a crucial position in economic and social development within a considerably long period of time, and continuously enlarge the government’s input into this area in order to achieve a large advance.

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Chapter

Credit Quotas

MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 1

What Is a Credit Quota? A credit quota (xindai zhibiao 信貨指標) is in essence an indicator of credit scale, and is also known as loan quota control or credit scale control. Specifically, China’s central bank will set the upper limit (credit ceiling) of new credit that can be extended to borrowers by commercial banks at the beginning of each year, and the new credit will be split among all commercial banks in the form of credit quotas. The total credit granted by banks cannot exceed the specified credit quota. Credit quotas are mandatory and must be observed by banks and financial institutions. However, since the credit quota plan is made at the beginning of each year, changes in the economic situations may render the plan incompatible with present needs. As a result, the central bank often adjusts the plan in the middle of the year, or it may be forced to escalate the credit ceiling under the pressure of the “reversed monetary expansion mechanism” (explained later). Essentially, credit quotas are a tool used by the central bank to strictly control the asset side of the balance sheets of commercial banks by virtue of administrative power in order to monitor monetary aggregates (total social demand) on a macroeconomic level, and adjust and optimize the credit structure on a microeconomic level. Through setting credit quotas, the government is able not only to control the size of total credits and money supply, but also impose different credit quotas on different sectors and regions, and achieve the purpose of adjusting the economic structure through credit quota management. The credit quota is always accompanied by interest rate control. Under the system of credit quota management, enterprises that have obtained bank loans in fact get access to low-cost capital, which reflects the government’s support for industrial and regional credit. Therefore, the credit quota is not merely an indicator for total aggregate control but also one for structural control. The credit quota is a monetary policy tool of the central government to control credit aggregates, thereby managing the amount of money supply. The credit quota has two levels of meaning: (1) It refers to the credit aggregates at a particular point in time, namely a measure of the credit flow. (2) It represents the newly increased credit within a certain period of time, that is, a measure of credit stock. Credit quotas are a quantified monetary policy tool and exhibit the role of administrative control to a certain extent. In socialist countries or some developing countries, banks and enterprises are either owned or controlled by the state or government, and the market mechanism and financial system are not well developed. Thus, the government plays an important role in allocating resources. Under such a circumstance, the microeconomic basis for monetary policy does not exist, and the government is able to better manage aggregate demand and credit

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aggregates through quantitative and administrative credit control. For quite a long time in history, the central banks of many countries have regarded the credit quota as a tool of monetary policy and set credit ceilings for commercial banks to contain economic overheating. Some European countries once regarded credit control as a monetary policy tool, so did many developing countries. Even in the history of some developed countries, they have long practiced credit control. This practice continued in France until 1981, the United Kingdom and South Korea until 1982, Japan until the mid-1980s, and Indonesia until 1983.1 Lately, with the development of the world economy and the improvement of the financial system, the drawbacks of credit quotas are becoming increasingly prominent. Many countries gradually abandoned credit quotas as a tool for credit fund management, and turned their attention to traditional market-oriented monetary policy tools, such as open market operations, adjusting the benchmark interest rate, relending, and adjusting the reserve requirement ratio. The monetary policy was characterized by direct and administrative credit control during China’s planned economy. After the launch of the Reform and Opening Up policy, credit quotas were both an intermediate target of China’s monetary policy, and an important monetary policy tool. Starting from 1984, the PBC clearly listed the credit quota as an intermediate target of monetary policy. From January 1, 1998 onwards, the PBC decided to lift the credit ceiling of stateowned commercial banks, and officially announced the cancellation of credit quotas which would be gradually replaced by an asset-liability ratio and risk management. However, to cope with the early signs of economic overheating that appeared in 2007 as well as asset price bubbles, China’s central bank reintroduced credit quotas as a tool for credit control in the latter half of 2007. The most effective and direct tool of monetary policy in the macroeconomic control and regulation after 2007 remains credit quotas, that is, the control over the annual total of newly increased loans in the monetary sector. It can be seen that the role of credit quotas will remain irreplaceable in China’s macroeconomic regulation and control for a very long time.

Credit Quotas in China: A Historical Perspective The planned economy period: Complete credit control From the beginning of New China to 1978, the government implemented a highly centralized planned economy, and production and distribution were determined by economic plans. To adapt to the system of planned economy, China built a

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unified banking system and the PBC was the only bank in the country. The bank set up branches in accordance with administrative divisions, and branches at all levels must strictly carry out the instructions and plans made by the head office. The PBC was at the same time the national financial administrative authority and an economic entity running the banking business of taking deposits and making loans. In it was integrated the roles of a central bank and a commercial bank. The credit card settlement and general ledger systems of banks were originally designed for the purposes of strict supervision and implementation of highly centralized plans. The long-term dependence of the banking system on the fiscal system made credit, settlement, and savings business all conducted according to the needs of the treasury. In terms of capital management, the consumption sector followed a strict cash plan, while the production sector implemented vigorous top-down planned management of credit funds. Banks carried out unified management of income and expenditure, and deposits and loans. That is to say, the head office of the PBC would set targets on deposits, credit, and cash issuance and withdrawal for its branches, and the successful completion of these targets must be guaranteed. Deposits in all lower-level banks had to be turned over to the head office and used at the head office’s discretion. Loans to different projects must be approved by the head office and made according to the credit quotas assigned by the head office. Local banks had to grant loans within the prescribed quota, and credit quotas could only be applied to their earmarked purposes and were not allowed to be diverted to other uses. Deposits and loans were managed separately through two channels with no interactions. In 1950, the PBC initiated a trial on the compilation of financial plans, which signaled the start of planned management of credit funds. In 1952, specific provisions on the compilation, revision, target management, implementation, and examination of credit plans were introduced, and the credit management system was basically established. Since 1953, in response to the requirements of the First Five-Year Plan, banks intensified planned management and centralized control in the bank credit plan, and adopted the management method of “unified control over deposits and loans” (tong cun tong dai 統存統貸). The credit management approach of “unified control over deposits and loans” had been established in China’s banking system by 1953. In terms of the organizational structure, the entire banking system was characterized by “threetier management, one-tier operation” (san ji guanli, yi ji jingying 三級管理，一級 經營). Credit money was brought into circulation through the release of loans, which was reflected in the cycle of “loans – cash and deposits – loans – cash and deposits.” From the perspective of monetary control, under the highly centralized

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banking system, bank deposits and cash were almost the only financial assets, and the expansion and contraction of money supply were basically decided by the credit size. Besides that, local banks did not have the right to create derivative deposits. They had to grant loans within the quota allocated by a higher-level bank. As a result, the quotas in fact determined the expansion and contraction of credit in money supply. As long as the PBC managed to keep control of the credit scale, the monetary aggregates could also be controlled. During China’s planned economy era, the money supply mechanism was characterized by the fact that the sizes of credit and money supply were determined by the central bank’s annual consolidated credit plan. The management system of credit funds adopted unified control over deposits and loans, and this was achieved through the allocation of credit quotas. The PBC acted as a “cashier” for the state planning and fiscal authorities. The source of its funds predominately came from government allocation based on national planning, while the main use of the funds was to issue short-term loans to enterprises. Therefore, the planning and allocation of credit quotas by the PBC essentially served the role of controlling money supply. Under a planned economy, the monetary policy of the central bank was in fact the complete control over credit quotas. Credit quotas were not just a means of total quantity control, but they also determined the loans accessible to each enterprise and project. Banks had no autonomy in making loans, and both prospective borrowers and loan amounts were decided by credit quotas. Thus, it can be said that credit quotas are a kind of monetary policy tool that perfectly fits into the planned economy.

1979–1984: The credit difference contract system as a variant form of credit quotas In 1978, China launched a reform in the economic system, and the planned economy was gradually transformed towards a market economy. In 1979, the Chinese government set out to reform the rigid planning and management of credit funds, and the management method of “unified control over deposits and loans” was gradually replaced by “centralized 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).2 This required that banks at all levels formulate an individual “credit difference” management plan based on the consolidated credit plan approved by the state and in accordance with the requirements of the PBC head office. This “credit difference” was basically the difference between the loans and deposits at provincial branches, and it was ascertained in annual terms by the PBC head office, as a quota to be met

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on a provincial basis, allocated top-down to lower-level banks. The PBC branches thus imposed credit control over local specialized banks (commercial banks) according to the ascertained deposit-loan difference. The regulation of base money by the PBC was predominantly achieved through its power to approve “deposit surplus” (deposits exceeding loans) or “loan surplus” (loans exceeding deposits) plans of specialized banks and PCB branches.3 The ascertained credit difference for each bank functioned like a quota such that in case of a deposit surplus, the current credit difference must be met while with a loan surplus, the current credit difference must not be surpassed. Under this “credit difference contract” (xindai cha’e baogan 信貸差額包干) system, although there was no explicit credit quota, the credit difference plan was essentially a variant of the credit quota. The amount of deposits received by banks determined the scale of loans, and the PBC was also able to control the size and structure of credit funds through credit difference plans.

1984–1989: Credit quotas as official intermediate monetary policy target Since 1984, credit funds became an important factor that could affect the size of social aggregate demand and money supply. To address the crises of runaway investment and consumption, uncontrollable credit booms, and excessive supply of money in 1984, China’s State Council decided to impose strict control over the total size of loans in 1985, which proved to be the most effective means. It was for the first time that control over the total loan size was considered to be an important means of macroeconomic regulation and control. The single regulatory approach of control over money supply was expanded to also include loan size control. In 1985, the PBC explicitly identified credit quotas as an intermediate target of its monetary policy. In 1985, on the basis of the credit difference contract system, the PBC issued the Trial Measures of Credit Funds Management to introduce the revised management method of “adopting unified planning, setting apart operating and credit funds, making loans based on deposits, and developing interbank lending” (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). According to this approach, credit funds of all specialized banks must be included into the national consolidated credit plan, and the PBC head office would be responsible for finding a balance between the supply and demand of all credit funds as well as determine specialized banks’ credit fund plans and plans of borrowing from the PBC. In most cases, credit quotas assigned by the central bank to specialized banks can be divided into two categories. One was mandatory targets, including deposit-loan difference plans, year-end and annual lending

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plans for fixed-asset investment, and year-end targets and maximum amounts of agricultural loans. This kind of credit quotas were placed under strict control and could not be exceeded without state approval. The other kind was instructive targets, including lending plans for industrial and commercial working capital, and various savings plans. Under the deposit-loan difference plan, banks were allowed to make loans in proportion to the savings amount. The more deposits a bank collected, the more loans it could grant. Instructive quotas could be transferred between different plans. However, in 1985 and between 1988 and 1991, due to inflation and economic overheating, the central bank’s control over credit aggregates was enforced once again through the sole tool of mandatory targets. After 1985, the management of the annual credit ceiling was achieved through the central bank’s compilation of a consolidated credit plan according to the demand of national economic growth on credit funds. The PBC determined the quotas of specialized banks based on the consolidated credit plan approved by the state. The head office of each specialized bank proposed a lending plan for its subordinate branches to be submitted to the PBC head office according to the assigned lending quota. Shortly after, the PBC head office would issue a loan notice, and the PBC branches would lend money to the branches of specialized banks in accordance with the quotas specified in the loan notice. The branches of specialized banks must make loans within the credit quota assigned by higher authorities. If there was a short-term financial shortage in the branches of specialized banks, they could borrow money from other banks to compensate for the credit deficit. If there was still a funding gap, they could also apply for temporary loans from the local PBC branch. If the assigned credit quota proved to be insufficient at the end of the year, branches of specialized banks could ask for larger quotas from the PBC head office and the additional quota would be allocated upon approval. For the sectors, industries, and regions to which the government considered necessary to provide extra support, preferential policy would be given in compiling the credit plan, and more credit quotas would be assigned to them with a favorable loan rate. In May 1989, under the macroeconomic environment of economic adjustment and monetary restraint, the PBC replaced credit quotas with credit ceilings and implemented the method of “managing credit ceilings and determining loan size based on deposits” (xian’e guanli, yi cun ding dai 限額管理，以存定貸) to continue the control over the total amount of credit funds on a quarterly basis. This approach applied to all regions, banks, credit cooperatives, and trust and investment companies. Credit ceilings were assigned through both vertical and horizontal control. For specialized banks, vertical control was adopted: Credit ceilings were assigned by banks at a higher level, and the PBC would consolidate the credit ceilings of prefectural, municipal, and county-level banks on a quarterly basis.

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For trust and investment institutions at provincial and municipal levels and urban credit cooperatives, credit control was exerted in a horizontal manner and credit ceilings were all assigned by the PBC. The credit ceilings imposed on banks and nonbanking institutions were mandatory, and financial institutions and provincial (municipal) banks were prohibited from breaking the limit unless permitted by the PBC. Credit management was enforced through a system where bank governors (managers or directors) assumed full responsibility and provincial branches of the PBC carried out annual assessments of policy implementation. Credit limit control followed the principle of “year-round disclosure, quarterly monitoring, monthly review, and timely adjustment” (quan nian liang di, an ji jiankong, an yue kaohe, shishi tiaojie 全年亮底，按季監控，按月考核，適時調節). The quarterly credit ceiling determined by the PBC head office was regarded as a criterion for monitoring, and the head offices of different specialized banks and PBC branches in different provinces, autonomous administrative regions, municipalities, and the cities listed independently in the state plan (jihua danlie chengshi 計劃單列城市) monitored the credit operations of their subordinate banks by region and industry. The head offices and branches of specialized banks were allowed to adjust their quarterly credit ceilings where necessitated by changes in external circumstances. If more loans were lent out by the branches of specialized banks than the assigned ceilings, they had to report the increase to their head offices. If the quarterly credit ceilings for the head offices of specialized banks were found to be insufficient, they had to ask for approval from the PBC head office to raise the limit. Experience proved that under the then economic and financial systems, control over the credit scale was a relatively effective means of containing economic overheating. This was because the total loan amount approved by the State Council could be broken down among specialized banks and other financial institutions in a top-down manner, which would facilitate subsequent implementation and inspection and the regulation of base money by the central bank. Basically, this was still an administrative means. Its major failing was that it did not provide for a proportional match between deposit and loan sizes, hence nondiscretionary management. Specialized banks could on the one hand be restricted from expanding loans by credit creation, and on the other hand be forced to make excessive lending obligations, which would lead to a hollowing out of bank funds.4

1994–1997: The gradual fading of credit quotas In December 1993, the State Council announced the Decision on Economic System Reform, which elevated the PBC to a real central bank and proposed turning specialized banks into real commercial banks. Accordingly, the PBC’s

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macroeconomic control over the credit scale gradually shifted from direct control via credit ceilings to indirect control through management of the asset-liability ratio, and its allocation of credit funds changed from following a centrally planned regime to a market-oriented one. The functioning of the PBC as a central bank alone was a landmark in the history of China’s financial system reform. It signified a fundamental switch of China’s financial system towards a market-oriented one. In 1993, the Third Plenary Session of the 14th Central Committee of the CPC passed the Decision on Some Issues Concerning the Improvement of the Socialist Market Economy. In the same year, the state council released the Decision on Reform of the Financial System. The two documents pointed out that the PBC had to shift its tools for adjusting money supply from credit scale management to reserve requirements, discount rates, and open-market operations. It was for the first time that the amount of money supply and the size of total social credit were collectively confirmed as the intermediary targets of monetary policy. To shield the implementation of monetary policy from the interference of local governments and governmental departments, the PBC head office retrieved the right to adjust the loan scale from the hands of its branches in all provinces, autonomous regions, and centrally-controlled municipalities in July 1993. In 1994, the PBC stopped making loans to nonfinancial institutions, and abolished all kinds of earmarked loan quotas and credit funds. After policy banks (noncommercial banks, namely Agricultural Development Bank of China, China Development Bank, and Export-Import Bank of China) were established in 1994, specialized banks embarked on a reform aimed at a transformation towards a commercial entity, and the central government no longer assigned instructive quotas on specific credit projects. However, state control over the total credit size remained through strict mandatory plans. In accordance with the requirements of the financial system reform, the control over money and credit supply by the PBC gradually shifted from credit scale management to adopting the tools of social credit planning, discount rates, rediscount rates, open-market operations, reserve requirements, the benchmark interest rate, asset-liability ratios and credit ceilings. In September 1994, the PBC announced standard measures of money supply, which were used as targets for monitoring. Data of different types of money supply indicators was to be released quarterly, based on which the financial and monetary situations would be analyzed. In 1996, money supply indicators, M1 and M2, were officially identified as intermediary targets. After 1994, credit quotas as a monetary control mechanism gradually faded away, and multilevel credit control began to move towards the center of money policy. At the same time, the nationwide unified interbank lending market and interbank foreign exchange market were built, the means of interest rate control

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was used more and more frequently, and open-market operations and rediscount business were successively launched. Starting from the fourth quarter of 1994, the PBC promoted the systems of asset-liability ratio management and risk management in all commercial banks, urban credit cooperatives, and trust firms. During the same period, credit quotas on cooperative financial institutions, jointstock commercial banks, and other commercial banks were successively removed. By 1997, only four wholly state-owned commercial banks and three policy banks were still subject to mandatory credit quotas.

After 1998: The abolition and reintroduction of credit quotas In 1998, China abolished the planned management of credit quotas in stateowned commercial banks, and substituted instructive plans for mandatory plans in managing the loan increments of those banks. A new management regime of “instructive planning, self-balancing, asset-liability ratio management, and indirect regulation” (jihua zhidao, zi qiu pingheng, bili guanli, jianjie tiaokong 計劃指導，自求平 衡，比例管理，間接調控) was implemented on the basis of the gradual promotion of asset-liability ratio and risk management. Specifically, the PBC would no longer control credit increments of commercial banks by mandatory plans, which were replaced by annual (quarterly) instructive ones. The PBC would determine the annual targets of different money supply indicators, and formulate base money and social credit plans according to the state’s economic development and price control targets while considering all factors affecting the velocity of circulation. On this basis, an instructive plan for the annul credit increments of commercial banks would be prepared, both as a target for the central bank to monitor the macroeconomy and as a reference for all commercial banks to perform their selfcomplied fund plans. Commercial banks would perform asset-liability ratio management on the basis of legal persons, and would seek to strike a balance between the sources and uses of credit funds. After depositing the required reserves with the PBC, setting aside excess reserves, repaying relending loans to the PBC, and purchasing policy bank bonds, commercial banks were allowed to make loans in accordance with the principles of security, liquidity, and profitability, as well as relevant national credit policies. By then, under the macroeconomic regulation and control of the PBC, the amount of money supply and capital position of commercial banks had substituted credit scale as the intermediary and operational targets. The administrative means of credit quotas was no longer used. Taking its place was the combination of various monetary policy tools, including reserve requirements, discount window

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loans, open-market operations, and benchmark interest rates, for the purposes of timely adjusting the base money and maintaining moderate loan growth. In 1998, while the PBC formally abandoned credit quotas and money supply became the intermediary target of monetary policy on paper, the central bank started to experiment with a variety of market-oriented operational tools, such as open-market operations, issuance of central bank bills, the use of monetary and credit policies or the “window guidance” tool, and the adjustment of the required reserves ratio and benchmark deposit and lending rates. One of the important reasons for the cancellation of credit quotas in 1998 was that there was a macroeconomic sign of deflation which caused a credit crunch in the banking industry, and credit quotas became useless. Between 1998 and 2005, credit quotas appeared to be no more than mere “decorations” and were of no practice use. In fact, the actual amount of new loans at commercial banks was lower than the instructive target given by the central bank. However, the macroeconomy began to expand and even showed a sign of overheating after 2006. In 2006 and 2007, the actual amounts of new loans rose to 27% and 20% higher than the instructive amounts, respectively. In the fourth quarter of 2007, the PBC started to restrain the loans of large commercial banks by means of “window guidance.” A comparison between the actual amounts of new loans and instructive targets from 2002 to 2009 is shown in Table 6.1. Table 6.1

Instructive and actual amounts of new loans (CNY1 trillion)

Year

2002

2003

2004

2005

2006

2007

2008

2009

Instructive amount

1.30

1.80

2.60

2.50

2.50

3.00

3.87

5.00

Total

1.90

2.80

2.20

2.40

3.18

3.60

4.91

9.59

Q1

0.44

0.82

0.81

0.75

1.26

1.40

1.33

4.58

Q2

0.51

0.98

0.58

0.73

0.92

1.11

1.12

2.79

Q3

0.54

0.70

0.35

0.51

0.58

0.82

1.03

1.33

Q4

0.40

0.30

0.46

0.41

0.42

0.27

1.43

0.89

Actual amount

Source: People’s Bank of China, Monetary Policy Report, various years.

Thus, credit quotas were resumed by the central bank in 2008 as a result of macroeconomic overheating and asset bubbles. From January to October, credit quotas were strictly implemented. However, owing to the outbreak of the global financial crisis, in November 2008, the PBC once again removed credit quotas and launched a CNY4-trillion credit stimulus plan to encourage loan issuance by commercial banks, in hopes of offsetting the negative effect of the crisis. Yet, this

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cancellation only lasted seven months, and credit quotas in effect went back to function again in July 2009. Following the extraordinary credit growth of CNY9.59 trillion in 2009, the volume of bank loans was limited to under CNY7.5 trillion in 2010, and new loans were required to be extended at a quarterly ratio of 3 : 3 : 2 : 2. Judging from the monetary policy adopted after 2008, credit quotas have played an unparalleled role in containing total demand compared with traditional monetary policy instruments, such as increasing reserve requirements or interest rates and open-market operations. Since the credit quota made a comeback in 2008, credit quotas for new loans have been determined by the central bank at the beginning of each year under the leadership of the State Council, and then broken down among different banks. Each bank must strictly follow the assigned credit quota and never break the credit limit. For banks which have made excessive loans, the central bank would issue central bank bills to them and raise their required reserves as a punishment. If this means had no effect, the management might impose administrative penalties on relevant bank staff. Moreover, the central bank and the China Banking Regulatory Commission (CBRC) laid down specific requirements on the projects funded with credit funds from commercial banks.5 In addition to controlling the total volume of loans, the regulatory authorities may also closely monitor the whole process of credit extension from the velocity and destinations of credit funds to post-loan use, in order to affect the speed, size and destination of the loans of commercial banks. For example, on August 4, 2008, the central bank raised the credit quotas for commercial banks to support small business credit, and differential rates of increase were applied to national and local commercials banks, which were 5% and 10%, respectively. This policy reflected the central bank’s intention to relieve the financing difficulties of small businesses. Apart from the traditional credit quotas, the supervision authorities and the central bank even made use of rules and instruments of microeconomic regulation such as the capital adequacy ratio and the so-called “three sets of measures and one set of guidelines” (san ge banfa, yi ge zhiyin 三個辦法，一個指引) to control the lending activities of commercial banks.6 It must be stressed that the credit quota management under the market economy is strikingly different from that under the planned economy. In the planned economy period, credit quotas were completely mandatory targets; both the quantity and borrowers of loans were decided by the government, and banks were only responsible for fulfilling the targets. In contrast, the credit quota under the present market system is more an economic means and instructive target. It only establishes a limit on the credit aggregates but does not restrict the actual uses of the funds. Moreover, the distribution of credit funds is decided by commercial banks rather than government administrative institutions.

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Potential Problems Arising from Credit Quotas Efficiency losses Although credit quotas have played an irreplaceable role in China’s monetary policy, the resulting loss of efficiency also deserves our due attention. Under a perfect market mechanism, interest rates are not subject to government regulation, and the financial market will form an equilibrium interest rate, which reflects the supply and demand of capital and the risk profiles of borrowers. However, with credit quotas, interest rates will be set lower than the equilibrium rate while credit aggregates are controlled. This will result in a loss in efficiency (Fig. 6.1). As shown in Fig. 6.1, the interest rate and credit funds are in equilibrium at i* and Q*, respectively. But as the central bank limits the size of new loans to point Q’ and set the interest rate at i’, the borrowers and lenders as a whole will suffer a welfare loss equivalent to the area of triangle ABO.7 Moreover, due to the administrative distribution of credit quotas and the soft budget constraint of borrowers, many enterprises and projects which are ineligible for loans according to the principles of commercial lending can also obtain loans. This will generate even larger economic efficiency losses (in terms of resource allocation). Fig. 6.1

Efficiency losses arising from credit quotas i S A

i* i’

O

B

E

D

D

Q’

Q*

Q

A major flaw of credit quotas is the harm to the efficiency of the lending decisions of banks. The essential role of the central bank is to ensure macroeconomic health and stability at a macro level: to guarantee moderate supply of money in order

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to satisfy the monetary demand of economic growth, maintain price stability, and prevent financial crises. The fundamental function of commercial banks is to optimize resource allocation at a micro level, in the other words, to transfer capital from surplus units to deficit ones, and to turn savings into investments. This role is reflected in three aspects: overcoming information asymmetry in resource allocation, undertaking risk management, and providing liquidity. As an administrative means, credit quotas grant the government the power to decide the target and size of loans, which impedes the functioning of commercial banks and reduces the efficiency of resource allocation. Apart from efficiency losses, credit quotas, as a kind of quantitative management tool, is becoming less and less operable and efficient. Considering the monetary policy practices around the world, in the 1970s and 1980s, the instruments and intermediary targets of monetary policy in Western countries were all quantitative: money supply or credit amounts. Yet with constant financial innovation, the boundaries between different levels of money supply were increasingly blurred, the connection between money supply and the ultimate targets of monetary policy became increasingly loose, and monetary instruments also grew less and less controllable. As a result, after the 1980s and 1990s, most countries have given up the quantitative tools of money supply and credit amounts, turning to pricebased instruments such as interest rates in choosing their monetary policy tools and setting their intermediary targets.

Failure in providing hard constraints Another important defect of credit quotas is that credit quotas can be easily broken, and thus cannot be called real hard constraints. Since credit quotas are decided by the government, it is very hard to ensure that they fit well with the needs of economic development. In most cases, the credit quota is either deficient or excessive, and therefore, constant adjustments are necessary during actual practice. Moreover, both state-owned enterprises and state-controlled banks are by nature under the control of the government, which often pressures banks into lending to state-owned enterprises. Consequently, state-controlled banks will not worry about nonperforming loans and low efficient management, for they can always raise necessary financing from the central bank in times of a capital shortage. Subordinated to the central government, the central bank has a low level of independence, and can hardly resist the pressure from the central government. As a result, the central bank has to constantly satisfy the demand of specialized banks for additional loans and increase money supply. This bottom-up expansion of money supply forms a “reversed monetary expansion mechanism” (dao bi jizhi

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倒逼機制). A typical scenario is that under the support of the government, a stateowned enterprise applies for loans from a primary-level state-owned bank branch, which, having exceeded the allotted credit quota, requests an increase in the quota from a higher-level bank or the head office, forcing the head office to expand the quota or even provide extra funds. Ultimately, the head office of each state-owned commercial bank will ask for relending loans from the central bank and force the central bank to expand the credit quota. Besides that, credit quotas opens leeway for moral hazard on the part of local banks and local governments through manipulation of time gaps in granting loans. After credit quotas are distributed at the beginning of each year, banks tend to make loans first to sectors and projects that they themselves and their local governments support, leaving only what is left of the quotas to projects supported by the central government. This forces the central government to assign additional quotas to ensure the capital supply of its own projects when the initial quotas are used up. This is another form of the “reversed monetary expansion mechanism.” The constraint of credit quotas often has the effect of encouraging banks to release loans as soon as possible in order to seize larger quotas, which are often exhausted by the end of the year. This will lead to two possibilities. First, enterprises with low repayment capacity may also be able to take out loans at the beginning of the year owing to banks’ eagerness to lend, which will increase the risk of nonperforming loans in the whole banking industry. Second, towards the end of the year, some competent enterprises may be in desperate need of money but find banks running out of quotas when they try to obtain financing. Financial shortages will create a negative impact on the development of enterprises. So either banks will be forced by the enterprises to borrow money from higher-level banks, or the enterprises will face a serious capital shortage. Finally, in practice, commercial banks can break the allocated credit quotas through various ways. They can cooperate with trust companies to issue trust loans to customers and transfer credit assets into off-balance sheet items which are not subject to credit quotas. If additional credit quotas are granted later, banks will immediately terminate the trust plans and the money will be reissued in the form of bank loans, but if no more credit quota is available before the expiration of the trust plans, new trust products will be created to replace the previous ones.8

Why Are Credit Quotas So Important for China? In 1998, the PBC formally announced the abolition of credit quotas. The Law of the Republic of China on the People’s Bank of China promulgated in 1995 also excluded credit quotas. The underlying reason is generally believed to be the decline in

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the operability of this regulatory instrument, in addition to the above-mentioned efficiency losses. With increasingly diversified financial institutions and products, credit from the banking system has been accounting for a shrinking share in total social financing, and to merely impose a cap on the credit volume of state-owned banks has become powerless in controlling the social credit aggregates. But how do we explain the reintroduction of credit quotas after 2009? The fact is in China, credit quotas, as an administrative and quantitative management tool, are more effective than other market-based instruments, such as interest rates and money supply. In fact, under China’s current financial system, credit quotas still play an irreplaceable role, especially in containing economic overheating. The primary reasons will be discussed in the following section.

Excessive credit expansion of state-owned banks From the perspective of credit supply, the controlling stake of most commercial banks is held by the state, so these state-controlled banks are only subject to soft budget constraints.9 Extensive government interference will lead to low-quality policy-based loans. Therefore, it is very likely that the management of banks will shift the responsibility for loan losses to the government. The establishment of state-run asset management companies to clean up banks’ bad debts is the best example. This greatly exacerbates the moral hazard of bank management and weakens the risk awareness of the banking industry, which tends to grant excessive high-risk loans. In addition to that, the Chinese government also sets a relatively fixed interest rate spread through regulated interest rates, and so the profits and loan size of banks are positively correlated. Therefore, it is reasonable that banks are inclined to issue excessive loans. From the perspective of demand for credit funds, projects of state-owned enterprises and governments at all levels are the major demanders of credit funds in China, and these projects are also characterized by soft budget constraints. The financial strategy of the Chinese government is to provide low-cost funds for stateowned enterprises by setting low interest rates (both deposit and lending rates), which are below the equilibrium point and thus bring about excessive demand for credit. The government itself also has an enormous influence on banks. For the sake of developing the local economy, local governments often put pressure on local banks to make loans via various ways. Moreover, even if government-led projects and state-owned enterprises default on their loan obligations, banks will neither be held responsible nor be subjected to huge political risks; therefore they are willing to extend loans to these projects.

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Due to the coexistence of excessive credit supply and demand, the central bank has to resort to credit quotas to control the credit aggregates. Otherwise, credit funds will surely be overissued.

Unsatisfactory results of traditional monetary policy tools When the central bank carries out monetary policy, it mainly relies on adjusting reserve requirements, open-market operations, and central bank relending to regulate interest rates and money supply. The adjustment of either the amount of money supply or interest rates is a market-oriented means rather than an administrative one and will impact the behaviors of financial institutions, manufacturers, and consumers through the transmission mechanism of monetary policy. The central bank adjusts the amount of money supply or the interest rates based on market-based indicators such as the inflation rate and unemployment rate. Financial institutions will make their decisions in accordance with the principles of business, and the central bank will not interfere. Although the central bank is able to influence macroeconomic indicators, such as the amount of money supply and interest rates, it can by no means intervene in the decision making of microeconomic agents such as commercial banks and enterprises. China’s market-oriented reform of interest rates has just started. Since the interest rate system is still subject to government regulation, the benchmark interest rate cannot accurately reflect the supply and demand of funds, and the interest rate system also cannot precisely reflect the maturity and risk structures. Due to the poor risk management ability of banks and unsound corporate governance, a rise in the benchmark rate may aggravate adverse selection, and augment the risk of loans of the entire banking system. The existence of soft budget constraints makes projects of state-owned enterprises and governments insensitive to changes in the benchmark rate, so the regulation of interest rates by the central bank becomes less effective. To raise the benchmark rate for the sake of containing economic overheating will increase the financing cost of state-owned enterprises or cause government-supported enterprises and projects to lose their loans. This goes against the government’s intention to support state-owned enterprises or optimize the economic structure through low-rate loans. A remarkable feature of China’s banking system is excess liquidity. The longterm existence of a mandatory foreign exchange settlement and sales regime and double surpluses has brought China’s banking system both ample funds and excessive liquidity. The deposit surplus of the banking system has remained high for many years, and it took up 6.71% of the total deposits in 1995, and surged to 21.8% and 33.13% in 2001 and 2008, respectively. The proportion of the deposit

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surplus in GDP rocketed from 5.47% in 1995 to 59.06% in 2008. Prior to 1997, there had always been a loan surplus in China’s banking system, and if commercial banks wanted to make more loans, they must borrow from the central bank. The size of loans extended to commercial banks was two to three times as large as their deposits at the central bank. After 1997, the loan surplus was turned into a deposit surplus, with the ratio of the loans and deposits of commercial banks at the central bank being 1 : 1.10. The ratio continued to rise in the following years, from 1 : 2.12 in 2003, to 1 : 7.43 in 2006, and 1 : 10.90 in 2008. Although commercial banks relaxed the lending restrictions in 2009, the loan-deposit ratio remained as high as 1 : 11.55.10 Meanwhile, the ratio between broad money (M2) and GDP was also continuously moving upwards, from 0.32 in 1978 to 1.81 in 2009, doubling that of the United States. Therefore, it is very difficult for the central bank to bring down the quantity of money supply and almost impossible to curb aggregate demand by controlling money supply. Moreover, even if the central bank did manage to control money supply, it would still be unable to effectively contain aggregate demand. According to the equation of exchange developed by Fisher, aggregate demand is the product of money supply and money multiplier. The money multiplier is determined by the behavior of economic agents, which is out of the control of the central bank. So, even if the central bank had full control over the amount of money supply, it would not be able to control aggregate demand. On the other hand, credit quotas place an effective restriction on the money multiplier: When money supply is too much, restrictions from credit quotas will bar commercial banks from extending further credit, and the part of funds that cannot be lent out will be turned into excess reserves flowing back to the central bank. Credit quotas effectively disrupt the money creation mechanism of this part of money, which in fact regulates the money multiplier and thus reduces aggregate demand. Empirical research from the Financial Research Institute of the Development Research Center of the State Council indicates that the ultimate target of monetary policy is closely associated with the credit aggregates.11 Moreover, if the central bank only regulates the total amount of money supply, then in a financial system where the interest-rate signal is distorted, loans cannot be decided according to the principle of business efficiency, and the difference in the competitiveness of banks may result in a large gap in their business performance, which will be harmful to the stability of the banking system. This also denies the feasibility of money supply as the intermediary target of monetary policy. Therefore, the only reasonable choice is to let the government determine the annual increment of loan quotas that will be distributed to each bank. This can not only confine the total loan size within a reasonable range, thus avoiding

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economic overheating, but also maintain the existing stability of the banking industry and the industrial pattern. More importantly, through credit rationing, the government can ensure its influence and control over the economic structure. For instance, in recent years, the focuses of credit control in China have been to strengthen the support of credit policies for social and economic weaknesses, employment, strategic emerging industries, and industrial transfer, effectively ease the financing difficulties of agriculture and small enterprises, ensure the loan needs of key construction projects, and strictly limit the loans made to industries with high energy consumption, high emissions, or overcapacity. Moreover, the limitations of open-market operations are also very apparent. The insufficient depth and breadth of monetary markets and the low-level liberalization of interest rates have been constraining the number of tradable bonds held by the central bank. In times of economic overheating, it is very difficult for the central bank to massively withdraw currency from circulation through selling bonds. Under China’s current economic background, credit quotas are indispensable in containing the overheating of aggregate demand.

Conclusions and Outlook Due to some of the peculiarities of China’s current economic and financial systems, including excess liquidity in the banking system, soft budget constraints of stateowned enterprises and state-controlled banks, poor corporate governance of stateowned banks, and the unsound transmission mechanism of monetary policy, credit quotas, as a monetary policy tool for controlling aggregate demand, still have remarkable and direct effects, and play an irreplaceable role in China. Besides that, by means of scale control and planned distribution of credit quotas, the government can easily achieve its intent of economic regulation, so the government is still inclined to consider credit quotas as a monetary policy tool. But, the credit quota is, by nature, a kind of quantitative monetary policy tool with a strong administrative intervention characteristic, which will lead to efficiency losses in resource allocation. Moreover, compared with price-oriented tools, quantitative tools are less flexible. That is why developed countries have successively given up quantitative monetary policy tools. In conclusion, from a long-term perspective, the deepening of the reform of China’s economic system also calls for a more favorable external environment for market-oriented monetary policy tools. It is necessary to gradually abandon the use of credit quotas, truly remove the control over state-owned commercial banks through credit quotas, substitute diversified market-based monetary policy tools such as interest rates, open-market operations, reserve requirements, central

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bank relending and discounting, and “window guidance” for credit quotas, and transform the monetary policy of the central bank from direct regulation to indirect regulation.

162

Notes Chapter 1 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32.

Fan, “ On the Relationship between the Fiscal and Banking Systems under the Socialist Market Economy.” Huang, Economics of Money and Finance, 525. Huang, Collected Books of Huang Da, Vol. 1, 166. Huang, Introduction to the Overall Fiscal-Credit Balance, 207. Huang, Introduction to the Overall Fiscal-Credit Balance, 200–30; and Deng Ziji, “Public Finance, Banking, and Integrated Finance.” Huang, Introduction to the Overall Fiscal-Credit Balance, 207–10. Deng, “Public Finance, Banking, and Integrated Finance.” Ibid. Huang, Introduction to the Overall Fiscal-Credit Balance, 211. Deng, “Public Finance, Banking, and Integrated Finance.” Huang, Economics of Money and Finance, 525. Ibid. Huang, Introduction to the Overall Fiscal-Credit Balance, 221–22. Huang, Economics of Money and Finance, 536–38. Hunan Provincial Finance Bureau, Excerpts from Historical Records of Fiscal and Economic Issues in the Hunan-Jiangxi Revolutionary Base, 434-35. Zhao, An Outline of the History of Finance and Taxation of New China, 19–20. Liu, “Review and Prospect of the Development of the Banking Industry of the New China.” Zhao, An Outline of the History of Finance and Taxation of New China, 64–68. Ibid, 201–2. Ibid, 203–4. Ibid, 291–2. Editorial, “Advocate Revolutionary Spirit, and Support the Boom of Production and Construction.” For more discussion on “large treasury, small banking,” please see chapter 8. The “overall balance” theory will be elaborated in chapter 4. For more information about the “small premature advance” and the “large premature advance,” please refer to chapter 5. Chen, “Construction Scale Must Be Compatible With National Strength.” Li, “A Sharp Ideological Weapon of Continuous, Steady, and Coordinated Economic Development,” 387-8. Yan and Jin, “Systematically Summarizing the Work Experience of Banks for the Better Service to the Three Great Revolutionary Movements.” Wang, “Insist on the Separated Management of Fiscal Funds and Credit Funds.” Ning, “Several Issues on the Fiscal-Banking Relationship.” Chen, “Study on the Changes of the Russian Banking System.” Xiang, The General History of China’s Government Finances, 89.

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Notes

33. 34. 35. 36. 37. 38. 39. 40. 41. 42. 43. 44. 45. 46. 47. 48. 49. 50. 51. 52. 53. 54. 55. 56. 57. 58. 59. 60. 61. 62. 63. 64. 65. 66. 67.

164

Fan, “Reasons and Conceptions of Reregulating the Relationship between Enterprises, the Fiscal Authority, and Banks.” Zheng, “China’s Finance — A Preliminary Study on the Reform of the Banking System.” Niu, “On the Relationship between the State Fiscal Authority and Banks under the Socialist Market Economy.” Wang, A 60-Year Review and Reflection of China’s State Finances, 737–38. Ibid, 188-9. Ibid, 738. Xiang, The General History of China’s Government Finances, 87. Zhou, “Dissecting the ‘Close-Crotch Pants’ Relationship: Rethinking the Fiscal-Banking System.” Xiang, The General History of China’s Government Finances, 98. Ibid, 99. Chen, “Study on the Changes of the Russian Banking System.” Wu, “Review and Evaluation of China’s Planned Economy.” Xiang, The General History of China’s Government Finances, 93. Huang, Introduction to the Overall Fiscal-Credit Balance, 236–37. Zhou, “Dissecting the ‘Close-Crotch Pants’ Relationship: Rethinking the Fiscal-Banking System.” Zhuo, “A Brief Discussion on the Fiscal-Banking Relationship.” Zhou, “Dissecting the ‘Close-Crotch Pants’ Relationship: Rethinking the Fiscal-Banking System.” Liu, “Review and Prospect of the Development of the Banking Industry of the New China.” Shen, “Review and Reflection on the Relationship between the State Fiscal Authority and Banks.” Huang, Introduction to the Overall Fiscal-Credit Balance, 237–9. Yao, “Study on China’s Current Financialization of Fiscal Risks.” Ren, “Several Questions about the Current Fiscal-Banking Relationship.” National Bureau of Statistics of the People’s Republic of China, China Statistical Yearbook 1992, 656. Chai, “A Preliminary Discussion on Fundamentally Straightening Out the Relationship between the State Fiscal Authority and Banks.” Fan, “On the Relationship between the Fiscal and Banking Systems under the Socialist Market Economy.” Liang, “Reform the Treasury System and Re-Shape the Government Finances-Banking Relationship.” Fan, “On the Relationship between the Fiscal and Banking Systems under the Socialist Market Economy.” Yao, “Study on China’s Current Financialization of Fiscal Risks.” Fan, “On the Relationship between the Fiscal and Banking Systems under the Socialist Market Economy.” Chai, “A Preliminary Discussion on Fundamentally Straightening Out the Relationship between the State Fiscal Authority and Banks.” Fan, “On the Relationship between the Fiscal and Banking Systems under the Socialist Market Economy.” Yao, “Study on China’s Current Financialization of Fiscal Risks.” Ibid. Ibid. Chai, “A Preliminary Discussion on Fundamentally Straightening Out the Relationship between the State Fiscal Authority and Banks.”

Notes

68. 69.

Ibid. Law of the People’s Republic of China on the People’s Bank of China, http://www.npc.gov.cn/englishnpc/ Law/2007-12/12/content_1383712.htm (assessed on May 4, 2015). 70. Xie, China’s Finance and the 30-Year Reform and Opening Up, Vol.1, 75. 71. Yao, “Study on China’s Current Financialization of Fiscal Risks.” 72. Zhang, “Capital Injection and the Reform of State-Owned Banks: From the Perspective of the Political Economy of Finance.” 73. Shen, “Review and Reflection on the Relationship between State Fiscal Authority and Banks.” 74. Xie, China’s Finance and the 30-Year Reform and Opening Up, 130. 75. Ibid, 132. 76. Ibid, 134. 77. Ibid, 130–5. 78. Yan and Chen, “Fiscalization of Financial Risks in China and Its Countermeasures.” 79. Ibid. 80. Xie, China’s Finance and the 30-Year Reform and Opening Up, 78. 81. Yao, “Study on China’s Current Financialization of Fiscal Risks.” 82. Ibid. 83. Research Group of Taizhou Central Branch of People’s Bank of China, “Financialization of Local Fiscal Risks: An Analysis of Local Government Behavior.” 84. Ibid. 85. Ibid. 86. Ibid. 87. Xiao, “On the Transformation between Fiscal Risks and Financial Risks in China.” 88. Yao, “Study on China’s Current Financialization of Fiscal Risks.” 89. Research Group of Taizhou Central Branch of People’s Bank of China, “Financialization of Local Fiscal Risks: An Analysis of Local Government Behavior.” 90. Shen, “Comrade Shen Shuigen Talks about the Division of Labor between the Fiscal Authority and Banks.” 91. Ning, “Several Issues on the Fiscal-Banking Relationship.” 92. Ren, “Several Questions on the Coordination between the State Fiscal Authority and Banks.” 93. Zheng, “China’s Finance — A Preliminary Study on the Reform of the Banking System.” 94. Deng, Selected Works of Deng Ziji on Finance and Economics, 108. 95. Zhou, “New Exploration into the Relationship between the Fiscal Authority and Banks.” 96. Yu, “Restatement on the Necessary Coordination between the Fiscal Authority and Banks.” 97. Wang, “Several Opinions on the Relationship between the Fiscal Authority and Banks in Macroeconomic Management.” 98. Fan, “Reasons and Conceptions for Reregulating the Relationship between Enterprises, the Fiscal Authority, and Banks.” 99. Zhang, “A Tentative Study on the Measures of Credit Control of China’s Central Bank.” 100. Zhu, “Thoughts on the Fiscal Overdrafts or Borrowings from Banks.” 101. Yu, “Restatement on the Necessary Coordination between the Fiscal Authority and Banks,” 1.

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Chen, Public Finance, 420-39. Yao, “Study on China’s Current Financialization of Fiscal Risks.” Yu, “Restatement on the Necessary Coordination between the Fiscal Authority and Banks.” Huang, Introduction to the Overall Fiscal-Credit Balance, 59. Ibid, 192. Yao, “Study on China’s Current Financialization of Fiscal Risks.” Ibid. Ibid. Guo, “Strengthen Budget Management and Improve the Financial Supervision over the People’s Bank of China.” 111. He, “Thoughts on Strengthening the Financial Supervision on Commercial Banks.” 112. Zhou, “On the Financial Supervision of China’s Policy Banks.” 102. 103. 104. 105. 106. 107. 108. 109. 110.

Chapter 2 1.

2.

3.

4.

5.

166

The English translation is from The Common Program of The Chinese People’s Political Consultative Conference, adopted by the First Plenary Session of the Chinese People’s PCC on September 29th, 1949 in Peking (accessed on January 13, 2015, http://e-chaupak.net/database/chicon/1949/1949bilingual. htm#f). According to Qian, the “historical perspective” refers to the views of people who lived at the time when the policy was implemented. Their opinions were comparatively more honest and objective. Evaluations by their descendants, who live many decades or centuries after the expiration of the policy, given solely based on the environment and requirements of their own age can just be regarded as the “contemporary perspective” (Qian, The Political Gains and Losses in Imperial China). In April 1982, the State Council approved and circulated the Report of the Restoration of On-Site Tax Administrators in State-Owned Enterprises formulated by the Ministry of Finance. This report stipulated the tasks of the on-site tax administrators: (1) Helping enterprises to comprehensively overhaul and strengthen financial and accounting work, improve the financial and accounting system, enhance economic accounting, and reinforce the management of costs, capital, and property in accordance with the guidelines of the Chinese Communist Party and the national fiscal laws and regulations. (2) Revealing problems in corporate operations and management based on financial analysis, expanding production while practicing economy, improving business management, reducing losses and wastes, and enhancing economic efficiency. (3) Urging enterprises to deliver profits to the state on time and make sure enterprises abide by the country’s financial and economic disciplines. From these requirements, it is obvious that supervision, management, and execution powers were concentrated in the hands of on-site tax administrators. The terms “specialized tax administrators” and “tax administrators,” being literal translations of the Chinese titles, do not reflect the degrees of specialization. In fact, as we shall see, the work of the taxing officials became more specialized with the evolution of the tax management system due to a refined division of labor. — Trans. Zhang, “Historical Evolution and Evaluation of China’s Tax Administrator System.”

Notes

6.

7. 8. 9. 10. 11. 12.

13.

The concept of tax effort was proposed by Western academia, especially the economists of the International Monetary Fund in the late 1960s. Lots of relevant analyses were done afterwards with the aim of comparing the tax effort indices of different countries. Barzel, Economic Analysis of Property Rights. Zhou, “The Nature of Publicly Owned Enterprises.” He, Dictionary of Economics and Finance, 383. Zhou, “The Nature of Publicly Owned Enterprises.” Barzel, Economic Analysis of Property Rights, 115. Here, the abnormal change in tax growth between 1993 and 1994 has been included. In 1993, when local governments heard that after the implementation of the tax sharing reform, part of the tax revenue which used to be included in the local fiscal revenue would be turned over to the central government and the return base of the value-added tax would be the tax revenue of 1993, they took various means, including settling taxes in arrears or even collecting taxes of the next year in advance, to promote the transfer of taxes to local treasuries. These acts caused a sharp decline of tax revenue in 1994 after a high growth in 1993. An, “How to View China’s Extraordinary Tax Revenue Growth and Tax Reduction in Recent Years”; Gao, “The Mystery of China’s Constant High Growth of Tax Revenue”; and Wang, “The Centralized Path to Rapid Growth of Tax Revenue: Theory and Empirical Analysis.”

Chapter 3 1. 2.

3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13.

Xie, A 60-Year History of China’s Public Finance. Financial and material resources accumulated over the years by governments of various levels, military units, schools, political parties, people’s organizations, and their affiliated departments and units. —Trans. (“Decisions of the State Council on the Unified Arrangement for the Production of Government Agencies,” People’s Daily, March 13, 1952, http://cpc.people.com.cn/BIG5/64184/64186/66657/4492827.html, accessed January 23, 2015) Wen, “Historical Evolution of the Budgetary System since the New China.” National Bureau of Statistics of China, China Statistical Yearbook, various years. Ibid. Ibid. Ibid. Wen, “Historical Evolution of the Budgetary System since the New China.” National Bureau of Statistics of China, China Statistical Yearbook, various years. Ibid. The Ministry of Finance, National Audit Office, and People’s Bank of China, “Specific Provisions on the Cleanup and Inspection of ‘Little Coffers’.” National Bureau of Statistics of China, China Statistical Yearbook, various years. The 13 government funds or charges referred to road tolls, vehicle purchase surcharges, railway construction funds, power construction funds, funds for the Three Gorges Dam project, new vegetable field development funds, highway construction funds, civil aviation infrastructure construction funds,

167

Notes

14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25.

26. 27. 28. 29. 30. 31. 32. 33.

rural educational surcharges, postal and telecommunication surcharges, port construction dues, telephone initial-installation funds, and civil airport management and construction funds. Wu, “Understanding and Interpreting China’s Economic Reform.” National Bureau of Statistics of China, China Statistical Yearbook, various years. The revisions to the Budget Law were passed by the NPC Standing Committee on August 31, 2014, and took effect on January 1, 2015. — Trans. Ping and Liu, “With Approximately CNY10 Trillion in Hand, China’s Local Governments Became ‘Landlords’ ” Zhou, “Almost No Government Departments Do Not Charge fees.” Research Group of “Fiscal Supervision” under the Ministry of Finance, Fiscal Supervision. Ping, “The Expansionary Trend of China’s Local Government Expenditures.” Xie, A 60-Year History of China’s Public Finance. Ibid. Olson, James M, The Logic of Collective Action: Public Goods and the Theory of Group. Ouyang, “The Expansion of Government Off-Budget Funds and Its Influence on Fiscal Policies.” This term is derived from “consumer sovereignty” in discussing the relationship between consumers and producers. It means that buyers ultimately determine which goods and services remain in production. — Trans. Zhou, “Off-budget Funds from the Perspective of Comparative Study.” Wang, “The Financial Power Struggle between Central and Local Governments.” More on the tax reform will be discussed in chapter 14. Liu and Bi, “Theoretical Interpretation for Off-Budget Funds and the Reform of the Measurement Methodology.” Ouyang, “The Expansion of Government Off-Budget Funds and Its Influence on Fiscal Policies.” Bird, Ebel, and Wallich, Decentralization of the Socialist State, Chapter 1, 39. Fu, “Off-Budget Funds: Indispensable for the Operation of Local Governments.” It refers to the law generalized by modern Chinese scholar Qin Hui based on the views of Ming-Qing thinker Huang Zongyi. In the article “The Reform of the Mergers between Different Taxes and the Law of Huang Zongyi,” Qin states that throughout the history of China’s tax reforms, after some initial success, the reforms unexceptionally went to their opposite end and farmers’ economic burdens became even heavier than before. Huang called this phenomenon “the evil of accumulation.”

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

168

Editorial Board of Economic Research Journal, Disputes over the Theories of the Socialist Economy Since New China, 623. Ma, “A Discussion of the Overall Balance Theory and the Law of Proportional Development Based on China’s Realities,” 120. Chen, Selected Works of Chen Yun: 1956–1985, 623. Ibid, 47. Liang, “Several Questions Concerning the Balance in Finance, Credit, and Materials.”

Notes

6. 7. 8. 9.

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

Ge, “The Overall Balance in Finance, Credit, and Materials.” Zhou, and Hou, “The Problem of the Gap between the Sources and Uses of Credit Funds.” Huang, Introduction to the Overall Fiscal-Credit Balance, 208. The classification of money supply has not always been there. Some developed countries began to draw the distinction since the 1960s. The PBC formally confirmed and decided to publish indicators of money supply on a quarterly basis in the third quarter of 1994. Huang, Economics of Money and Banking. Huang, Introduction to the Overall Fiscal-Credit Balance. Zeng, “The ‘Three Balances’ Theory Needs Further Enrichment and Development.” Huang, Economics of Money and Banking. Ma, Interviews with the Ministers of the People’s Republic of China. Sargent, and Wallace, “Some Unpleasant Monetarist Arithmetic.” Haan, and Zelhorst, “The Impact of Government Deficits on Money Growth in Developing Countries.” Thoma, “Sub Sample Instability and Asymmetries in Money-Income Causality.” Turnovsky, Methods of Macroeconomic Dynamics. Hicks, “Mr. Keynes and the ‘Classics’: A Suggested Interpretation.” Chen, and Li, History of International Finance Theories, 402. Dai, Future Development of International Finance: Theories and Methods, 44. Mundell, “Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates.” Wang, Reviews of the Western Monetary and Financial Theories of the 20th Century: Progress and Comments, 306.

Chapter 5 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15.

The term was likely derived from Marx’s concept of “fictitious capital.” See chapter 25 of Marx, The Process of Capitalist Production as a Whole. — Trans. Rong, “Recollection of the Fiscal and Economic Work under the Leadership of Chen Yun.” Song, The History of Finance in Contemporary China, 136. Ibid, 137–8. Song, The History of Finance in Contemporary China, 136; and Rong, “Recollection of the Fiscal and Economic Work under the Leadership of Chen Yun.” Li, “A Sharp Ideological Weapon of Continuous, Steady, and Coordinated Economic Development.” Ibid. Wang, A 60-Year Review and Reflection of China’s State Finances, 64. Gao and Jiang, “Li Xiannian’s Initial Management of New China Finances.” Chen, Collected Works of Chen Yu, 445–46. Li, Li Xiannian Discusses Finance, Financing and Trade, 67. Ibid, 37–38. Ibid, 57. Gao and Jiang, “Li Xiannian’s Initial Management of New China Finances.” Wang, A 60-Year Review and Reflection of China’s State Finances, 86; and Li, “A Sharp Ideological Weapon of Continuous, Steady, and Coordinated Economic Development.”

169

Notes

16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26.

27. 28. 29. 30. 31. 32. 33. 34. 35.

Rong, “Recollection of the Fiscal and Economic Work under the Leadership of Chen Yun.” Ibid. Li, “Historical Development of the Theory of ‘Three Balances’.” Ibid. Chinese Communist Party Central Literature Editorial Committee, Selected Works of Li Xiannian, 223. Li, “Historical Development of the Theory of ‘Three Balances’.” Liu, A Study on the Economic Ideas of Chen Yun, 220–1. Li, “A Sharp Ideological Weapon of Continuous, Steady, and Coordinated Economic Development.” Ibid. More on this principle and that implemented in the aftermath of the Cultural Revolution can be found in chapter 7. The Working Conference of the CPC Central Committee in December 1980 proposed three general requirements for economic adjustment: (1) To basically maintain a balance between fiscal revenues and expenditures and avoid a deficit; (2) To basically achieve a balance between the sources and uses of credit funds and stop the issuance of money for fiscal purposes; and (3) To basically stabilize commodity prices, especially the sale prices of basic necessities which account for 70% of the total household spending. This is the so-called policy of “two balances and one stability.” Li, “A Sharp Ideological Weapon of Continuous, Steady, and Coordinated Economic Development.” Wang, A 60-Year Review and Reflection of China’s State Finances, 738. Ibid, 133. Ibid, 133–4. Yu, “Restatement on the Necessary Coordination between the Fiscal Authority and Banks.” Huang, Introduction to the Overall Fiscal-Credit Balance, 59. Ibid, 192. Li, “A Sharp Ideological Weapon of Continuous, Steady, and Coordinated Economic Development.” Chen, Collected Books of Huang Da.

Chapter 6 1. 2. 3.

4. 5.

170

Zhou, Research on China’s Monetary Policy. Please refer to chapter 10 of the book. To be exact, if the sum of year-end total deposits and the credit funds allocated by the head office at a bank branch was larger than its year-end total loans, a deposit surplus plan would be drawn up; however if the sum was smaller than the total loans, a loan surplus plan would be prepared. In effect, a surplus of the source of credit funds over actual loaning was equivalent to an increase in base money. Zhou, Review and Outlook of China’s Monetary Circulation. For instance, in 2009, the CBRC stipulated that banks must strictly limit credit input in new projects while they continued giving financial support to the projected identified in the CNY4-trillion stimulus plan, and no more loans were allowed to be made to new projects, except the national programs approved by the State Council or the National Development and Reform Commission (NDRC).

Notes

6.

7. 8.

9.

10. 11.

“Three Sets of Measures and One Set of Guidelines” is an abbreviation for three interim national policies, namely, the Interim Measures for the Administration of Fixed Asset Loans, the Interim Measures for the Administration of Working Capital Loans, and the Interim Measures for the Administration of Personal Loans, together with the Guidelines on the Project Financing Business. — Trans. While the area of quardrilateral i*i’DB represents an increase in the welfare of borrowers, it also denotes a welfare loss to lenders, so from the point of view of the whole society, the two parts cancel each other out. The Bank of Beijing signed a capital trust agreement with Beijing International Trust between May 31 and June 2, 2010, to issue financial products based on bank-credit cooperation with a maturity of no more than one year, and the bank may terminate this agreement in advance. The funds would be used to issue trust loans to Financial Street Holdings for residential development. The term “soft budget constraint” was first introduced by Kornai in 1979 to describe the state of stateowned enterprises under the planned economy. State-owned enterprises typically expect the government to come to help in times of financial distress, so there is no hard constraint. Huang, “The Indivisible Dependence on Credit Quotas.” Financial Research Institute of the Development Research Center of the State Council, “Credit Supply Decisions of China’s Banking System and Its Impact on Economic Fluctuations.”

171

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Chapter 2 Chinese materials: An Tifu 安體富. “Ruhe kandai jin ji nian wo guo shuishou de chao chang zengzhang he jianshui de wenti” 如何看待近幾年我國稅收的超常增長和減稅的問 題 [How to View China’s Extraordinary Tax Revenue Growth and Tax Reduction in Recent Years]. Taxation Research 稅務研究, (8) (2002). Gao Peiyong 高培勇. “Zhongguo shuishou chixu gaosu zengzhang zhi mi” 中國 稅收持續高速增長之謎 [The Mystery of China’s Constant High Growth of Tax Revenue]. Economic Research Journal 經濟研究, (12) (2006). He Shengming 何盛明, ed. Caijing dazidian 財經大辭典 [Dictionary of Economics and Finance], Vol.1. Beijing: China Financial & Economic Publishing House, 1990. Huang Yunwu 黃運武, ed. Xin bian caizheng da cidian 新編財政大辭典 [A New Dictionary of Public Finance]. Shenyang: Liaoning People’s Publishing House, 1992. Ju Hong 巨宏. “Shuishou zhuan guan yuan zhidu de lishi bianqian yu chuangxin” 稅收專管員制度的歷史變遷與創新 [Historical Evolution and Innovation of the Specialized Tax Administration System]. Journal of Shanxi Finance and Tax College 山西財政稅務專科學校學報, (6) (2006). Mi Jianguo 米建國. “Shuishou reng hui chixu gao zengzhang” 稅收仍會持續高增 長 [Tax Revenue Will Continue High Growth Momentum]. China Taxation 中國稅務, (2) (2005). Qian Mu 錢穆. Zhongguo lidai zhengzhi deshi 中國歷代政治得失 [The Political Gains and Losses in Imperial China]. Shanghai: Shanghai Joint Publishing Company, 2005. Wang Jianfeng 王劍鋒. “Zhongyang jiquan xing shuishou gao zengzhang lujing: Lilun yu shizheng fenxi” 中央集權型稅收高增長路徑：理論與實證分 析 [The Centralized Path to Rapid Growth of Tax Revenue: Theory and Empirical Analysis]. Management World 管理世界, (7) (2008). Zhang Guosheng 張國生. “Woguo shuishou guanli yuan zhidu de lishi yange ji pingjia” 我國稅收管理員制度的歷史沿革及評價 [Historical Evolution and Evaluation of China’s Tax Administrator System]. Taxation Research 稅務 研究, (8) (2006). Zhou Qiren 周其仁. “Gongyouzhi qiye de xingzhi” 公有制企業的性質 [The Nature of Publicly Owned Enterprises]. Economic Research Journal 經濟研究, (11) (2000).

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Chapter 3 Chinese materials: Fu Yong 傅勇. “Yusuan wai zijin: Difang zhengfu yunxing bukehuoque” 預算外 資金：地方政府運行不可或缺 [Off-Budget Funds: Indispensable for the Operation of Local Governments]. China Business News 第一財經日報, March 30, 2007. Liu Han 劉涵, and Bi Meijia 畢美家. “Zhidu wai shouru de lilun quanshi yu cesuan fangfa gaige” 制度外收入的理論詮釋與測算方法改革 [Theoretical Interpretation for Off-Budget Funds and the Reform of the Measurement Methodology]. Modern Finance and Economics 現代財經, (9) (2008). Ouyang Rihui 歐陽日輝. “Zhengfu yusuan wai shouru pengzhang jiqi dui caizheng zhengce de yingxiang” 政府預算外收入膨脹及其對財政政策的影響 [The Expansion of Government Off-Budget Funds and Its Influence on Fiscal Policies]. Review of Economic Research 經濟研究參考, (30) (2008). Ping Xinqiao 平新喬. “Zhongguo defang zhengfu zhichu guimo de pengzhang qushi” 中國地方政府支出規模的膨脹趨勢 [The Expansionary Trend of China’s Local Government Expenditures]. Comparative Economic & Social System 經濟社會體制比較, (1) (2007). Ping Xinqiao 平新喬, and Liu Huang 劉黃. “10 wanyi yuan zuoyou GDP zai shou — Zhongguo geji defang zhengfu cheng dizhu” 10萬億元左右GDP在 手——中國各級地方政府成地主 [With Approximately CNY10 Trillion in Hand, China’s Local Governments Became “Landlords”]. China Business Times 中華工商時報, November 1, 2005. Research Group of “Fiscal Supervision” under the Ministry of Finance. Caizheng jiandu 財政監督 [Fiscal Supervision]. Beijing: China Financial & Economic Publishing House, 2003. The Ministry of Finance, National Audit Office, and People’s Bank of China. “Guanyu qingli jiancha ‘xiao jinku’ de juti guiding” 關於清理檢查「小 金庫」的具體規定 [Specific Provisions on the Cleanup and Inspection of “Little Coffers”]. Order No. 29 of the Ministry of Finance, 1995. Wang Shaoguang 王紹光. “Zhongyang defang caili zhi zheng” 中央地方財力之爭 [The Financial Power Struggle between Central and Local Governments]. August 8, 2004. Accessed February 5, 2014. http://m.aisixiang.com/ data/3771.html.

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Chapter 4 Chinese materials: Chen Daisun 陳岱孫, and Li Yining 厲以寧. Guoji jinrong xueshuo shi 國際金融學 說史 [History of International Finance Theories]. Beijing: China Financial Publishing House, 1991. Chen Gong 陳共. Caizheng xue 財政學 [Public Finance]. Chengdu: Sichuan People’s Publishing House, 1994. Chen Yun 陳雲. Chen Yun Wenxuan 1956–1985 陳雲文選1956–1985 [Selected Works of Chen Yun: 1956–1985]. Beijing: People’s Publishing House, 1986. Dai Jinping 戴金平. Guoji jinrong qianyan fazhan: Lilun yu fangfa 國際金融前沿發 展：理論與方法 [Future Development of International Finance: Theories and Methods]. Tianjin: Tianjin People’s Publishing House, 2000.

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Editorial Board of Economic Research Journal. Jianguo yilai shehui zhuyi jingji lilun wenti zhengming 建國以來社會主義經濟理論問題爭鳴 [Disputes over the Theories of the Socialist Economy Since New China]. Volume One. Beijing: China Financial & Economic Publishing House, 1985. Gao Hongye 高鴻業. Xifang jingji xue (hongguan bufen) 西方經濟學（宏觀部分） [Western Economics (Macroeconomics)]. Beijing: China Renmin University Press, 1996. Ge Zhida 葛致達. “Caizheng, xindai yu wuzi de zonghe pingheng” 財政、信貸與物 資的綜合平衡問題 [The Overall Balance in Finance, Credit, and Materials]. Economic Research Journal 經濟研究, (10) (1963). General Planning Department of the Ministry of Finance. Zhongguo caizheng tongji (1950–1991) 中國財政統計（1950–1991） [China Finance Statistics 1950– 1991]. Beijing: Science Press, 1990. Huang Da 黃達. Caizheng xindai zonghe pingheng daolun 財政信貸綜合平衡導論 [Introduction to the Overall Fiscal-Credit Balance]. Beijing: China Financial Publishing House, 1984. ———. Hongguan tiaokong yu huobi gongji 宏觀調控與貨幣供給 [Macroeconomic Regulation and Money Supply]. Beijing: China Renmin University Press, 1999. ———. Huobi yinhang xue 貨幣銀行學 [Economics of Money and Banking]. Beijing: China Renmin University Press, 1999. Huang Yiqing 黃挹卿, and Wang Chuanlun 王傳綸. Zhongguo guoku yewu quanshu 中國國庫業務全書 [A Complete Collection of National Treasury Services in China]. Beijing: China Financial & Economic Publishing House, 1994. Liang Wensen 梁文森. “Guanyu caizheng, xindai, wuzi pingheng de ruogan wenti” 關於財政、信貸、物資平衡的若干問題 [Several Questions Concerning the Balance in Finance, Credit, and Materials]. Economic Research Journal 經濟 研究, (10) (1961). Ma Guochuan 馬國川. Gongheguo buzhang fangtan lu 共和國部長訪談錄 [Interviews with the Ministers of the People’s Republic of China]. Beijing: Joint Publishing Company, 2009. Ma Yinchu 馬寅初. “Lianxi Zhongguo shiji lai tantan zonghe pingheng lilun he an bili fazhan guilü” 聯繫中國實際來談談綜合平衡理論和按比例發展規律 [A Discussion of the Overall Balance Theory and the Law of Proportional Development Based on China’s Realities]. Ma Yinchu jingji lunwen xuanji 馬寅初經濟論文選集 [Selected Works of Ma Yinchu]. Volume Two. Beijing: Peking University Press, 1981. Wang Guangqian 王廣謙. 20 shiji xinfang huobi jinrong lilun pinglun: Jinzhan yu shuping 20世紀西方貨幣金融理論評論：進展與述評 [Reviews of the

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English materials: Haan, J. de, and D. Zelhorst. “The Impact of Government Deficits on Money Growth in Developing Countries.” Journal of International Money and Finance 9 (1990): 455–69. Hicks, J. R. “Mr. Keynes and the ‘Classics’: A Suggested Interpretation.” Econometrica 5 (2), (1937): 147–59. Mundell, R. “Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates.” Canadian Journal of Economics and Political Science, (29) (1963): 475–85. Sargent, T. J., and N. Wallace. “Some Unpleasant Monetarist Arithmetic.” Federal Reserve Bank of Minneapolis Quarterly Review 5 (3), (1981): 1–17. Thoma, M. A. “Sub Sample Instability and Asymmetries in Money-Income Causality.” Journal of Econometrics, 64 (1994): 279–306. Turnovsky, S. Methods of Macroeconomic Dynamics. Cambridge, MA: MIT Press, 1995.

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Chapter 5 Chinese materials: Chang Qing 常青. “Shi lun Chen Yun de jingji pingheng sixiang” 試論陳雲的經 濟平衡思想 [On Chen Yun’s Thoughts of Economic Balance]. Journal of Northwest University for Nationalities 西北民族學院學報, (1) (1998). Chen Yun 陳雲. Chen Yun Wenji 陳雲文集 [Collected Works of Chen Yun]. Two Volumes. Beijing: People’s Publishing House, 2005. Chinese Communist Party Central Literature Editorial Committee. Li Xiannian wenxuan 李先念文選 [Selected Works of Li Xiannian]. Beijing: People’s Publishing House, 1989. Gao Jingzeng 高敬增, and Jiang Guanzhuang 蔣冠莊. “Li Xiannian chu li xin Zhongguo caizheng” 李先念初理新中國財政 [Li Xiannian’s Initial Management of New China Finances]. 2009. Accessed March 6, 2015. http://cpc.people.com.cn/GB/69112/152356/152383/9481459.html. Huang Da 黃達. Caizheng xindai zonghe pingheng daolun 財政信貸綜合平衡導論 [Introduction to the Overall Fiscal-Credit Balance]. Beijing: China Renmin University Press, 2009. ———. Huang Da wenji 黃達文集 [Collected Books of Huang Da]. Four Volumes. Beijing: China Renmin University Press, 2005. Li Chengrui 李成瑞. Chen Yun jingji sixiang fazhan shi 陳雲經濟思想發展史 [A History of the Economic Thoughts of Chen Yun]. Beijing: Contemporary China Publishing House, 2005. ———. “Chixu wending xietiao fazhan jingji de ruili sixiang wuqi” 持續穩定協 調發展經濟的銳利思想武器 [A Sharp Ideological Weapon of Continuous, Steady, and Coordinated Economic Development]. In Chen Yun yu xin Zhongguo jingji jianshe 陳雲與新中國經濟建設 [Chen Yun and the Economic Construction of New China]. Beijing: Central Party Literature Press, 1991. Li Hai 李海. “ ‘San da pingheng’ sixiang de lishi fazhan” 「三大平衡」思想的歷史 發展 [Historical Development of the Theory of “Three Balances”]. Public Finance Research 財政研究, (8) (1991). Li Xiannian 李先念. Li Xiannian lun caizheng jinrong maoyi 李先念論財政金融貿 易 [Li Xiannian Discusses Finance, Financing and Trade]. Beijing: China Financial & Economic Publishing House, 1992. Liu Fengqi 劉鳳歧. Chen Yun jingji sixiang yanjiu 陳雲經濟思想研究 [A Study on the Economic Ideas of Chen Yun]. Xining: Ningxia People’s publishing House, 1993. Peng Xuetao 彭學濤. “Li Xiannian caizheng sixiang jian lun” 李先念財政思想簡論 [A Brief Discussion on the Fiscal Thoughts of Li Xiannian]. Shehui kexue dongtai 社會科學動態 [Trends in Social Sciences], (7) (1999).

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Rong Zihe 戎子和. “Chen Yun lingdao caijing gongzuo huiyi” 陳雲領導財經工作回 憶 [Recollection of the Fiscal and Economic Work under the Leadership of Chen Yun]. Chen Yun yu xin Zhongguo jingji jianshe 陳雲與新中國經濟建設 [Chen Yun and the Economic Construction of New China]. Beijing: Central Party Literature Press, 1991. Song Xinzhong 宋新中. Dangdai Zhongguo caizheng shi 當代中國財政史 [The History of Finance in Contemporary China]. Beijing: China Financial & Economic Publishing House, 1997. Wang Bingqian 王丙乾. Zhongguo caizheng 60 nian huigu yu sikao 中國財政60年回 顧與思考 [A 60-Year Review and Reflection of China’s State Finances]. Beijing: China Financial & Economic Publishing House, 2009. Wang Jie 王傑. “Chen Yun de zonghe pinghe tantao” 陳雲的綜合平衡探討 [Discussions on the Overall Balance Proposed by Chen Yun]. Journal of Lanzhou University 蘭州大學學報, (3) (1999). Xiang Huaicheng 項懷誠. Zhongguo caizheng wushi nian 中國財政五十年 [A FifthYear History of China’s Finance]. Beijing: China Financial & Economic Publishing House, 1999. ———. Zhongguo caizheng tongshi 中國財政通史 [The General History of China’s Government Finances]. Volume of Contemporary China. Beijing: China Financial & Economic Publishing House, 2006. Yu Tianyi 俞天一. “Chong lun caizheng, jinrong bixu xietiao peihe” 重論財政、金 融必須協調配合 [Restatement on the Necessary Coordination between the Fiscal Authority and Banks]. Financial Science 金融科學, (1) (1992). Zhang Jian 張建, and Wang Jian 王建. “Chen Yun jingji fazhan guan chutan” 陳雲 經濟發展觀初探 [A Preliminary Study on Chen Yun’s Views on Economic Development]. Journal of Hefei University of Technology 合肥工業大學學報, (2) (2001).

Translated material: Marx, Karl. “Credit and Fictitious Capital” In The Process of Capitalist Production as a Whole. Volume 3 of Capital. Accessed on April 30, 2015. https://www. marxists.org/archive/marx/works/1894-c3/ch25.htm.

Chapter 6 Chinese materials: Financial Research Institute of the Development Research Center of the State Council. “Zhongguo yinhang tixi daikuan gongji de jueding ji qi dui jingji bodong de yingxiang” 中國銀行體系貸款供給的決定及其對經濟波動的影

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響 [Credit Supply Decisions of China’s Banking System and Its Impact on Economic Fluctuations]. Journal of Financial Research 金融研究, (8) (2003). Huang Jinlao 黃金老. “Li bu kai de daikuan xian’e kongzhi” 離不開的貸款限額控 制 [The Indivisible Dependence on Credit Quotas]. China Finance 中國金 融, (6) (2010). Li Yang 李揚, Wang Guogang 王國剛 et al. Zhongguo jinrong gaige kaifang 30 nian yanjiu 中國金融改革開放30年研究 [Research on the 30 Years of China’s Financial Reform and Opening Up]. Beijing: Economy and Management Publishing House, 2008. Wu Xiaoling 吳曉靈, ed. Zhongguo jinrong tizhi gaige 30 nian huigu yu zhanwang 中 國金融體制改革30年回顧與展望 [A 30-Year Review of China’s Financial System Reform]. Beijing: People’s Publishing House, 2008. Zhou Shengye 周升業. Zhongguo huobi liutong de huigu yu zhanwang 中國貨幣流 通的回顧與展望 [Review and Outlook of China’s Monetary Circulation]. Beijing: China Renmin University Press, 1993. Zhou Zhengqing 周正慶. Zhongguo huobi zhengce yanjiu 中國貨幣政策研究 [Research on China’s Monetary Policy]. Beijing: China Financial Publishing House, 1994.

English material: Kornai, Janos. “Resource-Constrained Versus Demand-Constrained Systems.” Econometrica, (47) (1979): 801–919.

185

Index accounts, final 7, 87–88 administrative power 15, 49, 80–81, 104–5, 144 aggregate demand 121–22, 136, 144, 160– 161 balancing 46, 137 Agricultural Bank of China 21–22, 32, 37 Agricultural Development Bank of China 36, 151 agricultural surtax 74, 78, 80 AMC (asset management corporation) 37 China Cinda 37 China Great Wall 37 China Huarong 37 China Orient 37 balance credit 3, 10, 20–21, 23–25, 31, 44, 46–47, 109–10, 112–18, 120–121, 128–30, 135, 137–39 fiscal 17, 108–10, 112–14, 116–18, 120, 129, 132, 138–39 foreign exchange 109, 115 material 109, 114–16, 118, 135, 139 balances three major 11, 109, 132, 134 four 109, 112, 116, 119, 122, 135–37 bank credit 2, 11, 19–20, 23, 46, 117–18, 126–27, 133 Bank of China 32–33, 36–37, 80, 87, 91, 93, 129, 153, 157 banks, policy-based 4, 51 base money 34, 121, 152–53 BoP (balance of payments) 109, 115, 123 budget deficit 21, 100, 117, 121 Budget Law 33, 90, 94

budget plan 80, 88, 93–94, 98, 111, 127–28 budgetary funds 26, 50, 86, 89, 95, 104–5, 130, 135, 138 budgetary revenue 75–76, 79–82, 86–90, 99, 102, 104, 126, 129 capacity, national 108, 135–36, 141 capital construction 7, 10, 12, 18–19, 22–23, 28, 80, 87, 109–10, 127–28, 130–131, 134, 140 capital flows 8, 20, 32, 118, 120–122 CBRC (China Banking Regulatory Commission) 154 Chen Yun 108–9, 128, 132–34, 139 China Construction Bank 7–8, 10, 18–19, 22–23, 28, 32, 36–37 China Development Bank 36, 151 China Guangfa Bank 37 closed-crotch pants relationship 2, 5, 12, 16–18, 21, 28, 33, 43–44 Commercial Bank of China 21–22, 32, 36– 37 constraints, soft budget 155, 158–59, 161 contract management responsibility system 88 corporate system, modern 24, 48–49 CPC (Communist Party of China) 15, 83, 88, 104, 109, 127, 131, 135, 151 CPC Central Committee 84, 89, 93, 135 credit balance deficit 3, 21, 113, 117, 130 credit ceilings 144–45, 149–51 credit control 145, 148, 150, 161 credit difference 114, 147–48 credit difference contract 148 credit difference plans 148

187

Index

credit funds 2–5, 7, 9–11, 18–19, 25–27, 39–40, 47, 108–10, 113, 128–31, 133– 35, 138–39, 147–49, 154–55, 158–59 credit funds management 7, 147–48 credit funds management mechanism 44 credit imbalance 113–14 credit plans, consolidated 114, 118, 147, 149 credit policies 44, 152–53, 161 credit quotas 143–62 credit scale 141, 144, 147, 150–151 credit sources 5, 15, 139 credit supply 8, 47, 109, 139–41, 151, 158– 59 Cultural Revolution 8, 11, 16, 81–82, 112, 134 currency circulation 7, 47, 133–34, 139 debts, bad 37, 46, 158 decentralization of fi nancial resources 99– 100 decentralization of power 8, 22, 59, 80, 82, 102–3, 105 dedicated management 57 depreciation funds 14, 75, 81–82, 85, 89, 104 division of labor 8, 26, 44, 58, 87 eating from separate pots 83 eating from the same pot 83 economic accounting 7, 18, 79 economic adjustment 11, 15, 111, 134, 137– 38, 149 economic globalization 62, 122–23 economic overheating 26, 35, 42, 135, 145, 149–50, 158–59, 161 economic system planned 5, 12, 28, 88, 95, 103, 112, 118 market 12, 28, 41, 49, 154 economic system reform 103, 150

188

economy, transitional 36 efficiency losses 155–56, 158, 161 enterprise funds 82, 84, 104 equilibrium external 123–24 internal 31, 122–23 expenditure responsibilities 83, 105 expenditures, off-budget 98–99 finance development-oriented 97–98 public spending-oriented 97–98 financial resources 29, 31, 42, 44, 77, 83, 98–100, 103, 138 financial system reform 151 fiscal-banking relationship 5, 9–10, 12, 15, 21, 24, 28, 31–33, 41, 43–44, 48 fiscal-banking system 20, 48 fiscal budget 100, 108–9, 114–16, 120, 129–30 fiscal contract system 10 fiscal-credit balance 20, 23–24, 31, 44, 46– 47, 109–10, 120–121, 137–39 fiscal deficits 22, 25, 33, 46, 108, 110–112, 120, 127, 133 fiscal functions 6–7, 26, 29, 33, 41 fiscal funds 4–5, 11, 19, 23, 25–26, 33, 38, 40, 43, 46, 74, 84, 90–91, 108, 113 fiscal overdrafts 25, 48 fiscal policy 34–35, 41–42, 44, 46–47, 102, 121, 123, 139 fiscal risks 38–40, 47 fiscal surplus 3, 113, 126–31 fiscal system 13–14, 20, 32, 36, 40, 77, 79–80, 83, 89, 92–93, 97, 101, 103, 105, 116 Five-Year Plan First 10, 79–80, 97, 127 Second 80 fixed-asset investments 23–24, 98, 149 funds, self-raised 77–78, 87

Index

GDP (Gross Domestic Product) 71, 88, 99, 160 Gosbank 12 government allocation pattern 106 government bonds 3, 33–35, 49 long-term 34 short-term 33 government debts 35, 49 government finances 2, 13, 15, 17, 20, 22, 46, 98, 115, 132–38 Great Leap Forward 8, 11, 16, 79–81, 111, 134, 138 growth elasticity 117 hidden subsidies 37–38 imbalance, fiscal 4, 24, 120, 133 income extralegal 89 household 41, 141 miscellaneous 74, 77, 79 industrial policies 48, 137 interest rate control 144, 151 interest rates, benchmark 145, 151, 153, 159 labor reform organizations 74, 78, 80 large treasury, small banking 9, 116–17 Li Xiannian 128–29, 131, 133 little coffers 88–89 loans nonperforming 24, 27, 32, 39, 156–57 relending 38, 157 loans for fiscal appropriations 22–23 macroeconomic regulation 2, 32–33, 43, 45–46, 116, 119, 123, 138, 140, 148, 152 management centralized 14, 16, 64, 116 decentralized 8, 100

mandatory plans 26, 152 market economy, socialist 41, 56, 88, 92–93, 101, 104, 151 mechanism, reversed monetary expansion 144, 156–57 Ministry of Finance 6–13, 16, 18, 21–23, 27–29, 33–38, 49, 78, 80–81, 84, 86– 87, 89, 91, 93–94, 129–30 monetary balance 116, 118, 120–121 monetary base 38–39 monetary policies 12, 15, 31, 34–35, 38, 41– 42, 44–50, 121, 123, 140–141, 144–45, 147–48, 151, 154, 159–62 intermediary target of 151, 153, 156, 160 monetary policy tools 34, 144–45, 147, 156, 161 money circulation 47, 117, 139 money supply 20, 41, 109, 111–14, 119–22, 128, 131, 133, 144, 147–48, 151, 153, 156, 158–60 money supply indicators 151–52 moneybags 2–3, 116 National Bureau of Statistics of China 76, 100 nonperforming assets 30, 36–37 nontax revenues 89–90, 92–93 NPC (National People’s Congress) 88, 98 off-balance sheet items 157 off-budget funds 73–77, 79–91, 93–103, 105–6, 138 coverage of 74, 89–91 management of 79, 81, 86–87, 90, 92–93 off-budget funds system 94, 96 off-budget revenue 75–76, 81, 86, 89–91, 99 Olson’s dilemma 101, 103 operation, open-market 151–54, 159, 161 overall balance 9, 15, 108, 119, 132

189

Index

overall balance theory 9, 15, 108–10, 112, 119, 124, 133–40 overdrafts 3–4, 33, 38 overhaul funds 74, 79–80

market-oriented 36, 118, 159 state-owned enterprise 38–39, 48, 104 revenues, fixed-ratio shared 83 revolutionary base areas 77, 132

PBC (People’s Bank of China) 6–10, 16, 18, 21–22, 28, 32–34, 38–39, 42, 50, 118, 145–53, 157 PBC branches 148–50 PBC head office 147–51 People’s Construction Bank 7–8, 10, 23 People’s Victory Bonds valued in kind 77 planned economy 2, 7, 9, 12–13, 15–16, 28– 29, 31, 55–56, 101, 105–6, 114, 116, 118–20, 138–39, 147 polyandry 125–29, 131, 133, 135, 137, 139, 141 pretax loan repayment 27 profit retention system 15, 23, 74–75, 80– 81, 85, 96, 104 property rights 30, 48, 65 de facto 65 de jure 65 Provisional Central Government 5–6 public institutions 74, 77–79, 81, 84–88, 91, 93, 95–96, 98, 100–101 public service charges 75, 84–85, 87, 89–94, 96 purchasing power 14–15, 100, 109, 116, 139 social 11, 134, 139–41

sberkassas 12 Seventh National People’s Congress 135 social demand, aggregate 15, 25, 34, 46, 136, 139, 148 social security funds 75, 90, 93 social supply, aggregate 115, 121–22, 137 specialized banks 12, 21, 32, 148–51, 156 specialized on-site fiscal supervisors 56 specialized tax administration system 53–67, 69–72 specialized tax administrators 54, 56–57, 59–61, 63, 66–71 State Administration of Taxation 58, 68–70 State Council 6–7, 21–22, 24, 28, 32–33, 36, 42, 58, 75, 77–78, 82–83, 86–90, 92–93, 129, 150–151 state-owned banks 22, 25, 32, 35–37, 48–50, 145, 152, 157–58, 161 state treasury 6, 22, 91, 93, 138 Stroibank 12 supply, double-source 7 surcharges, commercial tax 74, 78–80

rash advance 127, 132 anti- 132 ratio asset-liability 145, 151–52 capital adequacy 36, 154 reform economic 29, 32, 95, 105–6 educational 75, 86, 97 fiscal decentralization 75, 104

190

targets instructive 149, 153–54 mandatory 148–49, 154 tax administration powers 62, 64, 67–69 tax administrator system 58, 62–64, 71 tax administrators 54–55, 57–58, 62–64, 67, 69–71 tax effort 65–67, 99 tax elasticity 71 tax evasion 59, 63, 65–67 tax for profit 22, 55, 85 tax sharing reform 32, 60, 71, 95, 105

Index

taxation facilitator 59 three arbitrariness 39 three-pronged development 130 three rural issues 142 transfer payments 105 treasury, minor public 77–78, 95 unified control over fiscal revenues and expenditures 13, 116 unified state control over deposits and loans

191

Reveals the Unique Milestones in China’s Public Finance Development Major Issues and Policies in China’s Financial Reform Volume 1 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 1 kicks off with an overview of the “closed-crotch pants” relationship between the fiscal and banking systems, followed by how China’s tax administration shifted from the hands of “specialized tax administrators” to “tax administrators,” how “off-budget funds” have gradually faded out of government accounting, how China came to realize the importance of maintaining an “overall balance” in fiscal funds, credit funds, materials, and foreign exchange, how the “polyandrous” use of fiscal surpluses by the fiscal authority and banks was corrected in budgeting, and finally, whether “credit quotas” still matter to China’s monetary policy.

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