Major Issues and Policies in China's Financial Reform 9781623200770, 9781623200329

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Major Issues and Policies in China’s Financial Reform Volume 3

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: 11/F, Benson Tower, 74 Hung To Road, Kwun Tong, Kowloon, Hong Kong, China China Office: Rm 309, Building A, Central Valley, 16 Haidian Middle Street, Haidian District, Beijing, China Singapore Office: 16L, Enterprise Road, Singapore 627660 Chinese original edition © 2013 China Renmin University Press Editors in chief: Chen Yulu and Guo Qingwang Deputy editors: Zhang Jie, Wang Changyun, and Qu Qiang English edition © 2017 by Enrich Professional Publishing, Inc. With the title Major Issues and Policies in China’s Financial Reform Volume 3 Translated by Barbara Cao and Phoebe Poon Edited by Barbara Cao 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) 978-1-62320-032-9 ISBN (pdf) 978-1-62320-077-0 This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Enrich Professional Publishing is an independent globally-minded publisher focusing on the economic and financial developments that have revolutionized New China. We aim to serve the needs of advanced degree students, researchers, and business professionals who are looking for authoritative, accurate, and engaging information on China.

Contents Chapter 15 Reversed Monetary Expansion Mechanism ................................ 1

Song Wei

Chapter 16 Triangular Debts .............................................................................. 19 Qu Qiang Chapter 17 Tiger in the Cage .............................................................................. 37

Zhang Jie

Chapter 18 Designated Loans ............................................................................. 67

He Ping

Chapter 19 Tax and Fee Reforms ........................................................................ 91

Jia Junxue

Chapter 20 Soft Landing ...................................................................................... 109

Zhang Chengsi

Chapter 21 Unification of Exchange Rates ........................................................ 133

Wang Fang

Notes

............................................................................................................. 157

Bibliography .............................................................................................................

165

Index

179

.............................................................................................................

15

Chapter

Reversed Monetary Expansion Mechanism

MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 3

A “reversed monetary expansion mechanism” is a bottom-up expansion of money supply that occurred due to a soft budget constraint for state-owned enterprises (SOEs). Seeking growth, the SOEs’ burgeoning demand for loans will compel stateowned commercial banks to raise credit limits, which will in turn force the central bank to expand relending to the commercial banks.

Historical Background At the early stage of China’s Reform and Opening Up when the market economy had not been established yet and the planned economy remained in place, SOEs continued playing a dominant role in the national economy and state-owned banks functioned as financial providers for economic transition. It was against such a backdrop that the “reversed monetary expansion mechanism” came into being. Major players associated with the mechanism are SOEs endorsed by local governments, state-owned banks, and the People’s Bank of China (PBC).

State-owned enterprises SOEs have been, for a very long time, the main demanders in the credit market. Their demand, however, is not decided by the market, but a combination of multiple factors. First of all, SOEs shoulder not only economic functions, but also social functions, such as alleviating unemployment, improving social welfare, and ensuring social stability. Next, the state-dominated ownership structure saves them from the hard constraint of costs and benefits. The credit demand of SOEs, thus, can be categorized into three types: effective, inefficient, and ineffective demand. The demand based on the real market can be discerned as necessary, effective demand while that aroused from policy-oriented targets or self-interest maximization can only be deemed as inefficient, or even ineffective demand, imposing tremendous pressure on the banking system to expand credit. The enterprise behaviors stimulated by inefficient and ineffective demand are the primary trigger of the reversed monetary expansion mechanism. As the main driver of the national economy, SOEs topped the government’s reform agenda since the Reform and Opening Up in hopes of raising their efficiency. In retrospect, the reform in SOEs was a progressive process, from the early “power devolution and profit relinquishments to enterprises,” to the “responsibility contracting system,” “corporate reform,” and “stockholding system.” Following the idea of incremental reform, the Chinese government initiated a number of reforms to decentralize power and allow more profits to SOEs between 1979 and 1993, in order to improve their business performance. The persistent

2

Reversed Monetary Expansion Mechanism

problems such as unclear ownership, ineffective incentive mechanism, and insider control revealed the fact that those reforms had not fundamentally eliminated the deep-seated defects in SOEs with respect to the ownership system, corporate governance structure, and government’s functions. The coaction between the expansion mechanism of soft constraints in SOEs and local governments’ administrative intervention as well as the conflicts between micro and planned macro credit demand expansion caused inefficient and ineffective demand to be constantly satisfied, which created conditions for the functioning of the reversed monetary expansion system. Coase argues that every transaction has a cost, and transaction costs vary with property rights system, which in turn affects the efficiency of resource allocation; thus, the selection of the property rights system is ultra-important for the optimization of resource allocation.1 In November 1993, the Third Plenary Session of the 14th Central Committee of the Chinese Communist Party (CPC) brought forth that to establish a modern corporate system was the prerequisite for developing socialized mass production and a market economy and it was also the orientation of the SOEs reform. This announced the start of institutional innovation in China’s SOEs reform. In 1994, the State Council explicitly clarified the content of the modern enterprise system, which was “clearly established ownership, well defined powers and responsibilities, separation of enterprise from administration, and scientific management.” Shortly after, it released another policy of “restructuring major enterprises while relaxing control over small ones” (zhu da fang xiao 抓大放小) to reform SOEs. While gradually revitalizing economic stocks, China also made remarkable progress in developing economic increments. Non-state economy, which is more subject to market rules, developed rapidly and its share in total industrial output value constantly grew, from 22.4% in 1978, to 57.6% in 1993, and further to 71.8% in 1998. The growth of non-state economy meant that SOEs were no longer relied upon to perform social development roles, further ensuring the smooth implementation of progressive reform.

State-owned banks State-owned banks have long been the major suppliers in the credit market. In accordance with the efficiency principle entailed by the market economy, bank credit should go to the most profitable projects or enterprises. However, China’s state-owned banks were multitasked: Apart from seeking profits, they also had to help with governments’ reform. They played a unique and crucial role in China’s economic transition. Zhang pointed out that state-owned banks provided sufficient credit support for “intra-establishment output” (i.e., state-owned economy) and

3

MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 3

ensured its steady growth in the process of economic transition, but this was at the expense of the banks’ efficiency, manifested in a load of bad debts. Under the synergy of soft budget constraints and policy-oriented positioning, the credit businesses of state-owned banks were largely manipulated by local governments’ preference and banks’ localized interests, impelling the local banks to transfer the burdens of inefficient and ineffective credit to the central bank. To externalize credit risks and losses to the state was an important reason for the reversed monetary expansion.2 Looking back at China’s economic reforms, reform in the financial system lagged that in the real economy, reform in financial institutions lagged that in the financial market, and reform in state-owned banks lagged that in SOEs. The underlying reason was that financial reforms were complex for one thing; and for another, the government wished to support economic transition by means of financial control. China’s banking sector experienced four stages of reform, from specialization to the introduction of a multi-ownership system, commercialization, and modernization, in hopes of developing a modern banking system. After the Industrial and Commercial Bank of China (ICBC) was spun off from the PBC in 1984, a two-tiered banking system was formally established. In 1987, China’s first joint-stock commercial bank — China Merchants Bank (CMB), was incorporated, succeeded by the establishment of a dozen of similar banks. By then, a banking system with four big state-owned banks (namely, the Bank of China, the China Construction Bank, the ICBC and the Agricultural Bank of China) as the mainstay and other joint-stock commercial banks as supplements had been formed. Judging from the asset composition, state-owned banks had long held a dominant position in the credit spectrum, and it share in total loans of financial institutions was 92% in 1985 and 70% in 1992. Owing to government control, the financial system worked as a buffer during the economic reform. With the continuous accumulation of nonperforming loans, the costs of financial control rose sharply, and by the early 1990s, such an administrative control over the financial system could hardly meet the demand of continuous economic transformation and growth. In 1994, with the founding of three policy banks, the four big state-owned banks started to transition from specialized banks to commercial banks. After 1997, with the expansion of non-state economy and the further reform of “restructuring major enterprises while relaxing control over small ones,” state-owned banks’ pressure to finance economic transition was eased, and a series of measures were carried out to reform the banking system, such as strengthening internal supervision and risk control, centralizing credit decisions to the head office and provincial-level branches, introducing an one-vote veto system in loan approval, and linking the pay of loan officers to loan recovery. In this way, banks’ loan constraints became hardened

4

Reversed Monetary Expansion Mechanism

and government intervention was averted. At this point, the role of banks in the reversed monetary expansion mechanism began to weaken.

People’s Bank of China As monetary authorities, the PBC performs the functions of formulating and implementing monetary policy and safeguarding financial stability. Under a market economy, the central bank of a country enjoys considerable independence, and it releases monetary base and regulates money supply mainly through three tools — reserve requirements, the discount rate, and open market operations (OMPs). Prior to the establishment of the two-tiered banking system in 1984, the PBC was burdened with the businesses of commercial banks with little independence, and thus could not be deemed as a central bank in its real sense. After its split from the ICBC, the PBC divested itself of commercial banking businesses and repositioned itself as a real central bank. As a kind of institutional evolution, the return of the PBC to the central bank functions was also a gradual process. For a considerable long period of time, the needs to observe government plans and support economic transition made it impossible for the PBC to devise and carry out monetary policy all alone. At that time, there were only limited options of monetary policy tools, measures for regulating money supply were direct, and monetary decisions were made in an administrative manner. Credit quota refers to the upper limit of new loans released to meet the targets of monetary policy in a given period, and it is also known as aggregate loan limit. Starting from 1984, the PBC clearly made credit quotas as an intermediate target of monetary policy. Credit quotas would be confirmed when compiling the national bank credit plan and transmit to lower-level branches via the head office of each specialized bank. In most cases, the credit quotas of different loan types were instructive with just one exception that the limit on fixed assets loans was mandatory. In reality, banks can grant as many loans as they like as long as they have sufficient deposits. In 1989, the PBC renamed credit quotas “maximum credit ceilings” and prescribed corresponding management measures: With maximum credit ceilings, specialized banks and other financial institutions should make loans with their own deposits but must not exceed the credit ceilings prescribed by the PBC; however, the head office and branches of each specialized bank could adjust their quarterly credit ceilings based on actual situations. Since credit ceilings were man-made, they were subject to human factors. The desire to boost economic growth and the preference for low-interest loans impelled SOEs and local governments to frequently extend their investment demand beyond the state plans, forcing the specialized banks to demand a raise in the credit ceiling by the

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MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 3

head office of the PBC, hence forming the reversed monetary expansion initiated by commercial banks to the central bank. The credit scale management was premised on the allocation system of credit funds under the planned economy, and with the gradual establishment of a market economy and the diversification of market participants, the credit scale management stepped down from the stage. In 1998, the PBC abolished its direct control over credit size and replaced it with indirect regulation on money supply.

Working Mechanism of Reversed Monetary Expansion From the initial stage of China’s Reforming and Opening Up to 1994, it was a common consensus to ensure stable economic growth, promote gradual economic transition, and mitigate the shocks arising from radical institutional changes. During this period, to place a credit ceiling on commercial bank lending was the major tool used by the Chinese monetary authorities to regulate money supply, for state-owned banks were key links in credit creation and monetary policy transmission, and SOEs were the main power driving the real economy. Money supply in China displayed the following characteristics.

Overwhelming demand for bank credits State-owned banks were under tremendous pressure to meet their borrowing demand from SOEs. This pressure was predominantly derived from three sources: SOEs, local governments, and enterprise employees.

SOEs In accordance with the market selection rules, banks should conduct double screenings of both borrowing enterprises and projects based on their credit records, and prioritize loan requests from eligible borrowers while restrict or refuse loans to uncreditworthy, unprofitable or even loss-making enterprises. SOEs, however, obtained credit support by relying on government reputation and state ownership rather than their own market credit. For SOEs, regardless of the economic output, as long as they can derive loans from banks to sustain and expand production, their self-interests can be maximized; and even if losses are recorded due to ill management, they will be exempted from being closed down or holding liable for defaulting on loans. From the perspective of state-owned banks, the debts that SOEs failed to repay would be passed on to government fiscal departments as nonperforming loans.

6

Reversed Monetary Expansion Mechanism

Local governments It was the common objective of local governments to stimulate local economy by expanding production, increasing employment, and sustaining the continued operation of even inefficient enterprises. This was pertinent not only to local fiscal revenues and expenditures, but also regional and political stability. To achieve this objective, it was of paramount importance to strive for as many bank loans as possible when financing through market-oriented approaches, such as stocks, securities, and risk investment were still underdeveloped yet. Although banks had established its own systems in terms of the organizational fabric and management hierarchy, they had to tilt their financial resources in favor of local development in the face of the strong intervention from local governments.

Enterprise employees During the initial growth stage of the non-state sector, the amount of replaceable jobs it created was rather low. SOEs were a guarantee for an employee’s lifetime welfare benefits given the underdeveloped social security system. Naturally, the state’s employment pressure was laid on the shoulders of SOEs and even if an enterprise operated at a loss, it had to continue running and paying salaries and bonuses. Such rigid demand for individual benefits further increased the reliance of SOEs on bank funds.

The need to meet excess credit demand State-owned banks also had the intrinsic motivation to adapt to the excess credit demand. Prior to the incorporation of policy banks, state-owned banks were in charge of both commercial loans and policy-based lending. For those banks, their state ownership protected them from going bankrupt and allowed them to pass non-performing loans on to the fiscal department. Under the system of controlled interest rates, banks could receive stable interest spreads of deposits and loans, and the expansion of loans would mean more profits. For this reason, banks would naturally further extend credit to enterprises to meet their excess demand. It is evident from Fig. 15.1 that under the market economy, the neoclassical equilibrium is at E* where credit supply S(r) intersects with credit demand D(r) and the corresponding equilibrium interest rate and loan quantity are r* and L*, respectively. If the government intervenes in the credit market to press the interest rate down to r1, a lower interest rate will stimulate higher credit demand but suppress credit supply, and consequently, the new equilibrium will move to E1*. At

7

MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 3

this point, the credit supply curve will shift to L1* and the credit demand curve, to L2*, creating a gap between supply and demand which can be expressed as ΔE =L2* – L1*. However, considering the soft budget constraints on China’s banking sector, state-owned banks were not sensitive to the fluctuations of interest rates under the government-controlled interest rate system. Therefore, at the interest rate level of r1 as set by the government, the credit supply curve is a horizontal line parallel to the x-axis, S(r1), the credit equilibrium is the intersection of S(r1) and D(r) at E2*, and the equilibrium quantity of loans is L2*. So it can be concluded that the credit supply of state-owned banks reaches its maximum at the equilibrium point E2*. This depicts the first stage of reversed monetary expansion — state-owned banks adapting to SOEs’ credit demand. Fig. 15.1

Credit supply and demand curves for state-owned banks

r

S(r)

E*

r*

r1

E1*

E2* ΔE

0

L1*

L*

S(r1) D(r)

L2*

L

Incapability to control monetary expansion It was hard for the central bank to regulate the expansion of the monetary base. The low independence of the PBC decided the formulation and implementation of monetary policy had to be subject to the decisions of higher governmental authorities. In the absence of a sound external market, tools that can be used to regulate money supply, such as interest rates and the reserve ratio, by the central bank were very limited. State-owned banks were unaffected by interest rate changes whether when they were borrowing from the central bank or granting loans to

8

Reversed Monetary Expansion Mechanism

SOEs, because both interest rates were set by the government, having allowed considerable interest spread for the banks. With sufficient financial support from the central bank, state-owned banks usually can obtain more loans from the central bank to offset the side effects of raising the reserve ratio. In this case, credit quotas and central bank lending to commercial banks became readily available monetary policy tools. Under the pressure of continuous credit demand expansion, stateowned banks asked for a lift in loan quotas and additional lending from the central bank, resulting in the constant growth of monetary base and aggregate credit quantity. This delineates the second stage of reversed monetary expansion — stateowned banks transmitting credit pressure to the central bank.

Institutional Implications The phenomenon of reversed monetary expansion appeared during China’s transition from the planned to the market economy. Its formation was a collective result of three relational forces, between banks and enterprises, between the central bank and other banks, and between banks and local governments.

Relationship between banks and enterprises State ownership and soft budget constraints were two important institutional factors affecting Chinese banks’ loan decisions. In the absence of a market-oriented debtor-creditor relationship, credit contracts were unable to impose tight constraints on state-owned banks and SOEs. Therefore, the reversed monetary expansion was first triggered when banks responded passively to the credit demand of SOEs under soft budget constraints. Kornai was the first to bring about the concept of “soft budget constraints” by pointing out that in the context of transition economies, “if an enterprise found itself in financial trouble, the state bailed it out unconditionally. A variety of techniques were used for the purpose: extending financial subsidies, granting tax concessions or postponing tax commitments, rescheduling loan repayments, or providing new soft loans. All these techniques involved constantly breaking rules of financial discipline. This is the group of phenomena that I termed softness of the budget constraint….”3 There is plenty of research about the impact of soft budget constraints on the credit expansion of the banking sector. Qian and Wan studied the allocation of financial resources with government intervention, discovering that under soft budget constraints, credit imbalance between banks and enterprises would lead to distorted credit expansion, thus coming to the conclusion that soft budget constraints were one of the major reasons for the accumulation of credit risks in banks.4 Shi endorsed their research by finding

9

MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 3

that soft budget constraints were an inherent cause for state-owned banks’ nonperforming loans, and as long as the soft budget constraints existed, bad loans would continue accumulating to break credit balance and increase money supply.5 Chen at al. believed that soft budget constraints existed not only between SOEs and state-owned banks but also between private enterprises and banks, and in fact, soft budget constraints arose whenever there was government intervention or constant financial support from banks, driven by their own interests, to enterprises; so, the soft budget constraint syndrome could be found between the banking sector and any kind of enterprises. Distorted credit expansion under soft budget constraints, they added, would go beyond the credit scale under no government intervention, and the tighter the soft budget constraints, the larger divergence of the optimal credit scale from the equilibrium point.6

Credit scale management and relending to commercial banks by the central bank Since the establishment of the two-tiered banking system in 1984, the financial relationship between commercial banks and the central bank worked in two ways: First, the central bank imposed strict credit plans and credit scale management on commercial banks in order to control monetary base and currency supply; second, in accordance with reserve requirements of commercial banks, the central bank offered financial support through relending. Then came the second stage of the reversed monetary expansion: The central bank was compelled to adapt to commercial banks’ excessive credit demand and extra reserve requirements, arising from meeting the excessive borrowing demands from enterprises, which will ultimately lead to an increase in monetary base and money supply.

Credit scale management Prior to the Reform and Opening Up in 1979, the central bank implemented a system of “unified control over deposits and loans” (tong cun tong dai 統存統貸) in credit funds management. In 1979, this system was changed to the “credit difference contracting” (xindai cha’e baogan 信貸差額包乾) system. In 1984, the central bank announced credit management measures of “unified planning, hierarchical management, pegging deposits to loans, and contracting credit differences” (tongyi jihua, fenji guanli, cundai guagou, cha’e baogan 統一計劃，分級管理，存貸掛鉤，差 額包乾) to separate the central bank’s funds from those of commercial banks. After 1995, the credit planning system was gradually perfected and the “asset-liability ratio” was introduced to manage credit funds in commercial banks. Consolidated

10

Reversed Monetary Expansion Mechanism

credit plans were the major means used by the central bank in credit scale management. For a long time, consolidated credit plans regulated credit funds through imposing credit limits on banks in order to control money supply, stabilize commodity prices and promote sustainable economic growth. Planned allocation of financial resources disregarded the role of the market mechanism, resulting in constant violations of the planned scale and ineffective distribution of credit funds (see Fig. 15.2). Fig. 15.2

National credit plans and actual implementation

(%) 90

900

80

800

70

CNY1 billion

700

60

600

50

500

40

400

30

300

20

200

10

100 0

0

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Planned amount

Actual amount

-10

Variance (%)

Source: Statistics and Analysis Department of the People’s Bank of China, Almanac of China’s Finance and Banking, various years.

Judging from Fig. 15.2, apart from in 1988 and 1997, the actual loan scale outstripped the figures stated in the plans by 17.5%–77.4%. The underlying reasons can be summarized as follows. First, the central bank was not independent enough and had to be subject to government orders to adjust the loan scale and modify the credit plan in order to adapt to the needs of political and economic development. This was because for one thing initial plans were often not reasonable and required further adjustments; and for another, money demand created out of the changes in economic development overtook the number preset in the plan, which also entailed further adjustments. But these two factors were not larger enough to trigger substantial deviations from the plans, and there were two more profound reasons. Next, the defects in the credit management system allowed local branches of the central bank to press the head office to increase credit funds. Before 1994, PBC branches not only owned 7% of the credit scale adjustment right, but also handled

11

MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 3

70% of the central bank relending to specialized banks, as well as the distribution of special-purpose loans. The decentralized management of credit funds allowed the local branches to act in the interests of local governments by demanding larger credit amounts from their head office. It was not until the promulgation of the Law of the People’s Republic of China on the People’s Bank of China in 1995, which centralized the loan right to the head office, that the above phenomenon was disappeared. Last, to adapt to the expansionary investment demand of enterprises under soft budget constraints, commercial banks increased credit supply, which forced the central bank to expand the total credit scale. Besides that, commercial banks also relied on financing through non-bank financial institutions or holding shares in enterprises to evade the central bank’s credit scale management, both of which in fact expanded the actual financing scale.

Relending to commercial banks In most western countries, OMPs are an important tool used by the central bank to adjust the monetary base. But this is premised on large-scale securities and foreign exchanges in the market. Prior to 1994, as China’s securities market was at its primary stage and foreign exchange reserves were low, OPMs lacked the necessary market basis. Therefore, central bank relending was the primary channel for monetary base injection, accounting for over 70% in most years, and even surpassing 90% in 1986 and 1993; fiscal overdrafts were the secondary means for releasing monetary base. After 1994, loans to policy banks and positions for foreign exchanges purchases substituted for relending and fiscal overdrafts to become the major channels for monetary base adjustment (see Table 15.1). As the lender of last resort, the PBC must give emergency liquidity support when there is a funding shortage in commercial banks or a systematic crisis in the banking sector. The state ownership equipped commercial banks with soft budget constraints while shielding them against bankruptcy, and bank managers demanded constant increases in credit funds out of local and self-interests. More bank lending meant more required reserves, and loans without credit support may easily turn into bad loans, which would entail the central bank’s relending to replenish reserve funds; otherwise, the banking system would face systematic payment risk. Moreover, before the founding of policy banks in 1994, stateowned banks were entrusted with the issue of policy loans. Due to the lack of an effective monitoring system, however, state-owned banks often diverted the funds for policy loans to commercial loans and left the funding gap in policyrelated businesses for the central bank to fill. As a result, central bank relending, which is used occasionally in western market economies to prevent liquidity crises

12

Reversed Monetary Expansion Mechanism

Percentage (%)

—

—

9.50 20.5

–8.87

–9.1

0.38

34.63

7.47

21.6

—

—

14.49 41.8

6.69

19.3

5.99 17.3

72.41

58.09

80.2

—

—

6.15

8.5

0.65

0.9

7.53 10.4

1989

108.46

84.54

77.9

—

—

10.81

10

8.30

7.7

4.82

4.4

1990

141.20

88.11

62.4

—

—

11.65

8.3

31.41

22.3

10.03

7.1

1991

178.08

82.26

46.2

—

—

26.68

15

612.3

34.4

7.91

4.4

1992

118.03

85.36

72.3

—

—

17.33 14.7

–11.09

–9.4

26.43 22.4

1993

311.82

283.48

90.9

—

—

34.1 10.9

–25.50

–8.2

19.74

6.3

1994

412.62

6.42

1.6

–10.50 –3.4

310.47

75.2

14.04

3.4

–9.15 –2.9

Increase

Percentage (%)

97.8

Increase

Increase

Others

45.35

71.19 17.3

Percentage (%)

1988

Position for forex purchase

Percentage (%)

1987

Fiscal overdraft

Increase

46.36

Relending to policy banks

Percentage (%)

1986

Relending to commercial banks

Increase

Year

Increment in monetary base

Table 15.1 The supply of monetary base, 1984–1997 (Unit: CNY1 billion)

0.8

1995

312.41

–10.51

–3.4 112.29 35.9

0

0

230.29

73.7

1996

550.21

131.98

24 164.68 29.9

0

0

276.46

50.3 –22.92 –4.2

1997

452.96 –205.90 –45.5 203.05 44.8

0

0

307.22

67.8 148.53 32.8

Source: Statistics and Analysis Department of the People’s Bank of China, “Monthly Statements of Credit Statistics,” various years.

and safeguard financial stability, became a norm in China for commercial banks to constantly expand credit funds given their state ownership.

Government evaluation mechanism, political cycle, and local government intervention The evaluation mechanism of government performance decides the preference of government behaviors. Since the Reform and Opening Up era, economic construction has been identified by the Chinese central government as the top priority, and local governments have strong desires to pursue economic growth for it was a sign of their governing capability and a criterion of promotion. Fan et al. argue that investment impulse following the changing of office came from not so much the monetary policy of the central government or the central bank as their own will to boost their governance records.7

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MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 3

China’s economic cycle has a distinct political characteristic. After a change in leadership, the new office holder often embarks on major investment projects, as a way of showcasing one’s governing ability, buffing one’s political resume, and securing a future promotion. The boom in investment demand will force commercial banks to make more loans, which creates the same effects of an expansionary monetary policy. Reviewing China’s economic operation between 1978 and 1997, it can be discerned that major turning points in economic development coincided with the periods of government transition, such as in 1982, 1987, and 1992, but with the only exception of 1997 which could be attributed to the Southeast Asian financial crisis. The year or the following year after the shift of government was inevitably accompanied by a rapid economic upswing. Zhang and Wan’s research also reaffirms this point.8 They found that government succession overlapped the economic cycle which typically lasted for five years. Every new local regime will launch an investment campaign for both promotion and local benefits, which will more often than not result in more aggregate social investment than the central government wished to give, and price levels rising beyond both the economic carrying capacity and people’s expectations. At this point, the central government will intervene by imposing macroeconomic regulations, and the overheating economy will take a turn onto a slower track. This turning point usually takes place two to three years after the change of office. From then till the next government, it will be a period of economic slowdown, accompanied by the drops of commodity prices, thus constituting a complete economic cycle. To reverse passive impacts of China’s political cycle on money supply, it is imperative to change government functions by separating administration from economic regulation and reforming the evaluation and promotion mechanisms of government officials. By the late 1990s, China had made substantial progress in separating administration from enterprise management through government reforms and the institutional set-up of governments became more reasonable. By isolating the banking sector from local governments, the connection between political promotion and the supply of credit funds was cut off.

Reversed Monetary Expansion and Money Supply Endogeneity Theoretically, the reversed monetary expansion during China’s economic transition accounts for the endogeneity of money supply in the specific periods.

Reversed monetary expansion is a cause for endogenous money The debate over whether money supply is endogenous or exogenous is a recurring theme in economic literature. As the basic idea of neoclassical economics, the

14

Reversed Monetary Expansion Mechanism

exogenous money theory has long dominated the theoretical circle by believing that monetary authorities can control money supply through adjusting monetary base. Endogenous money proponents side with the opposite, namely, money supply cannot be directly controlled by monetary authorities but is decided by multiple factors in the real economy. In the late 1950s, the endogenous money theory revived in the criticism against neoclassical synthesis. In 1959, the Radcliffe report expounded a string of new ideas including endogenous money supply. Gurley and Shaw argued that the competition between monetary system and nonmonetary intermediaries hinges on the substitutability of their created financial assets, and the strong substitutability of money and non-monetary indirect assets makes money supply no longer just subject to the money creation of the banking system but become an endogenous variable.9 Tobin went further by conducting a general equilibrium analysis on money supply to establish an asset selection model as against the simple monetary base model, and the new model highlighted the endogeneity of money supply and the asset substitutability in the process of monetary transmission.10 After the 1970s, the endogenous money theory was furthered by post-Keynesian economists. Kaldor noted that as the lender of last resort, the central bank has no other choice but to satisfy the transaction demand for money in order to prevent disastrous debt deflation resulting from credit crunch.11 Moore took a step further by studying the impacts of the changes in the financial operation mechanism on credit money, monetary base, financial innovation, and banks’ roles.12 Entering the 1980s, a growing number of scholars studied money supply endogeneity from the perspective of interest rates with many important conclusions. Lavoie suggested that interest rates are exogenous and banks create credit money to accommodate loan demand, which forces the central bank, as the lender of last resort, to passively accommodate their demand for reserves, money supply is thus endogenous.13 Pollin maintained that money supply is, to a large extent, determined endogenously by the private system and interest rates are not strictly exogenous and are, rather, decided by a complex set of interactions between the central bank and the financial markets.14 McCallum and Bofinger emphasized the role of interest rates in money supply by pointing out the defects in the traditional money multiplier theory and gave a new interpretation of endogenous money supply.15 In a well-developed market economy, despite the endogenous tendency of money supply, monetary authorities can still influence the money demand through adjusting interest rates, which are an important variable in the money demand function, in order to manipulate money supply. As a transition economy, China’s money supply has long showed strong endogeneity, but its causes are strikingly different from those in developed

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countries. Chinese scholars have conducted research on the causes and influences of endogenous money on multiple aspects. Ning studied China’s money supply endogeneity from the perspective of money multiplier and monetary base;16 Wan and Xu analyzed the relationship between the endogeneity of money supply and the efficiency of monetary policy;17 Sun proved money endogeneity by pointing out the internal conflict between the central bank’s dual role of the lender of last resort and supplier of liquidity reserves, and also distinguished the characteristics of money endogeneity at different periods;18 Wang and Shu found that money supply dedicated to foreign exchange purchase creates strong money endogeneity;19 Zhao and Zhou believed that fiscal deficits resulting from excess fiscal spending is an important reason for China’s endogenous money supply.20 From the above analysis, it is apparent that institutional factors are the major reasons accounting for money supply endogeneity in China, and these factors take turns to play a role. Thus, we can further draw the conclusion that from the early stage of China’s Reform and Opening Up to 1994, the soft budget constraints resulting from the state ownership of SOEs and state-owned banks, local governments’ economic expansion impulse due to their dual role of administration and economic management, and reversed monetary expansion entailed by banks’ responsibility to provide financial support to economic transition are predominant reasons for endogenous money supply in the specific period. In addition, factors such as fiscal deficits will also impose pressure on money expansion. After 1994, the need to issue money in exchange for foreign exchanges became the major reason, due to the constant growth of exports.

From administrative-driven to market-driven endogeneity In western countries, the endogeneity mechanism of money supply arises from the obligation of the central bank, the lender of last resort, to accommodate to the reserves requirements of the banking system, and the need to adapt to the credit demand resulting from market-decided endogenous interest rates. Thus, western money endogeneity can be said to be market-driven. In contrast, China’s macroeconomy was a shortage economy in the early periods of the Reform and Opening Up, where SOEs were not real subjects in the market and were impelled to expand credit funds under government intervention. Banks selectively approved credit applications based on national investment plans or government demands rather than market conditions, inevitably resulting in a greater credit size than indicated in state plans and expected. Bank overdrafts for compensating fiscal deficits would also bring about excess money supply. So it can be concluded that

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China’s reversed monetary expansion was driven by institutional factors, thereby belonging to administrative endogeneity. As the economic transition was gradually completed in China, the share of nonstate sector in industrial output overtook that of state sector in 1993. This change helped relieve SOEs’ social responsibilities, leading to a decrease in their demand for low-cost credit funds, which paved the way for restoring the leading position of state-owned banks in the market as well as introducing the commercialization reform to banks. After the rise of many medium and small-sized joint-stock banks outside the state-owned banking system, the market mechanism began to play its role in the credit field. Local governments’ intervention in loans faded away and after 1994, fiscal deficits were solved through issuing treasuring bonds instead of taking out overdrafts from the central bank (see Table 15.1). Especially in 1997, SOE reforms made significant breakthroughs and commercial banks started to focus on risk control by imposing a lifelong accountability system on new loans, turning dad debt risks a hard constraint for commercial banks. As a result, deposit surplus continued to grow while loan growth declined year by year, leading to constant decreases in money supply. The strengthening of the risk control mechanism in commercial banks suppressed the effects of reversed monetary expansion. Since then, market factors gradually substituted for institutional factors in influencing China’s money supply.

Logical extension of money endogeneity The establishment of a market system and the reform of state ownership have brought about fundamental changes to China’s money supply mechanism: Money endogeneity transitioned from being administrative-driven to market-driven, and banks’ credit expansion was increasingly determined by market criteria such as market demands and expected future returns with ineffective demand being denied. However, benchmark interest rates and interest rates in lending markets, as controlled by monetary authorities, are all exogenous, offering limited guidance to market players with low elasticity and ineffective market feedback. Interest rate exogeneity further strengthened the endogeneity of money supply. Interest rate control is an expression of financial suppression and an interest rate lower than the equilibrium rate cannot accurately reflect the financing situation in the market, let alone the fact that the real credit demand is always even higher than that under an equilibrium interest rate. The reversed monetary expansion from enterprises to banks and then to the central bank is still effective under an imperfect market system with an unsound price mechanism. Departing from past practice where banks passively adapted to ineffective credit demand under the pressure of

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government intervention and soft budget constraints, they now accommodate to low-efficient credit demand resulting from financial suppression, so the role of reversed monetary expansion has changed to a certain extent. Market-oriented reform of interest rates can help both supply and demand sides of credit funds to optimize capital allocation following market signals, and the success of this reform is strongly influenced by the controllability of money supply and the effectiveness of monetary policy. In a market-oriented interest rate system where interest rates are transitioning from exogenous to half-endogenous and halfexogenous, monetary authorities can indirectly influence money supply through adjusting the benchmark interest rate, reducing the passive money increase from low-efficient credit demand. As China’s financial market continued to develop, the interaction between banks and securities markets linked up the price transmission mechanisms in money and capital markets. The market interest rate mechanism in the capital market and the controlled interest rate mechanism in the banking sector alternated to play a part, strengthening the controllability of money supply. In 1998, indirect scale management substituted for direct credit control, price index took the place of aggregate amount index to play an increasingly larger role, and interest rates were also evolved into a core variable in China’s monetary policy. With the opening up of the financial industry and the accelerating of the marketoriented reform of interest rates, the external environment of China’s monetary policy has changed, so it is of great significance to conduct further research on the effects of money supply endogeneity on improving the efficiency of monetary policy and stabilizing economic operation.

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Chapter

Triangular Debts

MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 3

Introduction The Chinese economy in the late 1980s was afflicted with an alarming phenomenon: Interenterprise debts abounded, causing state-owned enterprises (SOEs) to vex over disruptions to normal operational activities at the microeconomic level and regulatory authorities at the top to be anxious about macroeconomic stability and growth. The academics were equally concerned, probing into causes and solutions in their heated discussion. According to the most widely adopted figures, such “triangular debts” (sanjiao zhai 三角債) — a term coined to describe interenterprise debts outstanding beyond the ordinary term of maturity for commercial loans — shot up within one year from CNY32 billion in 1988 to CNY100 billion in 1989. By mid-1989, SOEs became so grimly short of funds that they flooded their superior departments with emergency wires, and local officials in charge of many large and medium-sized SOEs ran from bank to bank and ministry to ministry soliciting banks to assist with debt consolidation. This soon resulted in the People’s Bank of China (PBC) and the Industrial and Commercial Bank of China (ICBC)’s organization of several rounds of debt consolidation loan issuances, which settled debts of CNY80 billion. However, by the end of the year, the outstanding “triangular debts” bounced back to CNY100 billion.1 For this reason, on March 26, 1990, the State Council issued the Notice on the Commencement of the Clearance of “Triangular Debts” Nationwide and set up a leading group for this purpose. Under the direct leadership of the State Council, the leading group was composed of the State Council Production Commission, the Ministry of Finance, the PBC, the major specialized banks, and the major economic departments. The group held strategic discussions in telephone conferences in April, and managed to complete a round of debt clearance in most parts of the country by the end of June, clearing debts of CNY78.4 billion. By the end of that year, a total of CNY150 billion debts had been settled, but the outstanding debts still stood at CNY200 billion.2 After yet another similar nationwide exercise in 1991, the outstanding balance escalated to CNY330 billion. Not only did the debt consolidations not solve the problem, but SOEs actually continued to incur new debts as soon as their initial debts were cleared. Therefore, when the leading group announced the completion of its mission in 1993, some noted that the real debt size had not been cut down at all.3 “Triangular debts” as earlier defined are in fact commonplaces in the course of China’s economic development, with occurrences in the early-1960s, the 1990s, and even the 21st century, for example. This chapter, however, will only focus on the more abnormal interenterprise arrears from the late 1980s to the early 1990s. This phenomenon is deemed abnormal because, first, the debt aggregates were

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Triangular Debts

extraordinarily large with a high GDP share, a high share in bank loans, and most SOEs being creditors and/or debtors; and second, the period lasted for as long as five years from 1989 to 1993. The accumulation of such debts owed both to such rudimental factors as backward economic institutions, economic structural imbalance, and general negligence of credibility, and policy factors of the threeyear period of “governance and rectification” (san nian zhili zhengdun 三年治理整 頓) starting from 1988. It was with long-term institutional and short-term policy effects combined that the severe SOE debt crisis finally materialized.

Causes Long term: Institutional environment According to János Kornai’s classical analyses of firms’ investment behavior under traditional planned economies, the disparity between potential risks and returns and the “soft” budget constraint resulting from state “paternalism” would necessarily contribute to an “investment hunger” in firms. The developments in China in the 1980s largely fitted Kornai’s theory, although the exploratory nature of the Chinese Economic Reform tinted the Chinese case with more uncertainties. Consequences of this “investment hunger” can be observed from the growth in fixed-asset investment and the associated plight with working capital in China’s enterprises. The Economic Reform had the effect of diversifying the sources of enterprise investments. In addition to funds from the state budget, investments also came from local governments, enterprises, bank loans, and foreign investors, as the power of investment was decentralized. The investment hunger was also fed less directly by the fiscal contracting systems starting from 1980, which spurred local governments’ enthusiasm to develop industries. Comparing 1998 and 1981, total budgetary investments increased by 58.6%, making an annual growth rate of 6.9%, while investments raised by the public and other parties multiplied by 3.72, up 24.9% annually. While investment parties at all levels displayed a strong hunger in fixedasset and capital construction investment, state financial resources were limited, especially since the devolution of power and relinquishment of profits to SOEs at the beginning of the 1980s put a cap on funds at the central government’s disposal. In relative terms, fiscal budget revenue in 1979 accounted for 31.9% of GDP, but in 1989, this ratio fell to 18.8%, and the central government’s share in budgetary revenue slid in parallel from 60% to 45.2% over the same period. The state could hardly finance even its key capital construction projects. Simply

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between 1987 and 1989, the investment gap for the large and medium-sized capital construction projects in the state plan amounted to billions of yuan. In 1990, new or renewed projects of capital construction and technical renovation were not supported in time with matching investments. According to the estimates of the ICBC, by September 1990, funds allocated to the bank by the Ministry of Finance for lending to national-level capital construction and geological surveys had only met 54% of the budgeted amount, causing the bank to pay billions of yuan out of its own pocket. It was estimated that “triangular debts” stemming from fixed-asset investment gaps accounted for around 20% of the total of such debts.4 Investment gaps, coupled with cost overruns, sowed the seeds of interenterprise arrears. Cost overruns were in fact the consequence of fraud. To increase the odds of getting approval, applications were typically filed with underestimated costs, making large budget overruns the norm. A government investigation on large and medium-sized capital construction projects that went into operation in 1989 showed that over 95% of the projects were overbudget, and the actual expenditure exceeded the budget by more than 40%. As for the declared reasons for the overruns, price increases of production materials and equipment made up 40.3% of the overbudget amount; additions or revisions in the course of construction, 26.1%; land expropriation fees and all kinds of imposed charges, 10.3%; mismanagement of works, adjustments in interest rates and exchange rates, and others, 23.3%. As fixed-asset investments swelled, working capital could hardly catch up. While economic principles have established that a reasonable ratio between working capital and fixed capital should be maintained by the same investor, for the capital construction and technical renovation projects in the early and mid1980s, no arrangements were made for the working capital that would be needed after they went into operation at all. From 1987 to 1990, a gap nearing CNY100 billion was opened by the failure to provide for the working capital of enterprises of “whole-people ownership.” The situation would not have been much better for projects financed by local governments and enterprises’ self-raised funds, which depended most, if not all, of their working capital on bank loans despite the selffinancing minimum requirement of 30%. Banks were not faring much better, either, for two main reasons. First, the loan capacity of state-owned specialized banks was held up by fiscal overdrafts or loans from the central bank to cover the budget deficit caused by power devolution and profit relinquishment to SOEs and economic overheating. After 1979, the central government recorded a deficit in all years apart from 1985, accumulating a total of CNY74.42 billion. In 1990, budget expenditure exceeded revenue by CNY8.89 billion. This figure, on the surface, was slightly smaller than that of the previous

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year, but if the CNY33.44 billion from public debt revenue is counted towards the deficit, the figure would be a much higher CNY42.34 billion. Second, a lot of the new investment projects were government-led and introduced out of local governments’ blind pursuit of development. Many of these projects did not yield lucrative products and ended up making losses, consuming banks’ quotas for working capital loans. Measuring the state-owned industrial enterprises supported by budgetary funds, the gross output of industry in 1990 merely edged up by 1.5%, leading to an 18.5% drop in realized total profit and tax revenue, or a 58% plunge counting total profits alone. As many as 31% of these SOEs suffered a loss, up 1.5 percentage points from the last year, and the total loss multiplied 1.28 times. The scenario was even graver for the commercial enterprises. Also in 1990, realized profits of state-owned commercial enterprises and supply and marketing cooperatives totaled CNY1.2 billion only, a precipitous 84.6% slide year over year and the nadir since 1953. As a whole, the sector recorded losses for six consecutive months, which turned the CNY4.23 billion profits of the previous year into a loss of CNY0.16 billion. It was never before seen in the state’s history to have over a quarter of all its state-owned commercial enterprises and supply and marketing cooperatives, then 135,000 in number, to be making a loss. By estimation, growth of policy and operational losses together tied up a quarter of banks’ working capital loan addition.5 The interenterprise arrears of “triangular debts,” as seen, did not spring up overnight. This phenomenon was not only a domino effect in the flows of enterprise capital in the fatigued market in the late 1980s, but more importantly also the eruption of tension accumulated from economic overheating since the introduction of the Economic Reform, as manifested in the imbalance between supply and demand of social aggregates, the uncoordinated ratio between fixedasset investment and working capital replenishment, and low economic efficiency, amid the clash of old and new institutions. Throughout the 1980s and 1990s, due to huge shortages of fixed-asset investments and working capital, the asset-liability ratio of China’s SOEs skyrocketed. In 1980, the asset-liability ratio was 18.7% and current asset-liability ratio 48.7%, but in 1993, the two figures soared to the striking levels of 67.5% and 95.6%, respectively. In 1994, among the 124,000 industrial and commercial enterprises that had completed asset verification, the total assets amounted to CNY4,137 billion, total liabilities CNY3,104.7 billion, and owner’s equity CNY1,032.1 billion, bringing the average asset-liability ratio to 75%.6 The entire SOE-dominant economy was overburdened by debts, with extremely fragile economic and financial structures. Providing the long-term background to accumulated risks, the problems of overinvestment, excessive liability, and low economic efficiency nonetheless do not

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suffice to account for the sudden outbreak of the debt crisis among enterprises in the late 1980s. So, it will be necessary to examine the macroeconomic environment then, especially the macroeconomic regulation policy.

Immediate cause: Policy factors In the three decades following the 1978 reform, the Chinese economy was in a series of cyclic overheating and macro-regulation. The most direct and important cause of the outburst of the debt crisis was the rectification campaign starting in 1988, which sought to combat the increasing inflation with unprecedentedly stringent control over investment at the end of several rounds of tightening measures. As a result, the economy slid in a short time, and “triangular debts” piled up for an extensive period. Following Wu Jinglian’s classification of business cycles for 1979 to 1996 — 1979 to 1983; 1984 to 1986; 1987 to 1990; 1991 to 1995 — the period of “triangular debts” in discussion spanned the last two cycles and was closely entwined with the government’s oscillating attempts to control the third cycle of fluctuations. The first cycle saw the first bout of economic overheating triggered by the release of enthusiasm for economic construction in the early days of the Economic Reform, against the lingering legacies of the planned regime and the nascent groping of the reform leaders. Short-term planning of ambitious projects soon resulted in economic fluctuations, which the leaders responded with regulatory measures. Yet by 1982, the economy had already sped up, with GDP growth at 8.8%. The growth rate quickened to 10.4% in 1983 and then 14.7% in 1984. Economic overheating was salient. As for why the situation worsened in 1984, it all goes back to the official proposal in September 1982 of the target of quadrupling agricultural and industrial output by the end of the 20th century, which provoked regional races to reach the target ahead of time. This was aggravated by a technical error in the financial reform, of expanding the autonomy of specialized banks in lending from 1985 by raising the loan limit based on the actual issuance of loans in 1984. To secure a larger base for 1985, specialized banks set lofty targets for their branches, resulting in monetary and credit bloat overnight. Of the 28.8% increase in aggregate credit in 1984, December alone recorded a 84.4% growth year on year, and by the end of the first quarter of 1985, M0, M1, and M2 had surged by 58%, 39%, and 44%, respectively, much surpassing the trend rates of monetary growth. From the second quarter of 1985 onwards, prices escalated, and the retail price index hit 8.8%, 6 percentage points over 1984. As soon as early 1985, the State Council proposed the strengthening of macroeconomic regulation by controlling fixed-asset investment, the credit size,

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Triangular Debts

and money in circulation. In September 1985, Premier Zhao Ziyang announced in his explication of the leadership’s recommendations on the formulation of the 7th Five-Year Plan at the National Congress of the CPC that the 7th Five-Year Plan period would be divided into two phases: the first would focus on controlling investment and aggregate demand, improving the economic structure, and solving problems that emerged in the preceding years at a steady pace, while the second would bring investment back on the upward trend as the situation saw fit. This was a “soft landing” strategy having considered the pros and cons of containing overheating.7 But the problem was that once economic growth was started off, it was hard to slow it down. Projects that were underway needed additional investments, while those that were put into operation had to be sustained by working capital. Continuous loan support was inevitable. Therefore, although the overheating problem was alleviated to some extent in 1985, the institutional expansionary tendency only dipped temporarily. When GDP growth fell by 4.7 percentage points to 8.1% in 1986, the opening year of the 7th Five-Year Plan period, especially with zero growth in February, anxiety about economic “downturn” led to cries for loosening control of the monetary base to stimulate the economy. The government decided to loosen its control on bank loans from the second quarter of 1986, which aggrandized bank credit once again and made way for inflation. From the first quarter of 1988, industry and the national economy drastically heated up, with industry expanding at rates of 16.9%, 17.5%, 18.1%, and 18.8% in the four quarters and the annual GDP growth at 11.3%. Prices spiked accordingly, as reflected by the growth of the retail price index at the pace of 1 to 4 percentage points in the first nine months, to arrive at 25.4% in September and then 26.7% in December. The overheating in 1988 had obviously overtaken that in 1985, evincing not only the impact of general institutional and transitional factors but also the backfiring of the feeble regulation of the preceding overheating. Moreover, the “price conquering” reform launched in May 1988 to increase commodity prices — literally “prices to conquer [military] passes” (jiage chuangguan 價格闖關) — further pushed up inflationary expectations amid the formation of crises. As Zhao Ziyang admitted in retrospect, this reform was a severe error whether in terms of guiding philosophy or actual implementation.8 From mid-August 1988 onwards, urban residents all over the country were frantically drawing cash to stock up commodities, while simultaneously, officials were profiting from rent-seeking through arbitrage thanks to the dual-track price system, which intended to keep the prices of basic necessities low during the price reform. Social discontent boiled over, and the economic trouble was increasingly politicized, such that the government had to reinstall control over the economy.

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In September 1988, the CPC Central Committee raised in its work conference the principles of “governance and rectification,” proposing to “govern the economic environment, rectify the economic order, and thoroughly deepen reform” (zhili jingji huanjing, zhengdun jingji zhixu, quanmian shenhua gaige 治理經濟環境，整頓經 濟秩序，全面深化改革) within two years. In November 1989, observing the course of development, the government decided to extend the rectification period to three years or more. The crux of the rectification measures was, apart from removing virtually insolvent companies and strengthening price controls, to strictly restrain aggregate demand. There were three policy areas: greatly suppressing and controlling investment demand; greatly suppressing and controlling consumption demand; implementing tight fiscal and financial policy. The consequences of these measures are as follows: First, the suppression of fixed-asset investment brought about the domino effects of project abortions and debt accumulation. As a result of the tight fiscal and financial policy, the country’s fixed-asset investment fell by CNY50 billion, that is, 11%, to CNY400 billion instead of sustaining the average growth rate of 24.11% of 1982 to 1988 to make CNY558 billion. The real drop would be over 20% accounting for the inflation rate, and even greater considering the multiplier effect. The compression of capital construction investment and suspension of works in progress inevitably shrank demand for construction materials and mechanical and electronic equipment sets. As the supply of such equipment was usually a long process from the placement of orders and design to production and product delivery, the abrupt suspension of capital construction projects caused a great many mechanical and electronic manufacturers to find themselves in a mire of debts. Second, SOEs’ working capital shortages deteriorated due to inflation. In the late 1980s, SOEs’ capital accumulation capacity was weakened by increasing operating costs and various fees and levies. Even though certain SOEs did abide by the provision of allocating part of the production development fund to replenish self-owned capital, that portion was tiny. Comparing 1983 and 1990, although the gross output of industrial enterprises supported by budgetary funds grew by 69% and their delivered profits and taxes rose by 62%, the share of SOEs’ self-owned funds in their prescribed working capital slipped from 40% to 18%. Worse still, the meager working capital of SOEs kept depreciating during inflation. During 1985 to 1989, prices of raw materials and fuels hiked up 111.78%. State regulations required that in national adjustments of production material prices, the value of enterprises’ inventories should be adjusted accordingly, the appreciation to be directly charged towards state funds. However, eager to push up short-term profits, many SOEs got around by entering inventory items at cost value and the gains from appreciation

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Triangular Debts

directly as profits. This enlarged the enterprise’s nominal retained profit on top of the amount turned over to the treasury, but the capital increase was not backed by an equal amount of goods. By estimation, such “profits” from inventory appreciation amounted to tens of billions of yuan between 1988 and 1990. This encroachment on appreciation gains was in effect a depletion of SOEs’ capital bases.9 Soon, SOEs could hardly sustain basic production, let alone expanding production. Although banks did extend large loans for production activation, they could by no means fulfill all the working capital demand of SOEs. Shortages became inevitable, so were interenterprise arrears. Third, the curbing of consumption led to the piling up of finished goods. According to general economic principles, around 40% of capital construction investments would transform into consumption funds. The reduction of consumption demand, then, was a necessary step alongside suppressing investment. Both the commodity market and markets of means of production slumped. Finished goods piled up, thereby affecting the turnover of working capital. In 1989, retail markets nationwide hovered around low levels of activity, with the total volume of retail sales at CNY810.1 billion, which was a nominal increase of 8.9% but real drop of 7.7% given 17.8% inflation of commodity prices. Initiatives to activate the economy and markets in 1990 failed to fundamentally turn the structural sluggishness of the economy; stockpiling remained common. At the end of 1990, inventory of industrial finished goods and goods in transit increased by nearly CNY60 billion year on year. In other words, the new activation loans were almost all tied up by finished goods inventory. Some enterprises could only sustain production by borrowing from other enterprises.

Debt Clearance By the early 1990s, interenterprise “triangular debts” had cast a severe impact on the operation of the economy. Because of the wide-ranging implications of the matter, the State Council was compelled to organize debt clearance at the national level. Being the center of concentration of traditional SOEs and thus facing the grimmest situation, Northeast China was selected as the major pilot area of the debt clearance exercise. After that, the program was implemented nationwide.

Process of implementation On March 26, 1990, the State Council pointed out in its Notice on Commencement of the Clearance of “Triangular Debts” Nationwide that the arrears of debts among SOEs and

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other public institutions were becoming a salient problem that disturbed normal production and harmed credibility. The ensuing April 4 telephone conference clarified that the debt clearance exercise would involve the activation of industrial and transport infrastructure production apart from clearance, seeking also to combine the observation of the state’s industrial policy in adjusting the economic and product structures. It was decided that the exercise would be implemented horizontally and vertically in a bottom-up approach. The first step was to tackle the capital construction, foreign trade, commercial, and production material supply systems within provinces, autonomous regions, and direct-controlled municipalities. Local government departments were to organize debt clearance programs by themselves, amassing recent loan data and requiring enterprises and institutions which had received their designated share of state funding to pay back outstanding equipment and raw material loans immediately. For those which had not received their share, competent departments should immediately allot the prescribed amount in order not to contribute to new debts. The second step was large-scale interregional clearance targeting provincial regions which were owed relatively more debts. The third step was nationwide clearance based on the work of the second step. It was also stipulated that with effect from April 1, institutions with overdue debts should be liable to late payment interest at a daily rate of 3 . The debt clearance exercise was due to complete by July 1990; however, with the immense scope of parties involved and the intricate web of relationships among them, the problem of “triangular debts” was a real can of worms. In fact, many resorted to rolling over debts by securing more loans. In August 1990, the State Council’s Leading Group for the Clearance of “Triangular Debts” promulgated new Implementation Plans for Clearing Enterprise Loans in Arrears Nationwide, which demanded that the clearance of “triangular debts” be made a focal task of the government in the second half of the year. This round of clearance consisted of two phases: August 1 to 15, when the bank holding the payee’s deposit account would handle the payee’s consignment collection certificates and deliver them to banks holding the payers’ deposits; September 15 to October 10, when payers would entrust their banks to repay the loans and banks would complete the payment and collection process among themselves. Meanwhile, outstanding loans of over 500 key capital construction projects would be centrally cleared starting from August 20. In June 1991, Premier Li Peng dedicated a State Council meeting to the organization of new “triangular debt” clearance efforts, resolving to launch a pilot in the Northeast. Vice Premier Zhu Rongji pinpointed the major source and causes of the “triangular debts” after heading an inspection tour of the area: first, severe overruns of cost estimates, with insufficient funds arrangements made

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for investment projects and failure to enforce the provision on self-owned funds opening wide fixed-asset investment gaps; second, heavy losses of SOEs, which tied up their self-owned funds and bank loans, hence aggravating interenterprise arrears; third, poor marketing strategies or unmarketability of goods, leading to overstocking and the tying up of working capital. Other causes aggravating “triangular debts” included disorderly goods transactions, lax disciples, and low sense of credibility. To mobilize support, the People’s Daily on October 30, 1991 reported 10 typical cases of unreasonable rejections to repay debts, slamming SOEs for their lack of credibility and urging local governments, banks, and competent departments to strictly enforce debt repayment and forestall evasion. According to the gazette of the Leading Group for the Clearance of “Triangular Debts” issued in February 1992, in 1991, debts of CNY136 billion were rolled into debt consolidation loans of CNY30.6 billion, plus CNY2.45 billion raised by enterprises themselves, attaining the effect of settling CNY4.1 for the input of every CNY1. This round of clearance injected capital into the major source of “triangular debts,” namely fixed-asset investment projects, focusing on large and medium-sized SOEs in industries of means of production including electrical and mechanical industry, metallurgy, coal industry, and nonferrous metal industry. Most of the debt clearance funds were absorbed by large and medium-sized SOEs, whose capital shortages were considerably relieved. In 1992, the State Council continued to mark the clearance of debts incurred by fixed-asset investment projects the focus of the debt clearance exercise. In early March, the Third Work Conference on the Clearance of “Triangular Debts” was convened to make arrangements for the work of the rest of the year. The targets were still fixed-asset investment projects undertaken by whole-people-owned units considered to have debt repayment ability, to be economically efficient, and to be in tune with the government’s industrial policy, and the scope of clearance covered projects which had not been dealt with in the first half of 1991 and which had been put to use at the end of 1991. For those which had been covered in 1991 but had incurred new loans, the government would not inject new capital to clear their debts. The workflow followed the existing investment project management hierarchy, with capital construction and technical renovation projects of and arranged by departments and companies directly under the State Council handled and reported by the competent departments or companies, and other projects by provincial-level governments and governments of separately listed cities in the state plan. The state would no longer organize clearance for loans incurred after January 1, 1992, before the settlement of which no new projects would be approved. As regard arrears in working capital, it was prescribed that they would be solved not by consolidation loans but such measures as limiting production, compressing

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inventory, boosting profits, promoting technical advances, and adjusting the economic and product structures in order to equip enterprises with the capacity to repay their own debts as soon as possible. Before nationwide implementation, a pilot would first be carried out in major SOEs in metallurgy, electrical and mechanical industry, and production material industries, with care taken to prevent incurrence of further debts. The state would not organize clearance efforts for new debts incurred after January 1, 1992. In addition to debt clearance, in 1992, the government also put the problems of outstanding fiscal appropriations, subsidies, and refunds, as well as SOE losses onto the agenda, and continued to rectify the order of commodity transactions and settlement discipline.

Effects and lessons The effects and lessons of the initiative were discussed in the work report of the Leading Group for the Clearance of “Triangular Debts” in March 1993. It was reported that in 1991 and 1992, a total of CNY55.5 billion was injected to clear debts, CNY52 billion coming from bank loans and CNY3.5 billion raised by local governments and SOEs. Among this, CNY42.7 billion went to fixed-asset loans, settling 14,121 projects, including 5,420 capital construction projects and 8,701 technical renovation projects. Except for a handful of projects that were excluded for not being in line with the state industrial policy or loan conditions, “triangular debts” incurred by all capital construction and technical renovation projects prior to the end of 1991 had been settled, with payments of CNY183.8 billion, more than CNY140 billion going into energy-related means of production industries such as mechanical and electrical manufacturing and raw material industries, and construction and installation enterprises. For debts in key industries and products, the clearance exercise in 1991 covered the loans to coal enterprises, cotton enterprises, and the First Automotive Works. In 1992, after the exercise of the working capital debt clearance pilot in Baosteel, similar efforts were extended to key enterprises in the industries of coal, electricity, forestry, and nonferrous metals, settling debts of CNY7.3 billion. To relieve the funds shortages for cotton procurement, CNY2.8 billion was injected. In total, organized efforts to clear “triangular debts” pertaining working capital of key industries amounted to CNY35.2 billion. The two mentioned categories in total cleared debts of CNY219 billion (CNY136 billion in 1991 and CNY83 billion in 1992), with the effect of settling CNY4 for every CNY1 injected. The report recognized that the “triangular debt” clearance exercise significantly relieved SOEs’ capital shortages, sped up capital turnover, and raised

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economic efficiency, allowing a large number of key construction projects in energy, transportation, and raw materials to be put into operation and many loss-making enterprises to begin making projects, thereby revitalizing the economy. It declared completion of the exercise. The report pinpointed four main strengths of the debt clearance exercise. First was the success of getting to grips with the major source of the debts, namely arrears from fixed-asset investment projects, so as to disentangle the debt chain section by section, while at the same time preventing the incurrence of new debts. This approach proved to be effective as most of the debt clearance funds had flown back to medium-sized and large SOEs in means of production, construction, and installation industries. By this, SOEs regained the capacity to repay working capital loans, which prevented a significant expansion of the bank credit size. Second was dealing with the root of the problem of working capital shortages: overstocking. The practices of limiting production, compressing inventory, sales promotion, and approving loans on technical renovation based on SOEs’ performances in freeing capital tied up in finished goods, goods in transit, and receivables were successful experiments of fundamental measures to reduce and avert working capital arrears. Third were the well-coordinated and consistent efforts among government divisions. While the State Council set out the general principles and policy of beginning with fixed-asset investment projects, departments under the State Council and local governments played supervisory roles, and local planning commissions, economic commissions, banks, fiscal authorities, and debt clearance offices carried out the actual work. Finally was the prevention of new arrears. For this purpose, the State Council had promulgated eight sets of supporting documents, which tackled areas such as the clearance of “triangular debts”; limitation of production, compression of inventory, and sales promotion; turning losses into profits; and prevention of new grain procurement losses. The report concluded by giving suggestions on how to forestall the resurgence of “triangular debts.” First, it was advised that enterprises should keep capital construction within their capacity so as to avert the opening of investment gaps. Strict controls should be imposed on the size of fixed-asset investment, prohibiting the use of working capital for fixed-asset investment. It was also necessary to accelerate the reform of the investment system in order to unify the powers and responsibilities of the decision maker and approver of investment projects. Second, the recovery of debt consolidation loans must be enforced according to the Notice on Questions Concerning the Recovery of Fixed-asset Investment Project Debt Consolidation Loans and the terms of the loan contracts. SOEs failing to fulfil the annual repayment plan should not embark on new projects, and banks should be vested with the authority to deduct from the self-owned funds or investment

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project funds of the next year of these enterprises in accordance with the loan contract. Also to be enforced was the Regulations on the Transformation of Operational Mechanisms of Industrial Enterprises Owned by the Whole People, which grants SOEs 14 independent operating powers. Local governments were ordered to step back from SOE management in order to prevent product accumulation or arrears caused by erroneous guidance or planning, and SOEs were to regulate their own behavior according to market rules. Other comments included advising SOEs to quicken replenishment of selfowned working capital, free tied-up capital, look for effective measures to tackle arrears from grain production, and defend their own rights; and urging the strengthening of supervision and inspection of fixed-asset investment projects, the reform of the bank settlement system, and the enforcement of interenterprise credibility by contracts and bills.

Case study: “Triangular debt” clearance in Liaoning In early June 1991, the State Council set out to prepare for the clearance of “triangular debts” in Liaoning as the first pilot area in Northeast China.10 The choice was made because the province of Liaoning was dominated by heavy industry and thus among the first to be troubled by “triangular debts.” Moreover, Liaoning was one of the areas where the initial debt clearance efforts bore little fruit, with debt clearance leading to more debts. In 1990, “triangular debts” amounting to CNY14.5 billion were cleared, but by the end of May 1991, such debts had piled up to CNY26 billion, CNY10 billion over the previous year. It was reported that an enterprise in Liaoning had dispatched a carefully picked team of 200 for collecting debts around the country only to find that treating related parties to meals already consumed CNY300,000, while only a scanty amount of debts were recovered. When the Leading Group for the Clearance of “Triangular Debts” of the State Council sent its working group to the province to inspect the 915 medium-sized and large SOEs, 579 capital construction projects, and 340 technical renovation projects, it was discovered that the failure of the earlier debt clearance effort was the restrictive attention to working capital arrears while overlooking the major sources of the debts. The first source was fixed-asset investment gaps. The investigation showed that investment gaps from capital construction and technical renovation projects made up 14.6% and 20% of the province’s aggregate investments. The main causes of the gaps were cost overruns, short provision of funds in the state plan and reserved funds, shortages of self-raised funds, and increases in raw material prices.

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The second source was the tying up of capital in finished goods, goods in transit, and loan receivables and advance loan payments. In April 1991, such tied-up capital in the accounts of industrial enterprises at the Liaoning branch of the ICBC totaled CNY30.62 billion, 2.4 times that of the 1988 yearend figure. Goods in transit and loan receivables of the mechanical industry already amounted to CNY4.02 billion, of which CNY70 million was arrears. One cause of this phenomenon was that some products were not marketable, causing heavy overstocking; however, this was also partly caused by operators’ low sense of credibility, as manifested in deliberate defaults and the practice of profiting on loans in arrears. The third source was SOE losses. The delay of state appropriations, refunds, and subsidies to innately unprofitable SOEs which existed for policy reasons hampered their repayment. Other SOEs made losses due to mismanagement, and were resultantly deprived of financial resources. By the end of March, as much as 60.5% of budgetary-funds-financed SOEs in Liaoning were making losses. In general, the sense of credibility was so weak that it was rather common for SOEs to make profits by leaving loans outstanding. In the worst case, some SOEs took pride in operating on huge debts. Under the prevalence of default practices, some SOEs refused even to pay back their “triangular debts” even with the support of bank consolidation loans. Statistics from the Liaoning branch of the ICBC show that by the end of April 1991, it had issued consigned collection notices for debts worth CNY7.1 billion, but payments in arrears amounted to CNY38.2 billion, that is, 53.8%. The working group decided to implement the pilot program in four phases along four lines. The first phase focused on planning and organization headed by the vice governor of Liaoning. A Debt Clearance Office with some 30 members was formed out of the provincial Economic Commission, Production Commission, Department of Finance, and banks to concentrate human resources on the exercise. Five groups were set up under the office, and a strict accountability system was developed. In the second phase, investigations were carried out on the 919 fixedasset projects across the province to find out the total amount of “triangular debts”; on the province’s 1,943 state-owned industrial enterprises to examine the status of their finished goods; and on the Department of Finance to ascertain the total outstanding fiscal appropriations, refunds, and subsidies. Based on these investigations, 201 typical SOEs were selected to participate in the debt clearance pilot for the Northeast which would cover 319 key SOEs. The third and last preparatory phase was mainly about obtaining SOEs’ pledges to acknowledge outstanding debts, repay the debts, and make the effort to raise funds to clear debts. The final phase saw the actual exercise of debt clearance.

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The four lines of effort made in the final phase involved, first, such arrears owed for capital construction and technical renovation to the 201 pilot enterprises as creditors; second, such arrears owed for capital construction and technical renovation by SOEs in the entire province, as debtors, to SOEs in Northeast China; third, working capital arrears among the pilot enterprises; and fourth, the linking of technical renovation loans with SOEs’ performances in the compression of capital tied up in finished goods. The first two lines concerned fixed-assets, as an innovative approach of clearing “triangular debts” from the source. Local governments were to monitor the receipt of debt clearance funds, which were to be immediately transferred to repay debts, and individual account management was to be carried out to prevent losses of debt clearance funds. Upon the completion of debt clearance, an enterprise would be issued additional loans amounting to 20% of the repaid arrears. In a nutshell the whole process from the sourcing of funds to repayment would be completed within a closed system. The actual repayment phase for Liaoning was kicked off on August 16, 1991. The Leading Group for the Clearance of “Triangular Debts” did its final examination on site and resolved to inject CNY1.34 billion for the clearance of capital construction and technical renovation arrears. All the appropriated funds reached the designated parties. All payments were settled by telegraphic transfers, and the last transfer was made on September 20. The third line which dealt with working capital arrears among pilot SOEs was rather effective. The meeting to secure acknowledgement of payment responsibilities on working capital arrears was completed on August 12 with an acknowledgement rate of 80%. On August 20, a meeting was convened to fulfill obligations under bills of exchange, where the 201 pilot SOEs underwent the formalities of payment and receipt, and the competent banks entered the amounts into the books. Within 10 days, CNY7.6 billion of working capital arrears was cleared. The compression of finished goods inventories to free tied-up capital was another important measure in the clearance of “triangular debts.” Liaoning took the approach of pegging the issuance of new technical renovation loans with the compression of capital tied up in finished goods. This policy applied to the 1,943 state-owned industrial enterprises having accounts at the ICBC, and the target was to free CNY1.87 billion from finished goods by the end of 1991. To thwart evasion by turning finished goods into goods in transit, a more encompassing target of releasing CNY5.34 billion of capital tied up in finished goods, goods in transit, and loan receivables and advance loan payments was set, to bring it back to the year-start level. An accountability system was established to hold mayors, district governors, and factory managers accountable for meeting the targets.

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This round of clearance exercise was effective as it got to the gist of the problem by adopting a closed system that directly channeled funds into arrears from fixed-asset investments. The previous practice of issuing working capital loans to individual SOEs proved too lax and too superficial, so that SOEs were at liberty to incur new arrears. SOEs were also brought to the awareness of the adversity of “triangular debts” to overall economic development, and were in general cooperative in acknowledging responsibility. After the success in Liaoning, the pilot was extended to the remaining of the Three Northeastern Provinces, namely Jilin and Heilongjiang, including the cities of Shenyang, Dalian, Changchun, and Harbin, which were separately listed in the state plan. After figuring out the total “triangular debts,” the provinces and cities selected a total of 319 key SOEs as main creditors, which then issued over 50,000 loan collection notices. Around CNY19.7 billion was recovered in the form of bills of exchange. In July 1991, Vice Premier Zhu Rongji further clarified the State Council’s three emphases as he hosted a meeting about the pilot project and listened to the report of the working group: settlement of debts from both creditors’ and debtors’ sides; clearance of both fixed-asset investment and working capital arrears; a fundamental change of mentality. In the second half of August 1991, with the total “triangular debts” ascertained, the state injected CNY3.4 billion to fill the fixed-asset investment gaps in the Northeast, seeking to break debt chains that involved tens of billions of yuan from their very last link. This facilitated the settlement of CNY3.8 billion of working capital arrears, with commitment secured for 85.1% of the debts. By the end of August, a third of the debt chains in Liaoning were rid of, meaning the injection of that every CNY1 helped solve debts of CNY3, while Jilin and Heilongjiang had settled CNY2.35 billion and CNY1.3 billion of debts, respectively.

Theoretical Implications: Business Cycles and Credit Expansion In the context of the Chinese Economic Reform, the phenomenon of “triangular debts” provides insight into the relationship between business cycles and credit expansion. “Triangular debts,” as seen, were the outcome of the clash of the longterm institutional problems of excessive fixed-asset investment and working capital shortages with short-term macroeconomic regulation, which led to immediate difficulties in SOE operations and extensive interenterprise arrears. Two puzzling questions remain: While such institutional problems and macroeconomic measures had always been around ever since the Economic Reform of 1978 — that is to say,

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the Chinese economy had long fluctuated in cycles of overheating and regulation — why was it only the regulation in 1989 that provoked alarming “triangular debts”? Also, why was it that although interenterprise debts continued beyond 1993, the macroeconomic influence was not as great? To answer these questions, it is necessary to understand that “triangular debts” were the culmination of problems that intensified during the transition of economic systems. Without provisions for insolvency, “triangular debts” became SOEs’ only recourse as risks from excessive investment erupted in the face of cyclical adjustment. “Triangular debts” were by nature a form of “commercial credit” in China’s special economic context; it can be further understood as a passive but necessary endogenous credit supply mechanism for sustaining SOE operations. Being entirely a business among SOEs, “triangular debts” should have been solved by the enterprises themselves. When the state, continuing its old practice of centralized planning, organized credit funds for the clearance of “triangular debts,” it essentially shifted the creditor-debtor relationship between enterprises to banks and enterprises. No sooner had the debt clearance exercise in 1992 been completed than the problem of interenterprise arrears resurged. Ultimately, interenterprise dealings could not be completely settled by state-organized loans; a change in the operational model would be necessary. “Triangular debts” also rose against the backdrop of cyclical economic expansion and contraction, and were the ultimate expression of the over-indebtedness of economic agents and excessive credit issuance by the banking system. I have compared elsewhere traditional business cycle theory as framed by aggregate supply and demand and the Austrian structural business cycle theory, forming a credit-augmented structural business cycle analytical framework by linking endogenous credit expansion to the Austrian theory.11 I demonstrated that while traditional economic analysis provides a posterior representation of the aggregate supply–aggregate demand relationship by money based on the assumption of capital homogeneity, in reality, capital is heterogeneous, and therefore excessive credit expansion will upset the production structure and resource allocation, causing fluctuations when the failure to realize the expected economic value compels adjustment. “Triangular debts” are proof of this theory. However, in the early 1990s, SOEs could hardly go insolvent and the costs of credit expansion and inefficient resource allocation were covered up by interenterprise “commercial credit” and then “bank credit.” Eventually, the impact of “triangular debts” would be absorbed by China’s continuous economic growth.

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Chapter

Tiger in the Cage

MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 3

Introduction “Tiger in the cage” (long zhong hu 籠中虎) is a figurative description of the potential supply and demand shocks, as well as the resultant inflation risk, that can be brought by the cash and savings deposits held by Chinese households, particularly since 1988. The concept was first illustrated in Fan Gang and Zhang Shuguang,1 and was later picked up by Huang Da.2 Fan and Zhang saw “tiger in the cage” as the consequence of coerced savings, which they describe as a form of “coerced substitution.” According to them, “coerced substitution” takes place when substitution is not a voluntary choice of a household in accordance with the relationship between prices and costs or equilibrium relationships, but is forced upon by limits in quantities; that is, when unsatisfied demand in a market spills over to another market.3 Coerced savings are, in their words, to “buy the consumption of tomorrow when one cannot buy consumption today.”4 Taking it further, coerced savings are directly related to market shortages. Such shortages may be aggregate shortages in the nascent stage of economic development, and then become structural when the economy is developed to a certain stage; but most of the time, aggregate and structural shortages coexist. In the broad sense, coerced savings take two forms: as caused by shortages in consumer goods or investment products, although attention is usually drawn to the more narrow definition of growth in savings caused by consumer goods shortages. No matter what, in the age of monetary economies, surplus purchasing power will be held in the forms of cash or deposits, and such cash or deposits were compared to “tigers in cages” because they represent potential or unrealized purchasing power. “Consumers holding this kind of purchasing power,” explained Fan and Zhang, “are looking for the consumer goods they need in the market at all times. In any periods, coerced savings are like tigers awaiting opportunities to get out of their cages, which will ‘go down the hill’ at a mere rustle of leaves in the wind, constituting a major factor for economic instability.”5 Huang’s portrayal is very similar to Fan and Zhang’s.6 He held that the cash in the hands of households and the household savings at banks are “two tigers in cages,” using the metaphor of a “cage” because the money is not yet used for purchases and of “tigers” for the unimaginable consequences if the money were used for purchases in large amounts. Huang analyzed the situation of 1991 as an example: At the end of the year aggregate commodity inventories in society amounted to CNY423.79 billion, but aggregate savings totaled CNY910.7 billion, while the amount of money in circulation was CNY317.78 billion. In this case, if the “tigers” really broke their cages, they would indeed consume all the commodities in stock.7 Huang went further than Fang and Zhang by bringing the question to

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the level of monetary supply structure.8 Traditionally, money supply is divided into the two parts of M0 (or M1), which backs actual market demand and has a higher liquidity, and M2, which backs potential market demand and has a weaker liquidity. Comparatively, as Huang had commented, “since unused cash is placed outside banks, it is not easy to track its distribution or forecast its direction of movement, while [deposits] taken by banks are reflected in book value, providing a more accurate basis for analyzing their distribution and direction of movement.”9 For this reason, Huang understood the monetary “cage” as housing not one but two tigers with distinct characters: an M0- or M1-type tiger “caged” in the household balance sheet, which will readily run out; and an M2-type tiger “caged” in the balance sheets of commercial banks, which may not run out as easily. By this logic, the natural choice of the monetary authority would be to try its best to lure the first tiger into the cage of the latter tiger; that is, to convert as much M0 into M2 so as to lower the liquidity of money supply and hence reduce the possible monetary shocks on market supply and demand and macroeconomic equilibrium. Although in the course of China’s Economic Reform and economic growth, the “tigers” hardly broke out of the “cages,” and even if they occasionally did, were more often than not as tame as oxen in the field; even in its few instances of “going wild,” the “tigers” did not cause great shocks or harm to the reforming economy and financial system. However, the anxiety of the policymakers over its potential threat and their preventive measures did seriously affect their choices of pathways for the financial reform. This chapter will detail the formation of the “tigers in cages,” their escapes, and their transformation in order to decipher the internal reasoning behind the pathway selections in the transformation of the Chinese financial system.

Growth and Escapes of the “Tiger in the Cage” By 1980, the third year into the Chinese Economic Reform, the strategy of “Westernstyle leap forward” (yang yuejin 洋躍進) implemented in the aftermath of the Cultural Revolution and at the beginning of the Reform and Opening period grew into a serious budget deficit. The banking system, still undergoing modernization, experienced unprecedented pressure for monetary (or more precisely, credit) expansion, while after two consecutive years of rapid money growth, with M0 in 1979 and 1980 up 10.2% and 18.3%, respectively, the retail price index shot up from 0.7% in 1978 to a height of 6%.10 The Chinese consumers started to wake up from the prosperous atmosphere created by the reform policy to the hardship of price hikes. However, as household cash holdings and savings deposits had not increased significantly, this period of price hikes did not provoke the “tigers” to escape their

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“cages.” In fact, the “tigers” had yet to grow up: In 1980, total household savings deposits merely amounted to CNY39.58 billion, of which only CNY9.09 billion was demand deposits.11 Therefore, the regulatory policy in 1980, coupled with the fact that most commodities were still under price controls, quickly pushed prices back down to 1.5% by 1983. The easy success of macroeconomic regulation filled the leaders with blind optimism, contributing to feelings of elation that the “small frustration” of inflation was but an “accidental false alarm” in the grand program of economic reform and growth. So it was no surprise that the ambitious goal of doubling economic growth ahead of schedule instantly triggered intense competition among local governments and incited in them an extreme thirst for expanding investment. Meanwhile, this was coincided with the delegation of autonomy to SOEs in 1983, which allowed them to apply for loans from banks directly and hence increased their enthusiasm for borrowing, as well as the “technical error” of the People’s Bank of China’s (PBC) decision in 1985 to base the loan limits for specialized banks on the actual loan issuance of 1984, which stimulated interbank competition for credit expansion. Under these circumstances, not only did the specialized banks happily fulfil SOEs’ loan requests, but they in fact took the initiative to ask SOEs to borrow more. As a result, the size of bank credit in 1984 increased by 28.8% over the previous year.12 As SOEs would usually turn the loans taken out from local bank branches into cash for paying wages and other expenses, the PBC must issue more money to support these loans, and the credit expansion in 1984 was matched with a 50% increase of M0.13 With monetary increase came inflation, so in 1985, the retail price index rose by 8.8% and the consumer price index (CPI) recorded a 9.3% surge.14 This marked the return of the reforming economy back onto the path of overheating. Starting in 1980, the Chinese economic conditions, especially the fiscal and financial structures, began to undergo subtle changes. Generally speaking, a downward trend of fiscal budget revenue accompanied the devolution of power and relinquishment of profits to SOEs, which had by then been confirmed as the backbone of the Economic Reform. When the GDP share of budgetary revenue fell from the 1978 level of 31.1% to 25.5% in 1980 (see Table 17.4), the policymakers began to acknowledge the transformation of the country’s financial resource distribution that was underway and turn their sights on the strengthening household savings. On March 18, the State Council approved the PBC’s Report on the Adjustment of Savings Deposit Interest Rates and the Charging of Additional Interest on Overdue Loans, permitting the very first increase of interest rates on household savings deposits. The demand deposit interest rate was raised from 2.16% to 2.88%, and the rate for one-year time deposits from 3.96% to 5.4%. On May 28, the PBC released the amended Rules of the People’s Bank of China on Savings Deposits, where it emphasized

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the state’s protection to citizens’ ownership rights to their savings and provided for the principle of “voluntary deposition, freedom of withdrawal, interest payments for savings, and the maintenance of secrecy for account holders” to be upheld by banking institutions.15 In the following years, the government and the central bank issued a series of measures to promote savings deposits. After the PBC’s national branch manager meeting urged the government to organize deposit intake to facilitate withdrawal of money from circulation in January 8, 1981, on April 10, the State Council approved and transmitted the bank’s Report on Network Expansion for Furthering the Development of Savings Business, which the bank followed up by a notice demanding bank branches to solve the shortage of deposit service points within two to three years on May 6. On August 30, the PBC convened a seminar briefing its branch managers on its policy to further promote household savings, especially long-term savings, and on December 23, its Report on the Adjustment of Bank Deposit and Loan Interest Rates, which sought to lift time deposit interest rates and introduce eightyear time deposits for the sake of expanding and stabilizing the sources of credit funds, was approved by the State Council. On May 6, 1982, the State Council issued the Notice on Ensuring the Withdrawal of Money in Circulation and the Strict Control of Monetary Injection, whose focus was still on attracting deposits. About a year later, on August 27, 1983, it reiterated this stance by a similar document titled Notice on the Strict Control of Monetary Injection and Organization of Withdrawing Money in Circulation. With all these efforts, household savings deposits steadily increase, climbing to CNY121.47 billion by 1984,16 accounting for 16.85% of GDP (see Table 17.2). The dependence of the Economic Reform and economic growth on financial resources, especially household savings, caused the banking system to expand at an unprecedented pace. Right from the start, the banking system was entrusted with the historic mission of mobilizing as much savings as possible in order to provide more financial support for the reform. Indeed, by 1985, when the GDP share of fiscal revenue further slipped to 22.2%, the increase of savings deposits more than compensated the fall, reaching CNY162.26 billion by the end the year to make up 18% of GDP, from only 8.8% in 1980. But it was exactly the economy’s dependence on savings deposits that made them a decisive factor in macroeconomic changes, especially inflation. If in 1980, it had been two tiger cubs that were “caged” in the balance sheets of households and banks, then in 1985, they would have been gradually growing up and started to pose real threats. Seeing prices on the verge of double-digit growth for the first time since the start of the Economic Reform, the leadership could not have sat back and relax.

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The Chinese leaders launched a new round of contractionary policy aiming to curb expansion in investment and consumption at the beginning of 1985. On March 27, Premier Zhao Ziyang manifested in his government work report to the Third Session of the Sixth National People’s Congress the determination to control money in circulation and the credit size in order to accelerate the withdrawal of money in circulation. Early on March 14, the State Council had already approved and transmitted the PBC’s Report on the Adjustment of Some Deposit and Loan Interest Rates, which resolved to raise the interest rate on one-year time deposits from 5.76% to 6.84%. From April to the end of the year, the State Council, the PBC, and other state-owned financial institutions introduced a total of nine measures to control credit (see Table 17.1), the resoluteness in diction as well as frequency of policy issuance never before seen. One of the most important measures was the readjustment of the one-year deposit rate as stipulated in the PBC’s report of July 22, this time to 7.2%. It was certainly unusual to increase the deposit rates twice a year, which was the first instance since the Economic Reform, and this only showed the tremendous importance of maintaining steady growth of household bank deposits to macroeconomic stability. Table 17.1 Contractionary monetary policy of 1985 Date

Measure

Feb 1

General Office of the Communist Party of China and General Office of the State Council, Emergency Notice on the Strict Control of Bonus and Subsidy Issuance

Feb 27

PBC, Notice on the Prohibition of Local Banks’ Competition for Credit Business and Unauthorized Opening of New Branches

Mar 14

PBC, Report on the Adjustment of Some Deposit and Loan Interest Rates, approved and transmitted by State Council

Mar 27

Report on the Work of the Government to the Third Session of the Sixth National People’s Congress emphasizing the control of money in circulation

Apr 4

PBC, Provisions on the Control of the Loan Size of 1985, approved and transmitted by State Council

Apr 4

State Council, Notice on the Control of Fixed Asset Investment Size

May 28

PBC and four specialized banks, Notice on Provisions on the Control of Fixed Asset Investment Loans beyond the Planned Quotas

Jun 25

PBC, three specialized banks (excepting Construction Bank), and People’s Insurance Company of China, Notice on Further Bettering the Management of Bank Credit Funds in Line with the Spirit of the Meeting of Provincial Governors and Municipal Mayors

Jul 22

PBC, Report on the Adjustment of Savings Deposit Interest Rates and Fixed Asset Loan Interest Rates, approved and transmitted by State Council

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(Cont’d) Date

Measure

Aug 28

State Council, Notice on Ceasing the Expansion of Capital Construction Investment in 1985

Sep 17

PBC, Notice on the Immediate Termination of Trust Loan Issuance and Trust Investment

Oct 15

PBC, Proceedings of the Seminar on National Money Issuance urging establishment of branch manager responsibility system and strict control of supply of funds for money issuance

Dec 23

PBC, Notice on Strengthening the Management of Funds of Financial Institutions

Source: Wu, Major Events in China’s Financial Reform and Opening Up, 93–106.

The monetary policy operations quickly took effect, with money supply decreasing notably starting from the second half of 1985. Compared with the 49.5% of 1984, money supply (M0) only grew by 24.7% in the whole of 1985, and in 1986, the rate dropped to 23.34%.17 The year 1986 also saw the fall of the retail price index back to 6%.18 However, in spite of the unusual frequency and strength of this round of policy, the sustainability of the contractionary effect, especially the policy effect, was rather out of expectations. To make it plain, the operations had a promising opening but perfunctory end; it turned out that there was more talk than action. This was deeply seated in the great divide of the economists as well as the vacillation of the policymakers, as hot debate over the relationship between economic growth and inflation gradually gave rise to the opposing “schools” of “loose” and “tight” policy, which was to have profound impact on future policy formulation in the course of the Economic Reform. In the meantime, victory was with the “loose” school. It was also out of realistic concerns that a subtle turn of monetary policy transpired: Economic growth showed signs of slippage at the start of 1986, with zero growth recorded in February.19 In January, the National Economic Work Conference and the National Planning Conference put forward the in-between principle of stressing contraction to control money issuance on the one hand but “rational supply” to satisfy the demand of production and turnover on the other. Balanced as it may sound, such a principle already signaled a weakening tendency compared with the original contractionary policy. In February, the National Conference of PBC Branch Managers reaffirmed the monetary and credit principles as strengthening while improving macrofinancial regulation to allow for differential instead of across-the-board treatment; controlling inflated demand while improving supply, so as to extend as much loans as would suffice to stimulate the economy; and arresting inappropriate pace while supporting a speed of growth that would benefit the economy.20 No other policy measures for

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macroeconomic regulation were proposed in the rest of the year. In fact, by the second quarter of 1986, contractionary policy had lost all its substance. Therefore although money growth in 1987 maintained a slowly declining trend, dropping to the modest level of 19.38%, the retail price index went in the opposite direction, standing at 7.3%. Throughout 1987, the policymakers did not launch any measures concerning the maintenance of economic stability and stable growth of household savings deposits, implying an abrupt halt to monetary tightening in less than two years. The Chinese leaders had apparently underestimated the risk and consequences of loosening monetary control. Due to misunderstanding and misjudgment of the relationship between economic growth and inflation, the logic of economic marketization, and the conditions of market supply and demand then — and possibly certain realistic political and economic interests — the leaders opted for a “radical reform experiment” that centered on aggressive “price conquering,” hoping optimistically to solve all problems on economic marketization in a single “battle.” In this way, the gate of money supply was reopened soon after it was shut, and in 1988, money growth rose precipitously at 47%, and the market rapidly reacted with an 18.8% surge in retail price overall, an all-time high since the Economic Reform. Other statistics show that in the fall of 1988, the year-on-year growth of prices exceeded 30%, and in August, the retail price index peaked at the staggering level of 80%.21 As in the past, the macroeconomic situation became critical again, but the monetary and financial scenes were not quite the same. Startling the policymakers was that in this cycle of monetary expansion and hyperinflation, the “tiger” of household savings deposits which had been crouching in bank accounts and which had remained calm in previous instances of economic fluctuations started to be agitated; the “tiger” that had been kept in the “cage” of the banking system had now grown up. The severity of the problem surpassed their expectations. As Table 17.2 shows, in 1987, the GDP share of household savings deposits broke the mark of 20% to reach 25.49%, and even though this rate dipped for a while in 1988, it was still at a high level of 25.27%. In terms of amounts, savings deposits exceeded CNY300 billion in 1987, and in 1988 attained the record high of CNY380 billion. The leaders finally realized that such a weighty creature had the potential to wreak great havoc if it broke the cage. The least desirable scenario eventually became reality. Stimulated by continuous price hikes, from the first half of 1988, urban residents started withdrawing cash from their bank accounts to stock up commodities, and within a short time, the bank run spread across the country. It was the first time since the Economic Reform that such great numbers of people queued at banks to withdraw their deposits.

44

Tiger in the Cage

Table 17.2 Economic growth, price levels, money supply, and household savings deposits, 1978—2009 Year

GDP (CNY1 billion)

GDP growth (%)

M0 (CNY1 billion)

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

364.52 406.26 454.56 489.16 532.34 596.27 720.81 901.60 1,027.52 1,205.86 1,504.28 1,699.23 1,866.78 2,178.15 2,692.35 3,533.39 4,819.79 6,079.37 7,117.66 7,897.30 8,440.23 8,967.71 9,921.46 10,965.52 12,033.27 13,582.28 15,987.83 18,493.74 21,631.44 26,581.03 31,404.54

11.7 7.6 7.8 5.2 9.1 10.9 15.2 13.5 8.8 11.6 11.3 4.1 3.8 9.2 14.2 14.0 13.1 10.9 10.0 9.3 7.8 7.6 8.4 8.3 9.1 10.0 10.1 10.4 11.6 13.0 9.6

21.20 26.77 34.62 39.63 43.91 52.98 79.21 98.78 121.84 145.45 213.40 234.40 264.44 317.78 433.60 586.47 728.86 788.53 880.20 1,017.76 1,120.42 1,345.55 1,465.27 1,568.88 1,727.80 1,974.59 2,146.73 2,403.17 2,707.26 3,037.52 3,421.90

33,535.29

8.7

3,824.60

Household savings deposits (CNY1 billion)

Retail price index (%)

Money supply growth (M0) (%)

Household savings deposits in GDP (%)

26,077.17

100.7 101.9 107.5 102.5 102.0 102.0 102.7 109.3 106.0 107.3 118.8 118.0 103.1 103.4 106.4 114.7 124.1 117.1 108.3 102.8 99.2 98.6 100.4 100.7 99.2 101.2 103.9 101.8 101.5 104.8 105.9 99.3

8.5 26.3 29.3 14.5 10.8 20.7 49.5 24.7 23.3 19.4 46.7 9.8 12.8 20.2 36.4 35.3 24.3 8.2 11.6 15.6 10.1 20.1 8.9 7.1 10.1 14.3 8.7 11.9 12.7 12.2 12.7

5.78 6.92 8.79 10.71 12.69 14.97 16.85 18.00 21.78 25.49 25.27 30.29 38.12 42.43 43.68 43.03 44.65 48.79 54.12 58.60 63.28 66.48 64.84 67.27 72.23 76.29 74.78 76.99 76.25 67.05 72.47

21.06 28.10 39.95 52.37 67.54 89.25 121.47 162.26 223.76 307.33 380.15 514.69 711.98 924.16 1,175.94 1,520.35 2,151.88 2,966.23 3,852.08 4,627.98 5,340.75 5,962.18 6,433.24 7,376.24 8,691.07 10,361.77 11,955.54 14,105.10 16,158.73 17,253.42 21,788.54

11.8

77.76

Sources: 1. National Bureau of Statistics of the People’s Republic of China, China Statistical Abstract 2010, 20, 81–82, 91, 109;

2. Yi, China’s Currency, Banking and Financial Market: 1984–1993, Table 4.2.

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The “tiger in the cage” was escaping; the economy was caught in great tension. Of note is that this instance of price hikes had a different formation mechanism from past experiences. The previous price hikes can be attributed more to an M0 shock, but this time the factor of M2 shock came into play. Although M0 and M2 can be both described as “tigers in cages,” as long as M2 remains relatively stable, the M0 shock will hardly maintain its vigor; in other words, the strength of an M2 force can be mitigated by simply tightening money supply. It is a different story with the M2 “tiger,” however. Once M2 fluctuates, there will be more liquidity exacerbating the M0 shock as though waves behind impel waves before, disrupting market equilibrium for a prolonged period and increasing the costs and difficulty of future monetary operations. The crisis situation urged the leaders to devise coping strategies. It was imperative to achieve two tasks: tightening M0 and stabilizing household savings deposits (M2). The former had been performed many times and smooth sailing, but the latter was a new challenge, and was therefore experimental. There is a fundamental difference in policy transmission mechanism and financial logic between trying to draw household cash holdings (M0) into the banking system and hinder households from turning savings deposits at banks (M2) into cash (M0). At the beginning, the leaders simply stuck with their old practices: From June 11, 1988 when the PBC announced control of the monetary aggregates to its adjustment of deposit and loan interest rates on September 1 of the same year, all six monetaryfinancial policy combinations were based one-sidedly on controlling money supply (M0), plus a mild increase in gains on savings, but the effects were minimal. Even the “administrative head responsibility system” introduced in the PBC’s Report on Measures for Controlling Money and Stabilizing the Financial System, approved and transmitted by the State Council on August 11, failed to make much difference as great amounts of savings, especially time deposits, continued to be withdrawn and turned instantly into actual purchasing power under constantly strengthening inflationary expectations, subjecting the commodity market to increasing pressure of monetary shocks. The chaos called on a much stronger financial policy focusing on household time deposits. Realizing this, on September 3, merely two days after the September 1 deposit rate adjustment, the PBC urgently issued a new directive titled Gazette on the Introduction of Renminbi Long-Term Inflation-Proof Savings Deposits, announcing its decision to subsidize time deposits of three years or above at an inflation-proof rate above the regular interest rate. “Inflation-proof savings” is an extreme policy measure for tackling extreme monetary condition; it is also an extremely costly kind of macroeconomic policy operations. As an influential demonstrative policy, it is an absolute last resort. Therefore, the use of such a measure itself was already a statement of the full

46

Tiger in the Cage

exposure of the monetary and financial risks then, suggesting that policy operations were at a critical moment. Admittedly, such an extreme measure as “inflationproof savings” was a rather effective antidote to the extreme situation of a “tiger in the cage.” The series of sustained forceful contractionary measures which “inflation-proof savings” was part of finally took effect in the second half of 1989. With the restoration of macroeconomic order, the strong inflationary expectations significantly waned. There was a general return of confidence on the economy and the banking system, and household cash holdings started to flow back to the banks. From Table 17.2, it can be observed that by the end of 1989, household savings deposits surpassed CNY500 billion, occupying 30.29% of GDP. This evinced that the “closing in” of intensive contractionary measures and the increase of interest rates had succeeded in luring the M2 “tiger” that had been roaming about for a year back into its “cage.” Table 17.3 Monetary and credit policies against the “tiger in the cage,” 1988 and 1989 Date

1988

Policy

Jun 11

PBC, Provisions on Further Realizing the Financial Principle of “Controlling Aggregates and Adjusting Structures”

Jul 21

PBC, Notice on Further Strengthening Macroeconomic Control and Imposing Strict Management on Credit Funds, resolved at Beidaihe summit

Aug 11

PBC, Report on Measures for Controlling Money and Stabilizing the Financial System, approved and transmitted by State Council

Aug 8

State Council, Emergency Notice on Conscientiously Handling the Work on Commodity Prices and Stabilizing the Market

Aug 31

PBC, Practical Provisions on Further Controlling Money Supply and Credit Size in 1988

Sept 1

PBC full-scale adjustment of deposit and loan interest rates, with oneyear time deposit rate raised to 8.64%

Sept 3

PBC, Gazette on the Introduction of Renminbi Long-Term Inflation-Proof Savings Deposits

Sept 6

PBC, Notice on Provisions on Issues Concerning the Introduction of Renminbi Long-Term Inflation-Proof Savings Deposits

Sept 24

State Council, Notice on the Clearance of Fixed Asset Investment Projects in Progress, Compression of Investment Size, and Adjustment of the Investment Structure

Sept 26–30

3rd Plenary Session of 13th Communist Party of China (CPC) Central Committee resolved work focuses of 1989 and 1990 as compressing aggregate demand and curtailing inflation

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MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 3

(Cont’d) Date Sept 27 Oct 1 1988

Oct 3 Oct 6 Oct 14

State Council, Decision on Further Controlling Money and Stabilizing the Financial System addressing continuous excessive money supply, vigorous loan increases, and slippage of savings PBC announced resolution to clear and rectify financial trust and investment institutions nationwide

CPC Central Committee and State Council, Decision on the Clearance and Rectification of Companies State Council, Decision on the Strict Control of Corporate Purchasing Power

PBC, Notice on the Implementation of the “Decision of the State Council on Further Controlling Money and Stabilizing the Financial System”

Oct 24

State Council, Decision on the Strengthening of Price Management to Strictly Control Price Increases

Jan 12–18

National Conference of PBC Branch Managers confirmed 1989 financial policies as strictly control monetary and credit aggregates and reasonably raise interest rates to increase deposits

Feb 1 Mar 20– Apr 4 May 31 Jun 5 1989

Policy

Aug 5–9 Sept 19 Sept 22

Nov 6–9 Dec 4

PBC adjustment of deposit and loan interest rates, with one-year time deposit rate raised to 11.34% and continuous inflation-proof rate for time deposits of 3 years or above Premier Li Peng stressed contractionary policy, strict control of money supply, and stabilization and increase of household savings in government work report to 2nd Session of 7th NPC PBC, Notice on the Strengthening Savings Management banning local bank competition on savings intake

Bank run on Hong Kong branch of Bank of China (BOC); bank runs on some BOC domestic branches, and BOC Hong Kong, Macau, and overseas branches from late May to early Jul National Conference of PBC Branch Managers resolved to continue tightening monetary base and stabilizing the financial system PBC, Notice on the Strengthening of Management of the Funds of Urban Credit Unions State Council, Decision on Further Clearing and Rectifying Financial Companies

5th Plenary Session of 13th CPC Central Committee adopted Decision of the Central Committee of the CPC on Further Governing, Rectifying, and Deepening Reform, stressing gradual lowering of retail price index to below 10% and urging PBC to control banknote issuance and credit aggregates PBC, Notice on Further Clearing and Rectifying Urban Credit Unions

State Council National Planning Work Conference and National Fiscal Work Conference acknowledged effectiveness of control over loan size Dec 5–11 and money supply, growth of household savings, diminution of retail price increases, and abatement of public anxiety over price hikes Source: Wu, Major Events in China’s Financial Reform and Opening Up, 152–82.

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Tiger in the Cage

The strong contractionary policy since June 1988 no doubt achieved reasonable contingency results, but it also left behind numerous side effects. In fact, these side effects surfaced as soon as the second half of 1989, manifesting long-term repercussions on future reforms and evolution of the financial system that could be hard to anticipate. This round of contractionary policy was, by nature, resorting to a “hard landing” — trying to dampen price levels as rapidly as possible without much concern for other macroeconomic indices. As money supply (M0) growth slid from 46.7% in 1988 to 9.8% in 1989, with negative 1% growth in the third quarter of the year, the CPI quickly plunged after a short period of support in 1989, to the level of 3.1% in 1990. Simply put, this round of contractionary policy had obvious effects in curtailing prices, but the accompanying slippage in economic growth was an unpleasant surprise. Economic growth started showing sluggishness starting from the third quarter of 1989, bringing the annual GDP growth to as low as 4.1%, and the figure further faltered to 3.8% in 1990. It was another first time for the CPI and GDP growth rates to hover at such low levels. In such circumstances, emergency turns away from contractionary policy are inevitable. This was already the fourth such turn ever since the Economic Reform. But the economic and financial backgrounds of the 1988 and 1989 policy differed considerably from previous instances. The GDP of fiscal budget revenue had shrunk to 15.7% by 1989, implying that the treasury had no more financial clout to stimulate economic growth, while household savings deposits in the banking system had been swelling, reaching CNY711.98 billion, or 38.12% of GDP, in 1990, and nearing the CNY1,000 billion mark in 1991 with a GDP share of 42.23%. This decrease of fiscal extractive capacity and change in resource concentration directly affected the government’s choice of economic stimuli. Since then, monetary policy has shouldered the main role in stimulating the economy and even supporting growth time and again. In fact, as soon as 1985, the policy of “loans for appropriations” (bo gai dai 撥 改貸) had started shifting the pivot of economic growth towards the financial mechanism, particularly the restructuring banking system. It was only because of a dearth of financial resources that had prevented the banking system from supporting economic growth. The financial situation in 1990 was another world, with the banking system long completing its restructuring, stable growth of household savings deposits, and banks’ capacity to mobilize and allocate financial resources going from strength to strength. It seems most reasonable that the credit policy of the banking system would be the first to be operated for stimulating growth at the end of monetary contraction. Indeed, the PBC started reopening the credit gate in the fourth quarter of 1989, as a result of which the annual growth rate of loans made by state-owned banks rose from 13.44% in the previous year

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MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 3

to 17.75%, and then 22.35% in 1990.22 The PBC also lowered loan interest rates three times in March and August 1990, and April 1991, while at the same time shelving the rate on one-year time deposits from the peak of 11.34% in February 1989 to 7.56%, at an extent rarely seen since the Economic Reform. In April 1990, the average rate of decrease of deposit interest rates was a record figure of 1%. In addition, on November 27, 1991, the PBC issued an emergency notice announcing the cessation of processing new inflation-proof savings applications with effect from December 1. Thus after an extended lagging period, the economy started to pick up, resuming an economic growth rate of 9.2%. After a few rounds of policy operations, economic growth went back onto the fast track. The policymakers experienced a boost in confidence in their capability in controlling macroeconomic functioning. However, apprehensions about the consequences of the long-term effects of the recent monetary and credit policy operations still lingered, especially on the stability of the “tiger” of household savings deposits in the “cage.” The fear was easily justifiable: Around 1990, China’s economic growth model had completely transitioned from being fiscally driven to being financially driven.23 In the event of the escape of the “tiger,” not only would it disturb market equilibrium, but more importantly, it would fundamentally shake the financial system which was a microfoundation of the financially driven growth model. Unless the robustness of the banking system and growth of household savings deposits were maintained, the sustainability of this model would be out of the question. Certainly, to go further, the financially driven growth model would easily induce a reforming economy to quickly develop rigid dependence on the banking system, especially the credit mechanism of the state-owned banking system, and to avert this rigid dependence, it would be imperative to foster major institutional overhauls concerning market order and microfoundations, in particular the rebuilding of the enterprise system, simultaneously or even ahead of time. But the leaders had yet to grasp this matter. Without recognizing that the rebuilding of market order and microfoundations would take a long process of institutional transformation, the leaders were disposed to pursue short-term economic growth. Without reforming the microfoundations, then, rapid economic growth could only be restarted based on the existing institutional conditions. In January 1992, the National Work Conference for the Reform of the Economic Structure hosted by the State Council arrived at the following verdict: Thanks to the efforts since 1989, the economic order had been conspicuously improved, the reform environment had become relaxed, and it was time to speed up reform. With the impetus of Deng Xiaoping’s Southern Tour talks in early 1992, this optimism was swiftly translated into a new expansionary cycle. In the absence of the market

50

Tiger in the Cage

mechanism and economic expansion under the SOE reform, monetary policy would likely take the lead. Not surprisingly, at the Fifth Plenary Session of the 7th National People’s Congress in March, Premier Li Peng set the tone for the monetary policy: to proactively organize deposits, expand credit size, and provide emphatic support for agriculture and SOEs. This instantaneously triggered the investment enthusiasm of the interested parties, accompanied by unprecedented monetary expansion. In 1992, the growth rate of M0 escalated to 36.4%, and in 1993, the high rate of 35.3% was maintained. Never before had M0 growth exceeded 35% for two consecutive years. As for loan issuance by state-owned banks, the growth rates for 1992 and 1993 were 19.82% and 22.71%, respectively; and in 1994, it even ascended to 25.4%.24 With the strong support of monetary and credit expansion, the GDP grew by 14.2% and 14% in 1992 and 1993, respectively; but high growth sustained by monetary expansion alone is bound to be achieved at the heavy cost of money depreciation. Thus in 1993, the CPI more than doubled from 6.4% to 14.7% year over year, and a year later a new inflation record was set at 24.1% CPI, which has not been broken as of the time of this writing. Once again, policy operations returned to the start of a macroeconomic cycle. The coexistence of economic growth and high inflation would necessarily pressure savings deposits in the banking system. It was within expectations that provoked by record-breaking price hikes, the “tiger in the cage” was ready to strike. The severity of the problem lied in that the “tiger” by then was very different from that in the past. According to Table 17.2, in 1993, the household savings deposit balance was CNY1,520.35 billion, 43.03% of GDP, and in 1994, the two figures were CNY2,151.88 billion and 44.65%, respectively. The “tiger cub” of the old days had unmistakably grown into a “giant” capable of posing dreadful threats. The high level of commodity prices was already infringing the account holders’ “mental line of defense,” as evident in the fact that the GDP share of household savings deposits in 1993 had fallen markedly compared with 1992. The leaders came into realization of the imminent need to conduct policy to stabilize savings. On May 15, 1993, the PBC urgently released the Notice on the Adjustment of Deposit and Loan Interest Rates, raising the annual interest rates for time deposits by 2.18 percentage points on average with immediate effect. In particular, the one-year time deposit rate was increased from 7.56% to 9.18%. On June 24, the CPC Central Committee and the State Council released the Opinions on the Current Economic Situation and Strengthening of Macroeconomic Regulation and Control which was commonly referred to as the “16 Articles” in China, manifesting the policy intents of greatly boosting savings deposits and guaranteeing the payment of savings deposits apart from reinstating such ordinary measures as controlling money supply and curbing inflation. On July 2, Vice Premier Zhu Rongji was

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appointed to concurrently take up the post of PBC governor. On July 5, he convened a National Financial Work Conference where he called for banks to abide by certain terms,25 among which was the prohibition of interbank competition for savings, demonstrating a clear policy disposition towards stabilization of savings deposits. In the face of the grave situation, there appeared to be limited policy means that could be maneuvered apart from existing measures like credit control, yet it was reported that Zhu’s determination put the managements of the PBC provincial branches in fear, for Zhu had warned them that they would be sacked for seeing the credit quota surpassed.26 Even so, it took longer than expected for the policy to take effect, with the continuation of a wavering tendency in household savings which required further operations. On July 11, the PBC decided to raise the savings interest rate once more. This time the time deposit rates were increased by 1.72 percentage points on average, with the one-year deposit rate adjusted from 9.18% to 10.98%, the highest rate for household savings deposits since 1990. In addition, the PBC also decided to reintroduce inflation-proof subsidies for time deposits of three years or above deposited after December 1, 1991. Finally, the credit inflation that had lasted two years went back under control. The M0 growth rate dropped from 35.3% in 1993 to 24.3% in 1994, further declining to 8.2% in 1995. Along with this was the immediate decline of the CPI, to 17.1% in 1995 and then 2.8% in 1996. To the delight of the policymakers, strong contractionary policy had not significantly impaired economic growth: even as the price level fell by 15.8% during 1994 to 1996, average GDP growth was maintained at 11.3% — such was the much desired “soft landing” scenario of effectively curbing inflation without biting into growth. Stabilization allowed household savings deposits to resume steady growth starting from the second half of 1994, with aggregate deposits exceeding CNY2,000 billion, 44.65% of GDP, while in 1995 and 1996, the amounts increased to CNY2,966.25 billion and CNY3,852.08 billion, 48.79% and 54.12% of GDP. The “tiger in the cage” had been tamed. However, at the beginning of December 1995, the Central Economic Work Conference convened by the CPC Central Committee and the State Council repeated the mistake of making an overoptimistic estimation of the financial situation, opining that price hikes had abated and inflation had been effectively suppressed. Thus although the Central Economic Work Conference continued emphasizing the upholding of considerable monetary tightening to curtail prices in January 1996, the loosening of the macroeconomic environment was an accomplished fact from that year. On March 31, the PBC issued the Emergency Notice on the Termination of Handling New Inflation-Proof Savings Business, which marked an end to the inflationproof savings policy operations after eight years and recognition of the temporary dissolution of the threat of the “tiger in the cage.” On May 2 of the same year, the

52

Tiger in the Cage

PBC issued the Notice on the Lowering of Deposit and Loan Interest Rates of Financial Institutions, reducing the deposit rate by 0.98 percentage points on average. It was commonplace for the PBC to adjust deposit rates according to the financial situation ever since the Economic Reform; however, the lowering in May 1996 was not quite ordinary, being a watershed inaugurating a prolonged period of low interest rates. Between February 2002 and March 2004, the benchmark interest rate fell to 1.98%. It was puzzling that notwithstanding the low interest rate levels, household savings deposits swiftly amassed, with household savings deposits totaling CNY26,077.17 billion, making up as great as 77.76% of GDP. Even more bewildering was that the gigantic “tiger” in the banking system had lain dormant throughout the economic fluctuations in the ensuing years. None could have expected the savings fluctuations in 1993 would be the last “escape” of the “tiger in the cage” up until today.

The “Tiger in the Cage” Transformed From 1996 onwards, there has been a strong disposition towards high savings among Chinese households. In spite of the continually lowering benchmark rate, which went below the official retail price index in certain years, households seem to have forgotten their experiences of hyperinflation and have relentlessly sent their “surplus” cash into the banking system in exchange for savings statements. Theoretically, the securities market which China started rebuilding at the beginning of the 1990s should have provided the people with more financial choices despite certain obstacles to development at the initial stage. Yet even times of a roaring bull market failed to dissuade the majority from clinging to their savings statements. Statistics show that from 1992 to 2002, savings deposits took up nearly 80% of the structure of financial assets held by households. Comparatively, the average share of cash and bank savings in the household financial asset structures of the United States, the United Kingdom, and Japan in 2002 was no more than 30%; the United States had the lowest percentage of 10.6%, while that of Japan, which held the highest among the three, was just 54%.27 Throughout the period of 1996 to 2006, Chinese household savings deposits kept increasing at an average annual rate of 44.38%. Since the introduction of the Economic Reform, the proportion of household savings deposits in all deposits has been maintained at around 50%, that of time deposits steadily standing at the spectrum of 70% over a long time.28 Household savings deposits which were once regarded as a “tiger in the cage” suddenly became calm and tame, lying dormant in bank accounts for decades amid the intensifying economic and financial reforms. Henceforth, the policymakers, once frightfully alarmed at the mention of the “tiger,” have been at perfect ease

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in policy operations; even during fluctuations of price indices, they managed to keep interest rate adjustments at a steady pace. Why has it been so? Has the steady growth of savings deposits been the people’s own voluntary financial choice or induced by external factors? Has this been an accidental phenomenon in the course of economic reform or the outcome of deliberate institutional designs? These questions have long been causes of bewilderment. It is perhaps possible to identify a subtle institutional transformation of the “tiger in the cage” in the mid-1990s. It has been discussed that the government’s fiscal extractive capacity had shrunk in favor of the banking system since 1978. It fell to an all-time low around 1996, with the GDP share of fiscal revenue diminishing to 10.3% at one time (see Table 7.14). Simultaneously, the capacity of the banking system to absorb financial resources kept skyrocketing. Back in 1978, the fiscal and banking systems had similar capacity at around 31%. However, by 1996, when fiscal extractive capacity was at its nadir, the GDP share of M2 had just surpassed 100%. While after that extractive capacity picked up an upward trend again, going back to 20% in 2009, financial resources in the banking system expanded at a much quicker pace, so that M2 accounted for 180.77% in GDP in 2009. In general, the Chinese economy had yet to be removed from the structure of “weak treasury, strong financial system” (ruo caizheng, qiang jinrong 弱財政，強金融).29 Interestingly, in the midst of rising output, the majority of Chinese enterprises, especially SOEs, still lacked a rational and effective internal financing mechanism, which implied that for the time being, economic growth would inevitably take a peculiar path of resorting to external financing. Table 17.4 Fiscal extractive capacity and banking capacity, 1978–2009 Year 1978

113.23

1980

115.99

1979

1981

164.29

1986 1987 1988

31.80

184.29

25.5

40.54

223.45

136.70 200.48 212.20 219.94 235.72

M2 in GDP (%)

31.1

117.58

1984

Fiscal revenue in GDP (%)

115.91

145.81

121.23

1985

M2 (CNY1 billion)

114.64

1982 1983

54

Fiscal revenue (CNY1 billion)

258.98 307.50 414.63 519.89 672.10 834.97

1,009.96

28.2

24.0

22.8 22.9 22.8 22.2 20.7 18.2 15.7

35.89

45.68 48.65 51.57 57.52 57.66 65.41 69.24 67.14

Tiger in the Cage

(Cont’d) Year

Fiscal revenue (CNY1 billion)

M2 (CNY1 billion)

Fiscal revenue in GDP (%)

M2 in GDP (%)

1989

266.49

1,194.96

15.7

70.32

1990

293.71

1,529.34

15.7

81.92

1991

314.95

1,934.99

14.5

88.84

1992

348.34

2,540.22

12.9

94.35

1993

434.90

3,487.98

12.3

98.71

1994

521.81

4,692.35

10.8

97.36

1995

624.22

6,075.05

10.3

99.93

1996

740.80

7,609.49

10.4

106.91

1997

865.11

9,099.53

11.0

115.22

1998

987.60

10,449.85

11.7

123.81

1999

1,144.41

11,989.79

12.8

133.70

2000

1,339.52

13,461.03

13.5

135.68

2001

1,638.60

15,830.19

14.9

144.36

2002

1,890.36

18,500.70

15.7

153.75

2003

2,171.53

22,122.28

16.0

162.88

2004

2,639.65

25,410.70

16.5

158.94

2005

3,164.93

29,875.57

17.1

163.06

2006

3,876.02

34,560.36

17.9

163.08

2007

5,132.18

40,344.22

19.3

156.79

2008

6,133.04

47,516.66

19.5

158.04

2009

6,847.69

60,622.50

20.4

180.77

Sources: 1. National Bureau of Statistics of the People’s Republic of China, China Statistical Abstract 2010, 20, 76, 81;

2. Zhang, Construction and Evolution of China’s Financial System, Table 3.1.

The drastic weakening of the state’s extractive capacity made the bank-dominant financial system the main source of external financing. The transition of the growth model from a fiscally supported mechanism (characterized by internal financing) to a financially (banking) supported mechanism rendered paramount importance to household savings deposits. But after all, the huge savings deposits were a “tiger in the cage” prone to stir disturbances any time, and could hardly be relied on to shoulder the financial responsibility of supporting economic growth for the long term. A realistic and imminent policy choice had to be made to tame the “tiger” as soon as possible or probably thoroughly transform it, so as to turn it into an “ox in the field” at the free disposal of long-term economic reform and growth.

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A plan to transform the “tiger” into an “ox” was soon devised and instated. Thanks to past experiences, the policymakers judiciously discerned that the crux of this reform was to establish a banking system that would be deemed by consumers as reliable on the long term. As for how, it has to be traced back to the special “financial contract” that the state started conceiving as early as the mid-1980s to be signed with the banking system which was still evolving then. At that time, the state already had plans to secure the banking system’s long-term support for economic reform and growth by extending guarantee to household savings deposits.30 The state’s will to get the contract concluded increasingly strengthened with the several fluctuations in household savings deposits. By the time fiscal extractive capacity fell to the bottom in 1995, a new (state-owned) banking system never before seen around the world had already established its foothold in the full-fledged Economic Reform. It was based on this special banking system that the Chinese leaders provided bank account holders with the generous promise of pledging the state’s reputation as “collateral” for the long-term safety of household savings deposits. The assurance accorded by state guarantee convinced Chinese households, whose disposable monetary income had been soaring, to deposit most of their surplus funds into accounts held in the special banking system. And it is evident that the state did stay true to its word. Although the banking system was still undergoing institutional adjustments, the state had continued its “latent guarantee” for this system. In the capital structure of state-owned banks, the state had for a long time played the role of a “double investor,” not only investing tangible capital (by injecting funds) but also offering “intangible capital” via the discussed “latent guarantee.”31 For the people, the latter kind of “capital” was more assuring than the former; the guarantee of the state’s reputation made depositing money into bank accounts as secured as keeping their wealth in iron-cast “insurance boxes.” It may be argued that this institutional context most naturally encouraged a prevailing savings preference in the household sector. However, the stabilization of household savings by guaranteeing the safety of deposit accounts was only one of the many agreements in the “financial contract” concluded between the state and the banking system. The household sector was certainly more than pleased to see a stable banking system, yet this along would not suffice to put account holders completely at ease, for the periodic fluctuations of the retail price index since the start of the Economic Reform still constituted a source of misgivings. Unless inflation was kept at a low level, savings account holders would snatch their money away despite the state’s goodwill. Fortunately and as if miraculously, the state did manage to realize low inflation. As Table 17.4 displays, in the 13 years from 1997 to 2009, the average inflation rate was merely 1.48%, implying the dissipation of people’s lingering misgivings. The state’s success in

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honoring this demanding promise allowed Chinese households to develop stable expectations about the future instead of worrying that the value of their savings would be eroded by inflation as in the former Soviet Union. It can be said that “the fact that households were willing to rapidly increase their voluntary saving was,” as Naughton puts it, “a side benefit to the relatively stable economic environment reformers purchased through gradualist reforms.”32 The sustained high growth of household savings deposits since 1996 proves that reforms to transform the once roaring “tiger in the cage” into an “ox in the field” have been completed. Henceforth, household savings have been steadily supporting economic reform and growth. It was a dream come true for the leaders who have long been struggling to source funds in the state’s financial plight to find household savings appearing as a robust “ox in the field” in economic growth. However, there leaves one more question: The disposable monetary income of the Chinese household sector remains modest. According to state statistics, even in 2009, the GDP per capita was only CNY25,188,33 (i.e., around USD3,600), which is even lower than Latin America and some African countries. Given this GDP per capita interval, it would be typical for the people to have a relatively high tendency for consumption, but in China it is a reverse case: The household sector opts to save rather than spend more. No wonder a World Bank report described China’s high savings phenomenon in the language of surprise back in 1997: “The most striking feature of China’s remarkable performance since 1978 is its savings rate. Savings, as much as growth, is China’s miracle.” “The stability of the high savings rate was one of the primary successes of the reform path chosen by the Chinese,” it continued, remarking that China’s “extremely high savings rate at a very low income level makes it an exception” even among Asian economies.34 From this it is not hard to deduce that if the Chinese household sector was to make a normal economic choice between consumption and saving, then even with the state’s solemn guarantee, the “ox in the field” might not have ensued. There has to be stronger institutional factors for the transformation of the “tiger in the cage” into an “ox in the field.” One might possibly ascribe the transformation to sheer coincidence. That the “cultural factor” of frugality and intergenerational concerns (such as providing for children’s wellbeing and education and smoothing offspring’s financial risks) may have contributed to high savings needs not be precluded; but for the high savings tendency to have remained so intense for such a sustained period, there must have been conspicuous signs of uncertainty that caused households to save for a rainy day. Concurrently with the initial success of the “soft landing,” a more thorough series of reforms on the economic structure was embarked upon. On November

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14, 1993, the Third Plenary Session of the 14th CPC Central Committee adopted the Resolution on Issues Concerning the Establishment of the Socialist Market Economic Structure, demonstrating its determination to step up reforms by redressing the SOE system. On December 29, the Fifth Plenary Session of the 8th National People’s Congress adopted the Company Law of the People’s Republic of China, signaling the completion of legal preparations for the SOE reform and the establishment of the corporatization orientation on an institutional level.35 The process of the corporatization reform was by no means smooth sailing, yet it released the signal that more competition and efficiency mechanisms would be introduced in future reforms. That is to say, the people would have to share part of the costs and risks of reform which had been completely borne by the state. In September 1997, Jiang Zemin’s report to the 15th National Congress of the CPC touched the “forbidden zone” of unemployment for the first time, raising the issues of laying off and redistributing workers (xiagang fenliu 下崗分流) and reducing employees to boost efficiency (jianyuan zengxiao 減員增效). Real action was set off two years later, by the Fourth Plenary Session of the 15th CPC Central Committee’s adoption of the Decision of the Communist Party of China on Major Issues Concerning the State-Owned Enterprise Reform and Development in September 1999, such that “laid-off workers totaled 40% of the SOE workforce, and the urban collective workforce shrank by more than two-thirds.”36 However, in the meantime, housing and social security systems that would be important constituents of the risk-sharing mechanism were slow to form. “The old system where the state was responsible for everything was quickly demolished and yet the new system was developed at a slow pace, thus increasing people’s savings tendency and reducing consumption,” observes Wu Jinglian.37 Having been through a substantial period of Pareto improvements from which everyone could benefit, the Chinese Economic Reform had finally arrived at the point of non-Pareto improvements, where some would become better off while others worse off.38 People at this junction started to feel strongly that going forward, economic life would be subject to greater uncertainties, and hence the need to make financial preparations ahead. With the development of the social security system seriously lagging the SOE reform, the Chinese were forced to revert from “state security” and “enterprise security” to the thousand-year-long tradition of “household security” now grounded in savings deposits.39 The rapid and steady growth of household savings deposits and the “miraculous” transformation of the “tiger in the cage” into the “ox in the field,” then, were the combined effects of the successful management of the (macroeconomic) “soft-landing” policy starting in 1993 and the (microeconomic) SOE reform which was accelerated after 1997, reinforced by the state’s guaranteeing of the banking system.

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Paradoxically, while the leaders had worried that people would spend so much as to threaten the stability of savings deposits, they now started to be concerned about people unwilling to spend, which would dampen internal demand. It had been the leaders’ dream to see the retail price index fall and bank savings soar, but now they were restless. Suggestions were proposed to “wake the tiger” by developing the securities market, for example, yet the results left a lot to be desired. Irrespective of the waxing and waning of the securities market, the majority of the public have continued to view savings deposits as their top choice among all financial assets. Why has the securities market failed to divert savings away from banks? The reason is in fact very simple. As with the state’s intent of guaranteeing the banking system, the major motivation for the policymakers to intervene in the securities market was to raise funds for the financially distressed SOE sector.40 Given that household disposable monetary income remains unchanged, savings deposits and stockholdings will be in a zero-sum relationship, making it necessary for the state to find a balance between bank credit and equity financing in order to maximize the sum of financial support. The problem for China was that from the very beginning, its securities market had been mired in the swirl of gaming among different interested parties and therefore extremely unstable; therefore the state was unable to assign to it a greater weight in the formula of financial support. No matter what, the leaders would not have permitted the weakening of the proven and stable financial support of the banking system in exchange for uncertain and thus unreliable capital market arrangements as a consequence of institutional change. From this perspective, diverting savings from banks with stock would be a financial reform equation with no solution. With the marked comparative edge of the banking system in providing financial support, then, it was expectable that the leaders would be extremely sensitive and cautious over financial innovation such as developing securities. While financial innovation will undoubtedly benefit the establishment of an effective financial mechanism on the long term, on the short term it “might draw a substantial amount of funds from the banking system,” which explains why for a long time, “policymakers have been careful to maintain control over the overall financial system, and they have tried to maintain robust flows of saving into the banking system.”41 Not only that, but the Chinese people have been faced with a plight of dichotomized financial choices ever since the Economic Reform began. On the “menu” of financial instruments, they have only been given choices of two “dishes” of opposite risk levels, namely the risk-free bank statement and the highrisk share. Following the fervent attempts in the nascent stage and the ensuing market volatility, people started to calm down to carefully examine and “taste” the

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two financial “dishes” laid out before them. Savings deposits yield low benefits, sometimes even diminished by negative interest rates, but it has the incomparable strength of the risk guarantee contract signed by the state, the banking system, and the household sector, with which the savings statements will maintain the “smooth” nature of profits on the long term and completely put the account holders’ at ease. Stock, on the contrary, is known to be a rewarding yet high-risk investment, for which reasons stockholders’ fortune can be reversed overnight. In the nascent stage, the special institutional environment had kept many securities market beginners from realizing this fact, especially as the central and local governments’ interferences contributed to the illusion that stock investment would be all gains and no losses with government guarantee; however, later on, it became clear that the government has neither the intention nor ability to insure investors against the market risks that they ought to bear. Thus, compared with bank savings, stock investment has the innate disadvantage of the absence of a “guarantee” agreement between the state and stockholders. For the majority of the public who have on average a low level of income and who generally loathe risks, it is a rational choice to keep the mass of their financial wealth at the bank rather than invest in stock.

Institutional Bottleneck of the “Tiger in the Cage” In the course of the Chinese Economic Reform, the opposing changes of government and household savings and the policymakers’ apprehension over the stability of household savings deposits gave rise to an indirect institutional consequence, as Naughton observes: “a vastly enhanced role for the banking system, serving as an intermediary channeling household saving to the enterprise sector.”42 “Not long after the start of the reform, facing the quick decline of fiscal capacity, the state was already searching for special financial institutional arrangements that can satisfy its need for funds. This kind of institutional arrangements can mobilize the steadily increasing household savings, as well as provide support and timely capital support for the state’s investment preferences.”43 As a logical outcome of this phase of financial institution exploration, in the mid-1980s, the state-owned bank system that had been all set to go rose staggeringly at the starting line of the Economic Reform. It is beyond doubt that the 10% average growth rate of the Chinese economy has hinged on the special financial arrangement of a state-owned banking system extending generous credit support under the state’s guarantee, which unprecedentedly established a stable proportional relationship between household savings deposits and rapid economic growth. To take a deeper look, the establishment of this relationship was based upon the fact that the household sector,

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with its growing disposable monetary income, made the financial choice of holding more “sustained” bank statements over other financial securities, and it was this financial choice that enabled the dramatic transformation of the “tiger in the cage” of household savings deposits which had made several escapes into the “ox in the field.” When household savings deposits could finally lie at peace in the banking system on the long term, the long journey of “financially supported” economic growth was formally set off. From then on, “past saving has been transformed into investment through the intermediation of financial institutions.”44 It can be argued that the “tiger in the cage,” through supporting high growth, engendered a special banking system that accompanied the economy through its long reform process while safeguarding market confidence. But this has also come at a huge socioeconomic and institutional cost to the state. In order to provide security to household savings deposits that expanded rapidly with economic reforms, the state pledged its own reputation as collateral to the national banking system. Thus, the reason that the “tiger in the cage” appeared to be as tame as an “ox in the field” is that it had the company of the state’s reputation as protection. What seemed to be an insignificant bit of adjustment to the financial system actually required the involvement of the state’s own reputation — a hard bargain indeed! Of course, the state readily accepted these conditions because of the promising prospect of having a reliable financial support mechanism in its pursuit of economic reform and growth targets. But the true nature of household savings deposits as a “tiger in the cage” remained the same. In a hypothetical scenario where the state decides to withdraw its backing, any form of psychological shock would provoke the “tiger” to revert to its primal form, even if the daily lives of ordinary citizens were not impacted by any significant macroeconomic shock. If this scenario is true in reality, it would mean that the state’s reputation is completely held hostage by the “tiger in the cage,” and the cost of withdrawal would be extraordinarily high. As economic and financial reforms progress and various interests surrounding the banking system intertwine, the financial risks hidden in this arrangement will be hard to assess. Worse still, the “tiger in the cage” has opened up a “marketization paradox” in the evolution of China’s financial system,45 which makes it the initiator of the predicament into which China’s financial reform gradually sinks. In the special financial gaming pattern jointly “created” by the state, the banking system, and the bank account holders, all the interested parties will make their own rational choices. On the part of the state, now that it has paid the high price of its reputation, it will naturally pursue matching high returns. So, how does it ensure the highest possible returns? The answer is spelt out: to impose strict financial controls on household savings deposits to secure maximum power over financial resource allocation in

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place of the weakening fiscal extractive mechanism. Policymakers engineering the state-owned banking system would have understood that “a banking system operated in accordance with fiscal rules must have a stronger credit provision capacity than a banking system operated in accordance with financial rules,” and evidently, “the state-owned banking system which was quickly revived and rebuilt in that stage was a fiscal ‘substitute’ which the state tailored made and carefully crafted.”46 Accordingly, “about a third of their investment lending is allocated to projects selected by the State Planning Commission, and the rest is subject to considerable informal government influence, especially in the provinces.”47 In fact, although the state has shouldered a lot of financial risks through the mentioned “financial contract,” it has made sizable gains via the bank credit mechanism. For the banking system, its rational choice will naturally be to maximize riskfree gains. The best means of realizing this is to expand the size of credit assets as soon as possible, because only when credit assets expand will the accounting profits available for distribution be increased. The existing financial system design has extended to the banking system the great institutional convenience of earning zero-risk profits. Credit risk is almost totally diluted by the state’s “intangible capital”; therefore, “even though required to lend to loss-making SOEs, the state banks are not too concerned about it because the loans are considered “safe” — the state will bail them out.”48 On the other hand, the state-owned banking system has also been aware from the very beginning that the risk-free profits are acquired not without conditions: It is for the very sake of the sumptuous household savings deposits in its accounts, which form the basis of the credit directed mainly towards SOEs, that the state guarantees the deposits. The state is highly sensitive towards household savings deposits and credit availability, the former being a “cage in the tiger” and critical for the people’s vital interests and public support for the economic reform, and the latter being a “propeller” determining the prospects of reform. Again and again, the state-owned banking system has wittily made use of the state’s apprehensions to shape policymakers’ decisions over the reform of the banking system. By the time the state realized that the intangible capital initially intended to pacify the “tiger in the cage” would eventually open a big opportunistic institutional space for the marketizing banking system, it found itself caught in a deep institutional predicament of financial market reform. For the banking system, “the faster the marketization, the more risks are externalized, heightening the necessity for financial controls; and the more determined and sustained financial controls are, the more externalized the risks are, and the higher the impetus for marketization.”49 In this way, the market-oriented reform of the banking system entered a vicious circle of the mutual reinforcement of marketization impetus and state preference for financial controls.

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Comparatively, the household sector appears to be an audience member of the financial gaming. On the surface, from the late 1990s onwards, Chinese households have been extraordinarily calm in observing the conflict of interest between the state and the banking system. Although the actual microeconomic profits from the savings statements of the household sector are no match for the macroeconomic contributions they have made, they have been more concerned about the safety of their savings. It is their long-term preference for safety that has created the golden opportunity for the state’s low-cost acquisition and allocation of such massive financial resources, as well as made it possible for the state’s excess manipulation of the banking system. In this sense, the household sector’s sustained low-cost offer of their savings has a big hand in the institutional predicament that the state and the banking have landed in. This is not to say that the Chinese people are not concerned about profits; their low-cost offer of financial resources reveals their ignorance and indifference over their financial rights. To a large extent, the “financial contract” in discussion harbors extreme asymmetries in financial rights. Given that the contract was signed between the state and the banking system without the household sector’s full expression of their financial will (which was unfeasible), it is not hard to infer the uncertainty and dynamic financial risks in the process of contract compliance. In the most extreme case, during future reforms, any independent expression of the household sector’s financial will may possibly push this unbreakable-seeming “financial coalition” onto the verge of disintegration. And it is widely recognized that the disintegration of this “financial coalition” will bring disastrous effects. Most importantly, the indifference towards financial rights always accompanies the irrationality of financial behavior, and this kind of financial irrationality may take the form of long-term financial silence or a sudden financial outburst. With the advancement of the Chinese Economic Reform and the increase of personal disposable monetary income, the household sector is increasingly becoming aware of their financial rights. It is conceivable that if the rights embedded in the mentioned “financial contract” and the financial gaming patterns so implied are not adjusted timely, when the state’s and the banking system’s low-cost utilization of household savings reaches a certain limit while no corresponding (marketized) financial arrangement substitute is — or is intended to be — found, economic reform and growth proceeding along the same course will be doomed to fall at the last hurdle. This is no alarmist scenario. The household sector is, after all, the real owners of the “tiger in the cage” who hold the final decision over how and when to unleash it. In theoretical terms, deposit account holders are entirely free to make any independent financial decisions without consulting either signatory of the “financial contract.” To make it plain, that household savings have

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appeared as tame as an “ox in the field” since 1996 is in fact merely a temporary state of “financial silence.” To forestall development towards the other extreme of “financial outburst,” it is necessary to adjust the contract’s structure or enter into a new contract in response to the household sector’s awakening of their financial rights and the growth in financial rationality. In a word, complex and tough as the process of adjusting the financial contract may be, the crux of the adjustment is lucid: to comprehend and respect people’s financial rights which have long hidden behind the “tiger in the cage” and which have always been neglected in the process of economic reform. Only by this will China’s financial reform carve a feasible path out of its present institutional dilemma. In the end, however strong the banking system’s capacity for absorbing financial resources and the state’s financial control, the success of China’s financial reform will hinge on the commoners’ financial attitudes and choices.

Conclusion If we focus on the development of the Chinese Economic Reform, the “tiger in the cage” may appear to be no more than an isolated financial phenomenon that had once triggered a fleeting macroeconomic panic. Although it did catch the attention of Chinese economists as soon as the 1990s, this did not lead to extended discussion in subsequent years. By a detailed examination of the historical context and theoretical foundation of this special financial phenomenon, this chapter has nonetheless discovered that, neglected by Chinese economists on the one hand and yet mentioned every now and then on the other hand, the phenomenon does indeed contain numerous key factors and hints to understanding the logic of development of the Chinese financial reform. Under the centrally planned regime prior to the Economic Reform, the state had long borne “dual roles” in economic resource allocation, as both the major saver and major investor. However, as the Economic Reform was launched, a dramatic turn transpired, with the government’s share of savings shrinking and the state soon exiting from its role as the major saver. As a result, the state’s roles as saver and investor became severely lopsided,50 and the ambitious state which had long monopolized responsibility for economic growth and institutional adjustments found itself in the throes of an unprecedented financial dilemma overnight. The policymakers quickly realized the pressing task of seeking out or designing a new financial institutional arrangement capable of amassing household savings resources, lest further economic reforms and growth should be out of the question. In sheer theoretical terms, there was a clear alternative path for alleviating the financial predicament: to allow the household sector, which was gradually taking

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up the role as the major saver, and the enterprise sector, which was being endowed with various autonomous powers, to rise as resource allocators and hence shoulder the main responsibility over driving economic growth. The realistic problem was, however, that the transfer of such a heavy responsibility to new economic agents must be preceded by institutional preparations, especially the building of financial market mechanisms, on top of the strengthening of the country’s financial abilities, and this would not be achieved in a short time given the transitional nature of the economic regime. It took time for new investors to mature, but the economic reform was in urgent need of financial resource allocation. In this case, there was only one feasible path for alleviating the financial predicament, namely to establish a new financial institutional arrangement for concentrating the dispersed household savings. At the beginning of the Chinese Economic Reform, the fading out of its role as saver had filled the state with a sense of “financial tension” which compelled it to “tailor make” for the country a never-before-seen financial institutional arrangement, rapidly and widely mobilizing household savings by offering decisive and solid credit support. In this way, the state’s innate institutional response in the face of the dramatic change in national savings structure gave birth to a stunning state-owned banking system. Simply observed from the angle of mobilizing household savings, the establishment of the state-owned banking system can be compared to constructing a “financial dam,” with which as disperse “creeks” of savings gradually joined, capital flows that had been unperturbed suddenly condensed into a gigantic source of financial power capable of propping long-term economic growth. But when the “water level” of household savings deposits rose to a certain level, the financial stress borne by this banking system also surged. Here comes the paradox: While the initial purpose of establishing the state-owned banking system was to alleviate the financial tension created by the dispersion of savings, after being overloaded for years, the system once again brought the state into financial tension, except that it was caused by overly concentrated savings rather than otherwise. It is thus not hard to come to the conclusion that the “tiger in the cage” phenomenon was by no means an occasional “accident,” but the logical financial consequence of the state’s financial institutional design to alleviate and address the financial predicament caused by overly dispersed savings in the economic regime of that particular time. The phenomenon provides us with a holistic picture of the whole process of how the Chinese state-owned banking system as well as financial system had come into being, supported the Economic Reform, and got held up in reform dilemmas. Not only that — it also gives us a new possible angle for probing into the special logic in the Chinese Economic Reform. Particularly worthy of note

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is that the “tiger in the cage” phenomenon has evinced once more the importance of initial endowments and path dependence which institutional change theory so emphasizes. As an emergency institutional response, the establishment of the government-led financial system, particularly state-owned banking system, might have been a discretionary strategy to temporarily relieve the state’s financing difficulties; in those days some had recognized that while the cultivation of the market mechanism would benefit China’s financial development in the long run, it would be too far off to quench the state’s immediate thirst for money. Therefore the Chinese leaders’ policy choice was rational and could be spared from heavy criticism. However, this would not temper the frustration of standing before “locked” paths of development when the growth of market factors becomes increasingly necessary as financial institutional development advances, but can hardly attain the desired momentum despite strenuous efforts in market reforms. Even though the policymakers have the will to see the financial system marketized, their several market-oriented reforms have borne little fruit. The answer to this situation which has perplexed many over the years is in fact closely connected to the early policy on household savings: As soon as the household sector’s preference for savings and financial behaviour were established, a “self-strengthening” mechanism was developed, and gradually spread through the banking system which depended heavily on household savings deposits, eventually “squeezing out” people’s normal market preferences and choices and compressing the space for financial marketization.

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Chapter

Designated Loans

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During the reform of China’s credit funds management system towards expanding

the autonomy of commercial banks, designated loans (diandai 點貸) were introduced as a contingency measure to activate the economy in combating the economic downturn in 1989. This was an administrative credit funds arrangement directed by government instructions.

Term Definition Designated loans were a type of earmarked loans with prescribed intended borrowers, loan periods, and uses of loans, and the designated loans in the present

scope of discussion refer particularly to the policy loans which the People’s Bank of China (PBC) extended to designated state-owned enterprises (SOEs) in designated periods and designated quantities in an attempt to boost the Chinese economy

when it experienced a downturn in 1989, rather than loans designated at the will of bank managers as generally understood. At that time, however, the PBC that

was the monetary authority responsible for making and implementing monetary policy decisions did not issue formal official documents to thoroughly regulate

such loans. The designated loan policy remained an emergency, discretionary, and temporary measure to tackle a particular circumstance.

In terms of actual implementation, usually high-level bank branches would

assign a designated loan size to subordinate branches, either with or without allocating the necessary funds, in the latter case of which subordinate banks would have to raise funds by themselves or borrow from PBC branches of the

same administrative level. The emergence and utilization of designated loans were closely entwined with the wider environment of economic governance,

the general atmosphere of economic rectification, and the advancement of the banking reform. The policy was also a concrete expression of the central bank’s principle of “controlling the aggregates, adjusting structures, guaranteeing the

key, compressing the general, and making timely adjustments” (kongzhi zongliang,

tiaozheng jiegou, baozheng zhongdian, yasuo yiban, shishi tiaojie 控制總量，調整結構，

保證重點，壓縮一般，適時調節). Yet in actual implementation, many problems

were revealed. Like many other landmark policies during China’s market-oriented reforms, designated loans marked a significant transitional episode in the change of China’s credit policy. Being policy loans, designated loans also bore institutional and theoretical significance.

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Launch and Transformation of Designated Loans Macroeconomic background: Economic overheating and inflation in 1988 The designated loan policy was a discretionary measure during a period of overall tightening in the midst of specialized banks’ expanded autonomy over their use of credit funds. In 1988, the Chinese economy was perturbed by overheating, hyperinflation, and perennial expansion of aggregates. That year, the growth of China’s industrial value added spiked to a peak at 20.8%, seconded only slightly by the 1985 level, while fixed-asset investment grew by 23.5%, and the overall retail price level shot up by 18.5% to reach a ten-year high. From the south to the north, four tides of bank runs and panic buying of commodities spread through the nation. The year saw the most severe inflationary episode since the start of the Reform and Opening Up era. The main cause of the economic overheating was a seriously lopsided economic structure with agriculture, transportation, and energy industries falling behind, the poor timing of the price reform, and inexperience with monetary and credit policy regulation in the new economic circumstances. In the face of the chaos, the central government decided to devote three years or more to “govern the economic environment and rectify economic order.” On August 31, 1988, the PBC issued the Specific Regulations on Further Controlling Money Supply and Credit Size in 1988, underlying a series of monetary and credit policy measures to curb excess aggregates while providing guarantees for key projects. On September 29 and 30, 1988, the Third Plenary Session of the 13th CPC Central Committee convened in Beijing settled on the guiding principle of “governing the economic environment, rectifying economic order, and thoroughly deepening reform.” This set off a series of tightening measures including tightening fiscal and credit funds, compressing fixed-asset investment, controlling consumption demand, and regulating prices. Among them, it was loan limit management that took the quickest effect. Loans issued by banks and credit unions increased by CNY4.97 billion in the following September, dropped by CNY8.1 billion in October, and then increased mildly by CNY3.34 billion in November, making a moderate growth of CNY0.21 billion in the three months altogether, compared with the staggering figures of CNY61.84 billion, CNY61.35 billion, and CNY65.94 billion at the same time of 1985, 1986, and 1987, respectively. Bank credit size continued to shrink in the first quarter of 1989, with total loans of specialized banks falling by CNY2.17 billion compared with the beginning of the year. Compared with the CNY7.4 billion at the same period of 1988, it was an impressive CNY9.5 billion cutback.

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The first effect of aggregate tightening was a plunge in enterprise deposits, resulting in difficult turnovers, funds in arrears, and circulation of funds deviating from institutional controls. By the end of 1988, “triangular debts” accumulated by industrial and commercial enterprises throughout the country had reached CNY82.4 billion, and by the end of the first quarter of 1989, such debts hit CNY10.85, exceeding the credit level of ordinary years by far. From January 1989 onwards, the effect of tightening policy became even more salient. Industrial output fell precipitously. However, while intermediate demand was suppressed, which reduced supply, final demand continued to expand and prices remained high; overall it was a vexing scene of stagflation. Looking at the month-on-month growth rates of the major economic indices from October 1988 to March 1989, the figures for industrial output were 20.4%, 17.9%, 18.3%, 8.2%, 7.5%, and 14.8%; for nationwide fixed-asset investment, 37.5%, 31.4%, 21.7%, not available, –3.8%, and –2.1%; for total retail sales volume, 28.2%, 23.5%, 29.1%, 21.7%, 20.0%, and 26.0%; and for enterprise deposits, 16.0%, 9.0%, 10.4%, 3.1%, 2.7%, and 2.7%. The expansion of final demand was manifested first in the continuous swelling of consumption demand. Payroll expenditure under banks’ cash account in the fourth quarter of 1988 rose by 24.6% year on year, while in the first quarter of 1989, this figure increased to 27.7%. The drastic increase of household income propelled the continuous growth of consumption demand, resulting in a 27.4% year-on-year increase in total retail sales volume in the fourth quarter of 1988, and then 22.6% in the first quarter of 1989. Second, investment demand, too, was vigorous. Fixed-asset investment by enterprises of whole people ownership increased by 26.1% year on year in 1988, with the upward trend maintained in the first quarter of 1989. Sustained expansion of final demand kept driving up price levels in this period. In December 1988, the commodity price index was 126.7%, while the means of production price index hit 131.1%. In February 1989, the two figures stood high at 127.9% and 129.4%, respectively. The surging trend of prices did not at all subside in the first quarter of 1989. The rectification period went through six months of contraction in its early days, triggering the paradox of forced suppression of intermediate demand–induced supply and continuous swelling of final demand, hence sky-high price levels. It was recognized that an adjustment to the methods of rectification was necessary to send the economy back on a positive track of development.1 To combat stagflation and having learned a lesson from the 1986 mistake of allowing the economy to take off again before it landed properly, the government adopted an across-the-board tightening policy. In March 1989, the PBC allotted funds for designated loans to boost foreign trade and agricultural production. From the start, designated loans were a preferential credit policy to guarantee

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key projects in order to activate the economy and adjust the economic structure, and over time, the loans were extended to key industries and enterprises. In May 1989, the PBC issued the Notice on the Implementation of the “Important Decisions of the State Council on the Present Industry Policy,” announcing its plans to clear off triangular debts and providing specialized banks and other financial institutions with a credit policy blueprint for implementing the state’s industry policy. The document mainly provided that specialized banks should prioritize key industries supported by the state, especially large and medium-sized SOEs producing key products, in loan issuance, specified details regarding the scope of support and restrictions of fixed-asset investment loans, delineated the scope of support of working capital loans on an industry basis, and permitted specialized banks to independently determine the loan size and offer preferential credit support to large backbone industries producing key products as designated by the state. In a word, according to the state’s industrial policy, the PBC extended preferential treatment to agriculture, foreign trade, and large and medium-sized backbone industries and key construction projects supported by the state in relending, as did specialized banks in loan size. After the method of designated term, orientation, and quantum was fixed in 1989, the PBC issued a total of four designated activation loans. Overall, the macroeconomic control and regulation in 1988 to 1989 was effective, with the economy starting to trend up by the end of 1990 and maintaining steady growth.

Transformation of the bank credit system under expanded autonomy of specialized banks Being a special means of credit, designated loans must be studied against the backdrop of the long-term transformation of the Chinese bank credit system, which can be divided into three periods before the designated loan policy was implemented in 1989: the centralized monobank system before 1979; the mixed banking system between 1979 and 1984 before the PBC concentrated on its role as central bank; and the central bank system after 1884.2 The three periods bred different bank credit systems.

Credit funds management under the monobank system In 1953, New China kicked off its first Five-Year Plan period. Having only the Soviet experience to learn from in its exploration of Socialist construction, it naturally adopted the Soviet model of a highly centralized directive planned economic management regime. Thus, the banking system was but an appendance of state plans and the fiscal authority. As a component of national funds, credit funds

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were totally allocated by state plans, and the allocation of monetary funds was totally subordinate to the allocation of resources in kind. Correspondingly, a highly centralized banking system was established and then strengthened. This banking system took full shape at the end of 1952, with the completion of the setting up of banks under public-private partnerships in the industry and the Socialist transformation of private financial industries, and ran until 1972. In between, the Bank of China was founded in 1953; the Agricultural Bank of China was first set up in 1951 and had been abolished and reopened three times ever since; the People’s Construction Bank of China was established in 1954. Despite some changes, these specialized banks were never independent economic entities. They had remained bureaus of the state bank system or the Ministry of Finance in effect. With the formation of the highly centralized banking system, the PBC established a vertical credit funds management system. In September 1952, it called a major district branch managers’ conference and a banking planning work conference, adopting the Draft of the Methods of the Drawing Up of the Consolidated Credit Plan of the People’s Bank of China. The document stipulated that from 1953 onwards, banks at all levels would start drawing up credit plans, widely establish credit plan management mechanisms, and execute the credit plan management system. Banks at all levels would draft up their own annual (with quarterly quotas) and quarterly (with monthly quotas) credit plans and submit them to their next higherlevel branch for approval, and the PBC head office would eventually maintain an overall balance by assigning deposit and credit targets at a national level for local bank branches to implement. This vertical management system was known by the expression “unified control over loans and deposits,” which describes the practice that all deposit intakes at local levels were turned over to the head office and all loan issuance by local banks must lie within the quotas approved by the head office. In this way, the sources and uses of all credit funds were centrally controlled by the PBC head office.3

Exploration of credit difference control and reserve requirement under the mixed banking system In December 1978, the convention of the Third Plenary Session of the 13th CPC Central Committee heralded the commencement of the Reform and Opening Up era. The conference recognized that a serious shortcoming of the Chinese economic management system was the overconcentration of power and urged decentralization to allow local governments and industrial and agricultural enterprises more operational autonomy under the state’s centralized plans. Pointing out that the negligence of overall balance had upset the economic structure to the devastation

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of agricultural production, it proposed that reforms on the national economic management structure from 1979 begin with agriculture through institutional measures centered around the household responsibility system. Simultaneous with the rural reform was the expansion of enterprise autonomy in the cities. On July 13, 1979, the State Council issued the Notice on the Trial Implementation of the Quotas of the Fiscal Management Method of “Pegging of Revenues and Expenditures, Apportionment Based on Totals, Proportional Contracting, and Constancy over Three Years” (shouzhi guagou, quan’e fencheng, bili baogan, san nian bu bian 收支掛鈎，全 額分成，比例包干，三年不變). This was followed up on February 1, 1980 by the Notice on the Implementation of the Fiscal Management System of “Division of Revenue and Expenditure Responsibilities and Hierarchical Contracting” (huafen shouzhi, fenji baogan 劃分收支，分級包干), for incentivizing the central and local governments at the same time. The rural and urban reforms as well as the fiscal reform broke the strict boundaries of planned management, bringing the question of corresponding banking reform to the agenda in order to provide matching credit support. In the nascent stage of the banking reform, attempts were made to establish a banking system in which a state bank and specialized banks coexisted. Thus was inaugurated the period of the mixed banking system of 1979 to 1984 before the PBC focused on its central bank functions. This system was distinguished from the previous monobank system in that specialized banks became independent economic entities. In February 1979, the Agricultural Bank of China was reestablished for the fourth time directly under the State Council in keeping with the policy of the Third Plenary Session of the 11th CPC Central Committee of promoting agriculture. After several changes, the PBC was finally made a subordinate department of the State Council in August 1979, and placed under the supervision of the National Capital Construction Commission and the Ministry of Finance. It was resolved that specialized banks would be set up by the State Council, while the PBC would centrally devise cash plans. Specialized banks only operated services in a designated area and did not overlap with each other in business scope. As economic reform proceeded, however, banks’ business scopes also expanded. Services of the Agricultural Bank of China, for example, soon extended beyond making agricultural loans and managing the state’s agricultural subsidies, with the amount of industrial and commercial loans gradually exceeding agricultural loans alongside the development of township and village enterprises. The Draft of the Bank Law in January 1980 clarified the PBC’s status as state bank and its leadership role over the business of specialized banks. In actual implementation, however, each specialized bank had its own business area and maintained its own system, making it hard for the PBC to truly exercise its leadership role. In July 1982, the

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State Council transmitted and approved the PBC’s Request for Instructions on the PBC’s Role as Central Bank and Its Relationship with Specialized Banks, which affirmed the PBC’s role as central bank but at the same time provided for it to continue operating industrial and commercial loan and urban savings services. In actual practice, the PBC was always entangled in commercial activities and could hardly tackle financial problems from a distant position, not to mention properly handling its relationship with specialized banks with regard to allocation of funds. Observing these problems, the State Council issued a new document titled Decision on the People’s Bank of China to Exercise Only the Functions of the Central Bank in September 1983, which provided for the founding of the Industrial and Commercial Bank of China (ICBC) to take over industrial and commercial loan and savings services. The central bank system had thus taken shape. The funds management system of “loans based on deposits” (shi dai shi cun 實 貸實存) which came into being in 1985, as well as the reform of the interbranch (lianhang 聯行) system, eventually set the cornerstone for the central bank system. However, before that, many explorations had been undertaken in seek of an apt credit management system. The first system adopted pegged loans to deposits to achieve “credit difference” — difference between total deposit intake and total loan issuance — control. After the pilot scheme in 1979, the PBC resolved in 1980 to implement “unified planning, hierarchical management, pegging deposits to loans, and contracting credit differences” (tongyi jihua, fenji guanli, cundai guagou, cha’e baogan 統一計劃，分級管理，存貸挂鈎，差額包干) on its provincial-level branches and the Agricultural Bank of China, which was to assign credit difference targets apart from credit plans to bank branches. By the end of each year, bank branches must either meet the minimum “deposit surplus” or keep the “loan surplus” of their credit difference plans. As long as the credit difference plan was observed, bank branches could shift around industrial and commercial loan targets among themselves and use the saved credit funds and excess deposits to issue policy-permitted industrial or commercial working capital loans. Having met the demand for working capital and acquisition funds, banks could also issue medium and short-term equipment loans. The PBC established the “credit difference tenday report” (xindai cha’e xun bao 信貸差額旬報) system to keep track of and strictly control the credit differences of banks. Credit difference control kept loan issuance within the limits of deposit intake, changing the decade-long practice of allocating credit funds simply according to state plans without taking available deposits into account. This system was more flexible as the PBC local branches and specialized banks had freedom to shift around loan targets and hence more autonomy over lending decisions.

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But while the setting of credit difference targets was technically the job of the highest financial management authority, in reality it reflected more the outcome of the combined effects of multitudinous economic activities than the authority’s decision, for the credit difference was a quantum not subject to prior control or artificial influence in the process of implementation. As a result, despite its flexibility which to some extent answered the needs of economic reform, this system had its own limitations and was inherently transitional. More comprehensive institutional designs were necessary. Soon it exited and gave way to a reserve requirement system. In November 1983, the PBC issued the Work Arrangements for the People’s Bank of China and the Industrial and Commercial Bank of China of 1984, which required that all specialized banks turn specified percentages of their deposits to the PBC at its disposal. For the year 1985, 20% of enterprise deposits, 25% of agricultural deposits, and 40% of savings deposits had to be held at the PBC. As for the management of credit plan targets, these were divided into “directive” or “guided” targets. The former referred to targets on various types of deposits and working capital loans and could been shifted among projects within the deposit plan so that more loans could be issued if more deposits were taken. The reserve requirement system ensured that the PBC had sufficient funds for adjusting the credit structure. Its greatest advantage over credit difference control was that it made the credit differences of specialized banks a variable subject to the influence of the central bank. While in credit difference controlling, the credit differences of specialized banks were formed naturally as a result of the bank’s deposit and loan services, under the reserve requirement system, the required reserve partially decided the credit difference. The central bank thus managed to influence the lending capacity of specialized banks without changing the credit difference plan but by adjusting the required reserve ratio. Yet, from the angle of funds management, the reserve requirement system left a lot to be desired: The required reserve ratio was too large, dictating that 40% to 50% of all credit funds be supplied by the central bank, whose attention became diverted from macroeconomic regulation and control to the allocation of loans.

“Loans based on deposits” and credit plan management under the central bank system The reserve requirement system was, again, a transitional method adopted after decisions were made for the PBC to concentrate on its role as central bank. It failed to solve the problem of the central bank’s domination of specialized banks, and funds of the central bank and specialized banks remained fused under the interbranch system. After one year of preparations, the PBC introduced several

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supporting measures that completed the institutional setups for establishing itself as solely a central bank. These included the Trial Measures for Credit Funds Management, Provisions for the Implementation of the Reform of the National Interbranch System, and Provisional Provisions of the People’s Bank of China for Systematic Credit Funds Management. The Trial Measures for Credit Funds Management was the central document for whose implementation other regulations were made. The core provision of the Trial Measures for Credit Funds Management was the implementation of “unified planning, differentiation of funds, loans based on deposits, and mutual financing” (tongyi jihua, huafen zijin, shi dai shi cun, xianghu rongtong 統一計劃，劃分資金，實貸實存，相互融通) on the Renminbi capital of all specialized banks, including the China International Trust and Investment Corporation. This signified a change from the previous practice of assigning specific targets to specialized banks hierarchically, to allow provincial-level PBC branches to lend one off or multiple times to provincial-level specialized banks within a total loan limit prescribed by the PBC head office, for them to allocate to their branches to be deposited at an account with the PBC which could not be overdrawn.4 By this, the PBC prescribed that the provincial branches of all specialized banks must open a deposit account, a loan account, and a temporary loan account at the PBC branch of the same district, while local branches of specialized banks below the provincial level could only hold deposit accounts with the PBC. In case where specialized banks had surplus funds, their provincial branches would pay back the loans to the PBC centrally. To base loans on deposits and to differentiate between specialized banks’ selfowned funds and credit funds, thereby allowing them more autonomy, was a major breakthrough in credit funds management. No longer were funds linked to central plans so banks could make loans regardless of their ability to take deposits; specialized banks were now forced to optimize their business performance and the efficiency of credit funds usage. The free supply of credit funds and irresponsible reliance on central funds allocation were not to be taken for granted. This was an important headway in specialized banks’ development into real economic entities and provided an institutional guarantee for the central bank’s macroeconomic regulation and control. However, even in this period the PBC had not forfeited its power of making direct loans. For example, it had to cater to special needs arising from fixed-asset loans lying outside regular state plans. The PBC head office would centrally arrange the necessary funds and then, in accordance with the business scopes of specialized banks, allocate or entrust funds to their head offices, or entrust specialized bank branches with loan issuance through PBC branches. Additionally, the PBC head office also arranged an appropriate sum of low-interest development loans for the

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14 coastal port cities opened up to overseas investment and a number of special loans to facilitate economic development in ethnic minority regions, both of which it entrusted, via local PBC branches, local specialized banks to issue. Different from the credit difference system which controlled only the external funds of specialized banks, the practice of “loans based on deposits” sought to manage both internal and external funds. The credit difference was merely the difference between deposits and loans in the external funds of credit funds. It was a statistical figure, and all that a bank could control in managing its funds were figures in book value. Figures in the transaction accounts of specialized banks with the PBC were the result of the combined movement of external and internal funds, making it hard for the PBC to grasp whether the loans made by specialized banks had exceeded the limit and conduct macro control. This situation was altered in 1985 by several new provisions which facilitated the functions of the central bank. First, mutual agency services of specialized banks were changed into self-operated services, thereby cancelling the practice of mutual offsetting of surpluses or deficits, so that every bank would finance its own services. In this way, specialized banks started to develop into commercial banks, expanding their business scopes and providing overlapping, competitive services. Second, on April 1, 1985, the national interbranch system was transformed into bank-based interbranch systems which permitted direct interbank transfer of funds, direct mutual notice and handling of bankers’ acceptances, and immediate clearance of funds. Each having an independent interbranch system that was separate from that of the PBC, specialized banks truly became client banks of the central bank. Specialized banks must secure the necessary funds before remittance in their transactions with the PBC and their transfer of funds through the PBC. Third, in the transactions between specialized banks and the PBC, deposits and loans now went under separate accounts, which resulted in greater clarity to the benefit of the central bank’s macro control. The credit funds management system of “loans based on deposits” signified changes in China’s bank credit system from direct control towards indirect control, and from single-handed administrative control to respecting market rules. Specialized banks started to exhibit characteristics of corporations.5 The Chinese banking system was conspicuously departing from the control of vertical central planning of the old days. The credit funds management reform of 1985 transformed the PBC into a central bank in the real sense and enabled the development of credit funds planning and management systems under the central bank system. To afford specialized banks more credit autonomy to meet the needs of the Economic Reform, the PBC decided to abandon the practice of implementing the state credit plan by governing bank credit under a single target, but instead created separate credit plans for the PBC

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and the specialized banks while influencing the plans of specialized banks through observing funds plans. The years 1985 to 1989 saw the transition in the PBC’s credit plan control from scrutinizing specialized banks’ balance sheets to merely setting maximum loan limits. The 1985 Trial Measures for Credit Funds Management provided that the PBC head office should approve the annual credit plans of specialized banks, including the credit plans of subsidiary items and plans to borrow from the PBC. Under this system, specialized banks generally earned more flexibility in loan matters and were permitted to make more loans by taking more deposits. Yet the degree of control varied during these years, before the “designated loan” policy was finally introduced. It was in the nascent years of 1985 and 1986 when the PBC scrutinized specialized banks’ credit plan balance sheets; and in 1885, in spite of the “loans based on deposits” policy, which was implemented in provincial bank branches then, a loan limit was imposed on specialized banks alongside the State Council’s contractionary fiscal and monetary policy in the wake of the 1984 credit chaos, so banks were prohibited from extending extra loans based on excess deposits. The principle of “more deposits, more loans” was only put into practice in 1986. In the same year, certain provinces also ran pilots of “loans based on deposits” in prefectural-level branches. From 1987 onwards, the “loans based on deposits” scheme basically applied to all prefectural bank branches, although provincial branches held some discretion of adjustment. The specialized bank credit plans that the PBC approved in 1987 and 1988 were not balanced plans anymore: Planned loans exceeded planned deposits, the differences of which were financed in part by loans from the PBC and in part by the capital market. In these two years, the PBC only imposed strict control on specialized banks’ credit sizes when the State Council was determined to tighten money in the fourth quarter of 1988. Before that, no loan limit on specialized banks was imposed.6 In 1989, the PBC imposed directive loan limits on specialized banks, adopting the policy of quarterly monitoring and monthly assessment. It also retrieved the funds with which it had granted its branches autonomy to arrange central bank loans so as to centralize control over central bank loan limits. These were part of the policy measures to curb economic overheating, and it was when signs of stagflation emerged in the process that “designated loans” were born.

The Truth about Designated Loans Having to combat inflation in a troubled time of market sluggishness, product overstocking, and debt arrears, and yet finding other policy options unfeasible or ineffective, the Chinese government resorted to financial policy, seeking to activate

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the economy by loosening credit. It injected capital into the economy four times in a row, mainly as short-term loans to finance key projects, which have come to be known as “designated loans.” The first instance of designated loan issuance took place in 1989, when the PBC set aside loans of CNY28 billion for 234 large and medium-sized enterprises in the country. As these loans were offered on short terms and in limited amounts, they were mainly used to solve emergency and immediate capital needs in production. Their effects were largely local.

Features of designated loans Designated loans were directed towards designated projects — those which the PBC acknowledged as key projects of key enterprises — and could not be transferred to other purposes. The sizes of these loans, too, were preset. Most designated loans were rather large, issued to help ease capital shortages caused by insufficient liquidity and low turnover. Also specified was the loan term, which was strictly maintained and ran from the most common three months to a maximum of six months. Designated loans were earmarked for specific projects. In actual practice, the PBC head office would make temporary arrangements for a specific period and allocate funds along the administrative hierarchy, for local PBC branches to make short-term loans to enterprises via specialized banks. As a rule of thumb, funds for designated loans were allotted to local bank branches along with the loan notices from high-level bank branches (head office, provincial branches, and prefectural branches) to large and medium-sized SOEs or local backbone enterprises; in other words, local bank branches were notified of the loan decisions at the same time as the designated enterprises. Therefore, whether or not the designated enterprise actually had made a loan request, the local bank branch would have to issue the loan upon receiving the notice. Local bank branches only executed the decision of the superior branches in loan issuance and collection.

Distortions in implementation In loan projects Designated loans were meant to ensure the development of key enterprises and key projects, but the decision of what were “key” rested entirely with the PBC. Specialized banks and local governments could report suggested lists of key enterprises and projects, but it was the PBC which held the final verdict with reference to the state’s preferential industrial policy and the actual situation. Information

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was prone to be distorted in such processes of bottom-up reporting and top-down instructions, making it hard for the loans to really serve their purpose of activating the economy. In 1989, funds were a scarce resource, so it was the desire of almost every enterprise and government to gain a piece of the cake of these loans. Some enterprises went as far as to set up a public relations department and hire public relations personnel to lobby governments, competent departments, and banks, establishing networks and utilizing every possible means to secure loans from the superior government. Some enterprises had generalized for themselves “secrets” of success: first, to get the superior bank designate loans by establishing guanxi (“networks”); second, to use a strategy of never-ending projects (huxu gongcheng 鬍鬚工程) as a pretext for requesting further loans, since banks could not afford to see projects aborted and earlier loans unrecovered. Hence, many designated loan projects were granted contrary to the original cause. Statistics showed that of the CNY28 billion designated loans issued in 1989, 60% to 70% became enterprises’ overstock and inventory.

In terms of maturity It was intended that designated loans would help solve enterprises’ short-term capital needs, and they must be collected when the term was up. However, in reality, once the loans were taken out, they were often diverted to other uses. Some funds were held up directly by fixed-asset investment projects, meaning that recovery within the prescribed term of three months to half a year was next to impossible. Indeed, some enterprises could not repay their loans on time, and although extension of loan terms was not permissible, in order to support production, competent banks of designated loan funds often worked around the loophole that recovered funds could be reused to implement “target swaps,” which was essentially to extend virtual loans based on virtual repayment. This kind of “blank check” was issued again and again, leading to the swelling of phony designated loan targets. Moreover, the approval period of designated loans was relatively long. The process from application to the approval and transmission of the loan plan by the superior bank took at least two to three months, excluding even the time for communication among the enterprise, the competent authority, and the local government leadership, in the midst of which a great amount of manpower and material resources was consumed. For example, Jiangxi Phosphatic Fertilizer Factory which was designated as a key enterprise filed its application in June 1989, but had to wait until September when the loan plan was confirmed, and funds were not transferred until September 20. It was commonplace for an applicant to wait for three months as in this case.

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Local government intervention After fiscal decentralization, local governments became extremely concerned about local economic growth and local businesses, to the extent that they often used administrative means to interfere with the decisions of financial institutions. Their attitude to credit funds was no exception. As designated loans were granted to enterprises managed by the central government, local governments also demanded banks to allot designated loan funds to provincial, prefectural, and even country enterprises. Some local governments even manipulated administrative means to press local banks to invest designated loan funds allocated by superior branches in enterprises while retrieving issued loans of identical amounts themselves in order to free up more capital to back local enterprises. The consequence was often that banks became subservient to governments, and the limited expanded credit became scattered through designated loans, so funds were channeled towards preferred enterprises and the economic structure became even more lopsided. There were cases where government officials manipulated their personal name and authority to “designate loans” from banks. Banks’ autonomy was hazardously infringed, while projects were designated at irrational will. Worse still, when designated loans reached local levels, trying to cater to the interest of all, local governments often split the funds to various districts and counties, whose governments further shared out to collective enterprises which they deemed worthy of support. The funds scattered, each enterprise likely only gained around CNY10,000 to CNY20,000, which was too meager to be of use in activating production. Some even saw designated loans as relief funds, using them to pay wages and subsidies for financially troubled enterprises, which totally went against the principles of the loans.7 The ideal goals of “banks ensuring funds supply, enterprises ensuring efficiency; superior banks ensuring input, subordinate banks ensuring repayment” were never realized.

Case study Here is a case study of the use of designated loan funds in Leshan City, Sichuan. Shadowing investigations were carried out on 13 key state-owned industrial enterprises. At the end of 1989, the outstanding balance of designated loan funds was accumulated at CNY80.06 million, accounting for 78.2% of the outstanding balance of total industrial designated loans allotted to the city. The repayment dates were concentrated in February and March of 1990. Most enterprises expressed difficulty in repaying the loans on the due date and demanded application for continuous use. One of the main causes was the failure to provide for differential terms of

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maturity for industries with longer turnover periods. For machinery manufactures like Leshan Metallurgical Machinery and Roll Works, Yaxi Machinery Works, and Meishan Rolling Stock Works, for instance, a cycle from raw material preparation to production completion spanned three to five months at least and seven to eight months at most, whereas industries dependent on seasonal raw material supply such as Jiale Paper Mill and Leshan Silk Company needed sufficient funds to arrive once and for all. Designated loans of two-to-three-month terms apparently could not satisfy the turnover needs of these enterprises. The due dates removed from reality and local specialized banks having no discretion to make adjustments, application for extensions was the only recourse for enterprises. The next cause was that designated loans in effect became backing funds for enterprises’ working capital, thereby losing the effect of providing for shortterm capital turnover needs. As it had long been customary for banks to back up working capital, some enterprises took it for granted that banks would fill the working capital gaps of their new projects and production expansion plans. But coincidentally, the government was tightening monetary base against inflation, while accordingly specialized banks were controlling the credit size, so large portions of designated loans ended up filling in enterprises’ working capital gaps. To give an example, the new refrigerator compressor production line of Jianchuan Machinery Factory needed around CNY20 million to maintain normal production, and having no stable source of funds, it had taken CNY19.46 million designated loan funds by the end of 1989. Likewise, Dadu River Steel and Emeishan Salt Chemical Industry (Group) Company also financed the working capital of their new projects with designated loan funds after expansion of production capacity. Yet another factor for overdue loans was that PBC designated loans funds constituted a major part of enterprises’ annual loan increments. Taking the 13 key industrial enterprises as a reference, of the CNY89.55 million increase of the outstanding balance of their working capital loans in yearend 1989 over the beginning of the year, designated loan funds made up as much as CNY80.06 million, 89.4%. In the same year, total loans of state-owned industrial enterprises in Leshan increased by CNY125.17 million, of which CNY102.36 million, or 81.8%, came from designated loans. When enterprises failed to repay matured loans on time, it was designated loans that suffered most.8

Variants of designated loans To see designated loans as commercial loans born out of the central bank’s direct intervention, designated loans have evolved into other forms alongside credit funds management since the start of the Reform and Opening Up era.

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Central bank coordinated financing system This refers to the PBC’s attempts to influence the flow and allocation of credit funds by helping to solve financial problems of the state’s key projects, key enterprises, and key industries. In the period of economic transition, this system played an important part in supporting the reforms of large and medium-sized SOEs, the strategic reforms of large corporations, and the state’s key capital construction projects. It faded out of history following the 15th CPC National Congress, which kicked off the reforms of the commercial bank and financing systems. The scope of coordinated financing covered rescuing and reforming of key large SOEs, which were indispensable to the national economy and people’s livelihoods, and large SOEs with promising market prospects but in temporary difficulties, through the combined use of fiscal, taxation, and credit means. Having investigated enterprises’ production and operational conditions, the central bank undertook coordination in interest rates and loan repayment, extending “closed loans” (fengbi daikuan 封閉貸款), or loans offered based on independent cost accounting (described as “closed” management of the whole process of capital input, production, and sales), to cost-effective products, to enforce strict monitoring of enterprises’ finances.

Special project loans Issued by specialized banks for specified purposes designated by the state, special project loans were products of the planned economy and of an administrative character. They did not conform to the spirit of autonomous operation of commercial banks, and were of poor asset quality. The Law of the People’s Republic of China on Commercial Banks adopted in 1995 provides that commercial banks should conduct business operations without interference from any unit or individual. In 1999, the PBC requested instructions from the State Council on perpetual suspension of handling of policy loans by state-owned commercial banks of sole proprietorship, which would put an end to the form of special project loans in principle, with allowance for the continuation of specific recent loans deemed difficult to immediately cancel and truly necessary for providing key support until December 31, 2000.9

Effectiveness of Designated Loans By guaranteeing a stable source of funds for key industries that served as the backbone of the national economy, the designated loan policy introduced in 1989

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played a positive role in ensuring the steady growth of the economy. However, factors like market sluggishness, overstocking of finished goods, a generally high inflationary trend of means of production, and mutual arrears among enterprises increasingly undermined the feasibility of on time repayment of designated loans, which became tied up by enterprises over the long term. It was proven that not until enterprises’ operational problems were solved, the effectiveness of designated loans was doomed: They would do no more than perpetuating inventory accumulation while supporting production, so that sales would be accompanied by more arrears. As much as 80% of the invested designated loan funds turned out to become overstock or debts in arrears. Take designated loans issued by the business department of the ICBC of Neijing City, Sichuan as an example. The first two batches of designated loans totaled CNY14 million, CNY10.15 million, or 72.5% of which was made to Class I enterprises, and CNY3.85 million, or 27.5% of which to Class II enterprises. In terms of the uses of the funds, CNY10.03 million went to commodities, accounting for 72%. As far as repayment time was concerned, one enterprise paid back its loan ahead of time, which amounted to CNY2 million, or 14% of the total figure; seven others settled theirs on time, making up CNY3.6 million, 26%; and four enterprises had part or all of their loan overdue, totaling CNY8.4 million, 60%.10 The PBC was faced with a dilemma over what to do with the outstanding designated loans: If it resolutely collected them when the loans were due, it would be no difference from cutting off the means of survival of the majority of the key enterprises, which would shake the economy and is against the initial rationale of the whole policy; on the other hand, if it allowed most of the loans to stand in arrears, there was the practical problem of supplying funds for the planting season of winter crops and grain and oil procurement, plus the concern that the intended effect of easing short-term turnover capital needs would be weakened and lost over time. But as capital shortages of SOEs persisted and their business continued to slide, the PBC was forced onto continuous trials and errors of the administration-led designated loans in hopes of activating the economy. Before the banking reform of 1990 to 1994, designated loans became a common form of credit funds management. In approving credit plans, higher-level credit departments of specialized banks would set apart a lump sum of funds and specify the target enterprises, loan projects, and amount of loans, channeling credit funds to key projects in a concentrated manner in order to boost the efficiency of funds usage. In certain periods and places, the proportion of designated loans in total loans had increased. According to the statistics of the ICBC of Hinggan League, Inner Mongolia, for example, after 1991, the share of designated loans allotted to the county branch increased by 10 percentage points per year, reaching as high

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as 90% by November 1993. Moreover, within the PBC, designated loans had gradually evolved into multiple-tiered designated loans, with the head office, provincial branch, and city branches designating their own loans under the central operation of the head office. On the other hand, the size of each loan was shrinking, from millions of yuan to some hundred thousands, and then as small as some ten thousands in low-level administrative units. Designating loans became a common practice in state credit supply, but its significance and impact had deviated greatly from its original intent. Yet as far as the functions of designated loans were concerned, negative impacts were salient. First, the original goal of activating the economy was not reached. The purpose of preferential credit policy was to support product structure adjustment and hence enliven the market by selectively injecting credit funds. However, due to the lack of proper direction as to what to be given preferential treatment, the credit funds failed to fundamentally change the economic and product structures in answer to market needs. On the contrary, production continued in its original scale, if not expanded along the line of immediate demand, becoming increasingly removed from commodity supply. This affected the channels of product circulation, causing reverse transmission and a considerable number of finished goods to be stagnated in the production link. According to a survey on 40,000 Chinese industrial and commercial enterprises in 1998, as much as 65% of new bank loans were tied up and barred from normal circulation. More than that, designated loans distorted the credit funds management mechanism and violated the normal credit order. The approval and details of designated loans were all the business of the government and high-level banks. Lowlevel banks were in a totally passive position with no autonomy in investigation, scrutiny, and loan issuance. Competent government departments were very eager to approve loans, neglecting practical questions like the feasibility of debt collection and the efficiency of loans. The reality was that superior banks held the control over loan issuance, enterprises disposed of the loans, and local banks were charged with loan collection. Seeing that the loans were not made by them, local banks were less than enthusiastic about loan collection. Such incongruence in the management, issuance, and collection of loans caused by the separation of power and responsibility meant no pressure or motivation on the part of both high- and low-level banks, and also distorted the relationship between banks and enterprises, and superior and subordinate banks. In short, designated loans had shattered the conventional strict loan management system, allowing enterprises to bypass normal loan application procedure at the bank where their account was opened but to lobby government departments and high-level banks for approval. In fact, despite stipulation of the main usage of each batch of funds, designated loans were

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never free from the interference of the human factor: As the Chinese saying goes, “it is the crying baby who gets the milk.” There was no prescribed regulation on how provincial and local banks should keep track of designated loans or the maximum number of loans to be issued. The lack of transparency seriously undermined the regulation of the loan granting procedure. Designated loans had the adverse effects of encouraging enterprises’ irresponsible reliance and sustaining the vicious circle of taking out designated loans, starting half-finished works, taking out more designated loans, and starting more half-finished works. Capital injection into large and medium-sized enterprises through designated loans can be compared to blood injection: Whether one can eventually fully recover depends on oneself. If the recipient of the loan utilized it on a pivotal point, then it would help enliven the enterprise; otherwise, the loan would only be wasted on unworthy works and be written off as a nonperforming or bad debt, lowering the quality of assets. High-level banks in charge of designating loans did not necessarily have a full grasp of enterprises’ production and operating conditions. Enterprises and local governments alike vied to secure loans without effective constraints. Instead of adjusting their product structure and trying to release tied-up capital, many enterprises simply sent personnel to the provincial or national capital and use unscrupulous means from exaggerating their financial difficulties to bribery by restaurant meals or gifts to secure a designated loan quota. In the end, loans fell into the hands of those with most successful “networking.” Just as they would lobby high-level authorities to designate loans in their favor, enterprises too would manipulate local banks which carried out their duty of debt collection halfheartedly. In this respect, designated loans actually made way for corruption. When the loans were to be due, notices demanding repayment often went unheeded, and massive nonperforming debts resulted. As an extraordinary policy to activate the economy following the contractionary policy of the fall of 1989, the designated loan policy failed to serve its purpose. Designated loans did enter the state-owned sector, but did not form the expected strong demand for major products of large and medium-sized SOEs. The partial means of credit and monetary policy operations could hardly achieve the goal of macroeconomic management.11

Conclusion It is apparent from the background, implementation, and evolution of the designated loan that being a form of loan with a designated size, target recipient, and term of maturity enforced through administrative authority, it was a typical

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means of direct financial control in a transition economy, and although it gradually weakened, variant forms of the loan continued to exist for a while. According to the financial repression and development theory of Ronald I. McKinnon and Edward S. Shaw,12 for developing countries in the nascent stage of industrialization, capital bottlenecks induced by insufficient savings often constrain investment expansion and technical improvements, constituting a major factor that obstructs economic growth. To break the “vicious circle of poverty” as analyzed by Ragnar Nurkse,13 most developing countries have made use of financial repression policies, that is, such tools of financial control as low interest rates, policy loans, and fiscal investment instead of the financial market mechanism, to finance industries. These policies were so called because they would repress economic growth in the long run. The designated loan policy implemented around the 1990s in China was exemplary of such an adverse consequence: Created not as a commercial product out of market demand, designated loans disrupted normal the credit procedure and eventually aggravated the situations of SOEs, resulting in huge nonperforming debts. In 1973, McKinnon and Shaw proposed financial deepening as a panacea for the financial repression of developing countries, holding that governments should withdraw from excessive intervention of the financial market and the financial system, and relax control on interest rates and exchange rates, so that interest rates and exchange rates can be signals reflecting changes and contrasts in the supply and demand of capital and foreign exchange, thereby facilitating increases in savings and investment and pepping up the economy.14 According to this theory, financial deepening can be achieved as the financial industry effectively mobilizes and allocates funds, forming a virtuous circle in which the financial market and economic development enhance and foster each other. However, financial deepening is preconditioned by the existence of a Walrasian equilibrium, which is rather rare in developing countries. Moreover, later on, financial liberalization proved to be often pushed so far as to reinforce existing financial risks despite facilitating economic growth. The debt crises in Latin American countries following the 1980s and the Asian Financial Crisis in the late 1990s prompted another reassessment of financial repression. In 1991, McKinnon proposed the conditions and order of economic liberalization,15 while Park held that while financial repression does not obstruct economic growth, there is no evidence that it would boost growth.16 The financial constraint theory of Hellman, Murdock, and Stiglitz based on the East Asian miracle, however, provided a new perspective into this area of research.17 Due to information asymmetry in the economy, their study revealed, it is hard for capital to be effectively allocated even under a Walrasian equilibrium; therefore appropriate government intervention benefits economic growth.

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Going further along this line, we can see that this is in fact a question of market and government relations in the realization of effective resource allocation. Financial repression and liberalization being two resource allocation mechanisms, economists have never stopped investigating into the relationship between market and government. Such efforts can be categorized into three stages. In stage one, classical economists represented by Adam Smith held that a free market and economic behavior for self-interest could best realize the optimization of resource allocation and foster the maximization of overall social wellbeing. Smith advocated laissez-faire and allowing the “invisible hand” to freely regulate economic activities, opining that government intervention in the market would only lead to low economic efficiency. Accordingly, government functions should only be confined to the executive, the judiciary, and the maintenance of necessary public works and facilities in a minimalist role similar to a “night watchman”; the less government intervention in the economy, the merrier. Stage two was marked by crises of the capitalist system during the Great Depression of 1929 to 1933, which signaled the bankruptcy of classical laissez-faire economics. Market failure in the course of resource allocation gave birth to Keynesian government interventionism, which slowly ascended to the mainstream of economic theory studies. Critical of unrestrained laissez-faire, Keynes believed that the “visible hand” of the government should play a greater role, by active intervention in the market through economic policies which would expand demand and thereby propel economic growth and repress crises. Stage three was marked by the prevalence of stagflation in the West in the late 1970s, when Keynesian theory no longer sufficed to provide a reasonable explanation or effective coping measures to the phenomenon. This triggered a resurgence of the emphasis on the “invisible hand,” with burgeoning calls for the strengthening of the market and weakening of government intervention. Such schools as the monetarists and public choice theorists criticized Keynesian government interventionism from political and economic angles, arguing that with government failure, government intervention not only could not remedy market failure, but would actually worsen the economic situation. Yet they were also aware that because of the presence of market failure, government economic intervention was somehow necessary, and a retreat to complete laissez-faire was unrealistic. They embraced the middle ground of having some government intervention while limiting government economic functions. Debates about market and government relations have revolved around the question of “failure.” In economic terms, market failure refers to the situation where the ideal of Pareto optimality can hardly be attained in a realistic market. Some common manifestations of market failure are monopoly, externality, and the supply of public goods. In the broad sense, inefficient resource allocation, unfair

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distribution, and macroeconomic instability can also be seen as expressions of market failure. In addition to the context of a transition economy, the implementation of the administrative means of designated loans can also be ascribed to the failure of market financing methods in serving the cause of the state’s industrial preferential policy and lifting large and medium-sized enterprises from their dire straits. As for government failure, a reason that studies in this area by far less deep and mature than those on market failure may be the absence of an objective standard like Pareto efficiency for gauging government performance. Government failure generally refers to situations when economic intervention fails to attain the expected goal, when the expected goal is realized at high costs which created immense waste of social resources, or when the expected goal is achieved with high efficiency but in spite of other negative effects. The performances of designated loans fitted into these general descriptions of government failure. The government’s inaptness in identifying qualified projects, deviated forms of designated loans, and corruption were main causes of the resultant nonperforming loans, all of which embodied government failure. In the same way market failure in resource allocation necessitates government intervention, government failure makes it imperative to precisely delineate market-government relations and make a rational choice between the two. In the end, it goes back to the question of finding the right balance. The choice to make is not “either-or,” but “to what extent.” The more a choice leans towards nonmarket, the more likely it is for the economic system to encounter crises causing market limitations. Experiences have proven that nonmarket limitations are far more severe than market limitations, and a market system operates more desirably than a nonmarket system. Therefore, China has gradually adopted market means in its financial and credit reforms, building a sound and modernized banking system, stressing risk management in loan matters, and using market methods combined with government guidance to achieve the state industrial policy and enterprise reform. The synergy of market and government means, though, is an area that requires long-term exploration. The ineffectiveness of designated loans also helped illustrate Masahiko Aoki’s competitive institutional analysis theory: The outcome was in fact not surprising as all eggs were put in the basket of monetary credit without seeking institutional improvements on enterprises and consumer behavior which caused market sluggishness.18 A system will only take effect when supported by matching counterparts. This is the magic of “institutional coupling” and “institutional complementarity.”19

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Chapter

Tax and Fee Reforms

MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 3

Since the 1990s, the Chinese central government initiated a string of tax and fee reforms to improve the government revenue system and balance fiscal distribution between central and local governments to smooth its transition to a market economy. These reforms proved to be effective in cleaning up illegal charges, funds and contributions levied on firms and households, conducive to optimizing the governance structure as well as improving the incentive and constraint mechanism for government officials. At the same time, it should be noted that fees, as an important source of government revenues, have played a special role in increasing the efficiency of government services and resource allocation, and thereby relevant reforms must not overcorrect and be carried out in coordination with the reforms in administration and fiscal systems.

Definition The tax and fee reforms started in the late 1990s aimed to replace arbitrary fees with a standardized system of taxes coupled with a few types of necessary fees to accommodate to the development of the socialist market economy, regulate government behaviors in income distribution, and safeguard market order.1 It needs to be pointed out that even at the beginning of the reforms, the name and contents of the reforms were still in dispute among Chinese scholars. At first, the majority, be them government officials or academic researchers, mentioned the reforms as “tax-for-fee” reforms (fei gai shui 費改稅). But as Guo and Zhao argued that it is impossible to substitute taxes for all fees due to the differences in revenue nature.2 Not only was the conversion of fees to taxes infeasible, but it will trigger off a lot more difficulties. For this reason, the tax and fee reforms did not mean to simply replace fees with taxes, but were expected to establish a new fee collection system side by side with the taxation system, with the responsible agency, collection scope, chargeable items, and payment standards clearly defined.3 China’s tax and fee reforms can be generally divided into three stages. At first, a standardized system of administrative charges management was established to end the problem of “three arbitraries” (san luan 三亂): arbitrary fee collection (luan shoufei 亂收費), arbitrary cost apportionment (luan tanpai 亂攤派), and arbitrary fundraising (luan jizi 亂集資). Then, reform priority was given to areas or fields which were most problematic and at the same time, influential, for example, rural taxation and transportation and vehicle taxes. Last, reforms were expanded to fields which involved complicated interest conflicts and deep-seated problems. The tax and fee reforms are a huge revolution to China’s fiscal revenue system and reflect the internal demands of the socialist market economy. They are helpful in regulating fiscal distribution order, perfecting the government revenue system,

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promoting the transformation of government functions, relieving economic burdens of the society, and realizing the sound and orderly development of the economy.

Reform Background Large-scale tax and fee reforms were launched in the late 1990s when the practice of “three arbitraries” was going rampant in China. Its prevalence, from the early 1980s through the late 1990s, was inextricably linked to China’s economic system reform, especially the reform in the fiscal and tax management system and the subsequent impacts on the central and local governments’ behaviors. In fact, prior to the 1980s, there were only a very limited number of chargeable items, such as surcharge on the agricultural tax, road tolls, and miscellaneous fees of primary and secondary schools, and the total size of fee revenue was small, generally below CNY10 billion. With the introduction of “power devolution and profit relinquishment” (fang quan rang li 放權讓利) to reform China’s economic system, however, the imbalance between revenue and expenditure became prominent. For one thing, the “tax for profits” reform and the “fiscal contracting” arrangement designed to give more power to enterprises and local governments, respectively, brought down by a large margin governments’ fiscal revenues, especially those of the central government. For another, at that time, since the planned and market economy coexisted in China, the central government not only assumed the duties of macroeconomic regulation and economic growth, but also was burdened with the responsibilities of the planned economy, huge costs incurred from the market-oriented reform, and massive historical debts. All these facts added to the pressure on government expenditures. While it was hard for tax revenues to dramatically rise, the central government had no choice but to pin its hope on administrative fees, government funds, and other incomes. In January 1980, the Central Committee of the Communist Party of China (CPC) and the State Council jointly promulgated the Notice on Retrenching Non-Productive Expenditures and Combating Waste, which presented that “public institutions which are capable of increasing incomes should unleash their potential to expand their services in exchange for more incomes to solve the budget shortage and seek for further development.” The release of this document broke the traditional mode of financing public institutions with budget funds, and made it legitimate for local authorities to create new chargeable items. In December 1982, the State Council issued the Measures of Fund Collection for Key Construction Projects of Energy and Communications, which stipulated that a rate of 10% would be collected on the extrabudgetary funds of public institutions, government agencies, armed forces,

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and local governments, and on the after-tax profits of urban collective-owned enterprises for such a purpose. This rate further escalated to 15% in 1983 with small collective enterprises and rural commune- and brigade-run enterprises also included. Apart from the above fund collection by the central government, after 1984, the State Council successively enacted a series of policies to allow local governments and departments to generate more revenues to remedy fiscal deficiency. All these policies were pertinent to the interests of government organs, and the more revenues they generated, the more they could spend and the larger benefits they could enjoy. Driven by huge departmental benefits, different levels of government branches began to create all sorts of new charges, including governmental funds and administrative fees, and the number of chargeable items shot up. At the same time, in the mid-1980s, China introduced the “fiscal contracting system” which entitled local governments to fiscal surplus, significantly arousing the enthusiasm of local authorities. This system, however, gradually revealed its defects. Due to a lack of stability and standardization, it overemphasized the autonomy of local governments, leading to considerable confusion in fiscal distribution: As the central government was at a disadvantage in fiscal distribution, fiscal revenues could not be guaranteed, forcing the central authorities to frequently alter the proportion of revenue that local governments should hand in. Recurring changes in institutional arrangements not only ran against the requirements of the market economy, but also sparked discontents from local governments, aggravating their suspicion and mistrust against the central government. As a result, local governments attempted to stifle the growth of budget income while raising as many extrabudgetary and extra-establishment4 incomes as possible through cost apportionment and fee collection in order to reduce revenues turned in to the central treasury and retain more disposable revenues. In the absence of stringent regulation, the number of chargeable items built up and local fee collection swirled out of control. Some local authorities even turned services within their duties into commodities which were used on a paid basis, and therefore, administrative costs transformed from being fully government-funded to partially government-funded, and then self-financed, extrabudgetary funds grew larger and larger, and arbitrary fee collection got worse.5 Under the joint “effort” of the central and local governments, the problem of “three arbitraries” was getting increasingly acute and came to a head in the late 1990s. Actually, no accurate estimation was made as to how many chargeable items there were across the country. According to incomplete statistics, as of 1998, there were approximately over 6,000 kinds of administrative fees and government funds. Among them, nearly 300 were charged by the central government to cover

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administrative expenses, while the number of local chargeable items differed from province to province with the most levying more than 400 items; as for government funds, there were almost 500 kinds of national government funds, about 40 were set up under the approval of either the State Council or the Ministry of Finance, while the rest was founded by local governments or government departments without approval from the central authorities.6 According to Li, Sun, and Song, it was roughly estimated that by early 1997, there were 371 state-approved chargeable items, among which 217 items were imposed on enterprises by 59 government departments and service units, including 27 from the Ministry of Agriculture, 18 from the Ministry of Health (now National Health and Family Planning Commission), 15 from the Ministry of Transport, 13 from General Administration of Customs, 12 from State Food and Drug Administration (now China Food and Drug Administration), and 10 from the Ministry of Construction (now the Ministry of Housing and Urban-Rural Development).7 Local chargeable items, they continued, varied from place to place in both number (ranging from dozens to hundreds) and kind. For instance, Hebei Province had more than 1,200 chargeable items and funds in 1996, concerning over 20 departments. In this case, government funds and fee revenues continued to expand, and in 1998, according to incomplete statistics, the total size of fees and funds added up to CNY450 billion (excluding social security funds), equivalent to 46% of national fiscal revenues over the same period.8 The revenues from fees and funds generated by local governments, especially by those below provincial level, grew at a faster speed, and were basically the same as or even higher than budgetary revenues. It was reported that in 1996, the revenues from funds and fees raised by Henan Province reached CNY14.6 billion, 1.7 times of its tax incomes and 96.3% of its fiscal revenues.9 Moreover, the majority of the charges was set up at local authorities’ sole discretion, with the scale and standards of the charges being quite arbitrary, and fund use and management were also problematic, allowing unauthorized division of funds among different administrative units to replenish their own coffers. It is worth noting that rural areas were hit hardest by the “three arbitraries.” Rural authorities mainly levied two kinds of charges: funds retained for villagelevel collective undertakings (i.e., reserved funds, public warfare funds, and management costs) and fees imposed on enterprises and households for the unified management of overall township planning (i.e., fees for financing rural education, family planning, subsidies to entitled groups, militia training, and rural road construction), which were collectively known as “three retentions and five unifieds” (san ti wu tong 三提五統). As a matter of fact, these regular charges had posed enormous financial burdens on farmers. It was reported that the total amount of taxes and fees levied on farmers reached CNY114.3 billion in 1997, CNY130

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per person; besides that, rural labors also fulfilled compulsory and accumulative input of 8.2 billion work days, and if the remuneration is calculated at CNY 10 per day, an additional contribution of CNY93 was made per person. The two together accounted for 12.2% of per capital net income of farmers in 1996.10 Worse still, some local governments or departments arbitrarily imposed fees, costs, fines, and fundraising obligations on farmers irrespective of state bans, and in some areas, the total number of fees was as many as over 100 with more than 10 charged for marriage registration services, adding to the burdens on farmers. The statistics from Farmers’ Burden Supervision and Administration Office of the Ministry of Agriculture showed that in 1991, farmers paid CNY2.31 billion for fines, CNY4.1 billion for cost apportionment, and CNY3.81 billion for other social obligations. According to a local survey, unreasonable government charges accounted for 5%– 7% of per capita rural net income, far beyond the results reported by the Ministry of Agriculture and the warning line of 5% set by central government.11 The ever-intensifying “three arbitraries” had tremendous impacts on the Chinese society and economy, which are prominently manifested in the following aspects: 1. The problem of “three arbitraries” created considerable confusion in the government revenue system, and disrupted the normal fiscal distribution order. Driven by enormous financial benefits, local administrations left out on purpose revenues from fees and government funds in budgetary management and special account management, and diverted these unsupervised extraestablishment funds in their “private coffers.”12 This fact badly hampered the normal operation of enterprises as their financial burdens were increased dramatically, and also directly lessened their taxable profits. Meanwhile, local governments and governmental departments were keen on fee collection and fundraising, even by coercive means, in pursuit of huge economic interests, which strongly stimulated the growth of fee and fund incomes and generated a crowding out effect on tax revenues.13 2. The imposition of various fees built up financial burdens on microeconomic agents and caused serious damages to the economic order. The wide variety and ascending scale of chargeable items heavily burdened enterprises and impeded the progress of enterprise reform, while discouraging the increase in rural production yields and retarding agricultural development. 3. Conflicts between government officials and the massed were aggravated and the governing basis of the central administration was undermined. The diversification of government distribution participants, separation of funds among different departments, and the creation of “private coffers” by local governments not only intensified social distribution inequity, but also brought

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about embezzlement of government funds and corruption. On top of that, heavy financial burden and tough collection means provoked huge public discontent, posing grave threats to the stability and sustainable development of the Chinese society and economy.

Reform Course The tax and fee reforms, starting from the 1990s, ran through the whole process of China’s fiscal and taxation reforms, with its content and characteristic varied at different stages. Fig. 19.1 depicted the timeline of the tax and fee reforms. Fig. 19.1

The timeline of China’s tax and fee reforms

Combating the “three arbitraries”

Rural tax and fee reform

Fuel duty reform

Mid-1990s

2002 to 2006

Mid-1990s to 2009

Combating the “three arbitraries” Since the mid-1980s, the central government started to reexamine the nature, function, and target of fee collection and released a series of measures to redress the problem of “three arbitraries.” In 1986, the State Council issued the Notice on Strengthening the Management of Extrabudgetary Funds. This notice stipulated that extrabudgetary funds should be “saved under a special account of the fiscal department at the same level, managed according to state plans, approved by the fiscal departments, and monitored by banks” under the premise that the ownership, sources and uses of the funds remain unchanged, and this method should be implemented on a trial basis. In 1990, the CPC Central Committee and the State Council launched the Decision to Ban Indiscriminate Collection of Fees and Fines and Unwarranted Apportionment of Expenses to scale up the campaign to a nationwide level. In 1991, the State Council decided to reassign the administrative authority of fee collection and concentrated the approval right to the central and provincial-level governments and the management power to fiscal departments and price control authorities. In 1993, the General Office of the CPC Central Committee and the General Office of the State Council transmitted the Provisions on Regulating Arbitrary Fee Collection made by the Ministry of Finance to further combat the “three arbitraries” by scrapping a batch of illegal and unjustified

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charges. In 1995, the Ministry of Finance, the State Planning Commission (now the National Development and Reform Commission), the Ministry of Supervision, and the Ministry of Agriculture jointly issued the Notice on Further Carrying Out AntiCorruption and Continuing to Eliminate Arbitrary Fees. All these measures manifested the central government’s attempt to include fees, government funds, and other extrabudgetary incomes into the standardized fiscal management system. The lack of determination coupled with the absence of radical measures and a clear blueprint from the central government, resulting from its disadvantaged role in fiscal distribution after the fiscal contracting reform in the mid-1980s, made these policies turn out to be merely expedient measures, failing to contain the activities of “three arbitraries” at the root. The tax-sharing reform in 1994 regulated the fiscal relationship between the central and local governments by restoring the dominance of the central government in the fiscal distribution, laying a sound institutional foundation for future rectification against the “three arbitraries.” In 1996, the State Council released the Decision on Strengthening the Management of Extrabudgetary Funds, which explicated, for the first time, that “extrabudgetary funds are state fiscal funds instead of own funds of governmental departments and institutions, and thus must be covered in fiscal management; administrative fees must be reported to the central and provincial governments for approval, and governments at levels lower than the provincial level have no authority to approve administrative fees.” In the same year, the CPC Central Committee and the State Council also announce the Decision on Doing a Good Job in Relieving Farmers’ Burdens, and introduced a series of measures to clear up the “three arbitraries” in rural areas and lighten farmers’ burdens. In 1997, they rolled out the Decision on Regulating Arbitrary Fees, Fines and Apportionments Imposed on Enterprises, demanding to abolish all sorts of administrative fees, fines, fundraising, funds, and apportionments that are against regulations and also prescribing that new fees charged against enterprises and the collection standards must be reported to the competent department at the provincial and ministerial level for approval. Distinct from the previous efforts, the policies made after 1994 marked a real start of China’s campaign against the “three arbitraries” and the tax and fee reforms. The focus of this period, however, was put on wiping out illegal and unjustified fees and funds and perfecting the institutional construct, including improving fee collection administration and implementing separate management for revenues and expenditures. Thanks to the forceful measures carried out by the central and local governments, the campaign against the “three arbitraries” produced notable results: In 1996, the central government put an end to 48 fees on construction projects charged by 12 departments, including departments of construction, and

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industrial and commercial administration, further cancelled 49 administrative fees and 217 illegal funds, surcharges, and fees established by local governments in 1997, and banned 147 funds in 1998; local governments also cleaned up 2,028 fees and funds by the end of 1998 and had upscaled their efforts ever since to remove 1,805 fees and lower the fee rates of 479 chargeable items between 1998 and 2003, reducing social burdens of CNY141.7 billion.14 At the same time, the central government embarked on institutional construction to regulate the supervision of fee collection, laying a solid basis for effectively restraining the “three arbitraries.” One of the important measures was to establish a sound fee collection management system through, such as, drawing up a catalogue of fees and funds for management, putting administrative fees under separate management by specialized departments, and reinforcing the supervision over the invoices of administrative fees. Another far-reaching policy was to advocate the “centralized collection and payment through the state treasury” and the “separate management over revenues and expenditures.” Specifically, a treasury single account system was introduced, requiring that administrative fees, fines and other non-tax fiscal revenues from government departments and public agencies should be deposited into the single account of the central bank while expenditures would be withdrawn from this account according to the budget plan prepared by the Ministry of Finance. By this, revenues were decoupled from expenditures and the interests between the two were cut off, which helped end the phenomena of the “three arbitraries,” “little coffers,” and spending abuse.15 Thanks to these measures, the trend of “three arbitraries” was effectively curbed, paving the road for later tax and fee reforms.

Rural tax and fee reform The rural tax and fee reform was initiated by the central government with the aim of alleviating farmers’ financial burdens and safeguarding their benefits. It was known as the “Third Rural Revolution in China,” after the land reform in 1949 and the reform of the household responsibility system at the beginning of China’s Reform and Opening Up, and marked the passing into a critical stage of China’s tax and fee reforms.16 Table 19.1 presented a short chronology of events in the rural tax and fee reform. Similar to many of China’s reforms, the rural tax and fee reform also originated from local governments’ spontaneous experiment. In view of the heavy tax burdens on farmers, Xinxing Town, Guoyang County, Anhui Province tried an experiment in tax and fee reform in 1992, and proposed that the sum of taxes and fees would be determined based on the town’s annual expenditures, and taxes and fees should

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Table 19.1 A short chronology of China’s rural tax and fee reform Time

Location

Content

1992

Pilot reform in Guoyang County, Anhui Province initiated by local governments

Simplified the procedure of tax and fee collection

1998

—

Set up a Rural Tax and Fee Reform Working Group under the State Council

1999

Suixi County, Lai’an County, Jiangwang County, and Huaiyuan County in Anhui Province

2000

All counties in Anhui Province, and 34 counties in Hebei, Inner Mongolia, Jilin, Heilongjiang, Henan, Hunan, Gansu, and Shaanxi provinces

2001

All counties in Anhui Province, and 102 counties in other provinces; Jiangsu Province implemented pilot reform on its own

2002

2003 2004

2006

“Three cancellations,” “two adjustments,” and “one reform”; the central government granted financial support to local governments through transfer All counties in Anhui, Hebei, Inner Mongolia, payment for the rural tax and Jilin, Heilongjiang, Jiangxi, Shandong, fee reform Henan, Hubei, Hunan, Sichuan, Chongqing, Guizhou, Shaanxi, Gansu, Qinghai, and Ningxia provinces, and 53 counties in the rest provinces except Zhejiang, Shanghai and Jiangsu provinces which were allowed to undertake pilot reform on their own Nationwide Nationwide

Abolished the taxes on all special agricultural products except for tobacco; exempt or abate the agricultural tax

Nationwide

Substituted the tobacco tax for the agricultural specialty tax on tobacco; revoke the agricultural tax

be collected as one and apportioned to each Mu (≈ 666.67 m2), that is CNY30 per Mu. This could be perceived as the prototype of China’s rural tax and fee reform.17 Following that, Zhengding County and Wei County in Hebei Province, Taihe County in Anhui Province, and Wugang City in Hunan Province also carried out similar pilot reforms in the hope of alleviating farmers’ burdens. Concentrating predominantly on simplifying the collection procedure, the experimental reforms

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introduced by local authorities failed to any breakthrough in reducing farmers’ tax burdens. The efforts, however, successfully caught the attention of the central government. In September 1998, the Central Rural Work Leading Group decided to form a Rural Tax and Fee Reform Working Group under the State Council, led by the Ministry of Finance and participated by the Ministry of Agriculture and the Office of the Central Rural Work Leading Group, to conduct intensive investigations in villages in Anhui, Jiangsu, Shandong, Henan, Sichuan, Hunan, Yunan, and Inner Mongolia, whose result was the Opinions on the Rural Tax and Fee Reform made on the basis of soliciting opinions from the central and local authorities. This document preliminarily determined the leading ideology, principles, contents and complementary measures of the rural tax and fee reform and called for a trial run. In 1999, the central government initiated the pilot reform in Suixi, Lai’an, Wangjiang and Huaiyuan counties in Anhui Province. In 2000, the pilot project was expanded to all counties in Anhui Province. In the same year, 34 counties in Hebei, Inner Mongolia, Jilin, Heilongjiang, Henan, Hunan, Gansu, and Shaanxi provinces were also included into the project. The over one-year pilot work, however, revealed some prominent issues in the initial reform plan, mainly in the following five aspects: 1. Unreasonable, non-standard, and overly complicated tax bases; 2. Unfair tax rates in disregard of the difference in agricultural work among farmers; 3. A drop in local fiscal revenues causing a funding shortage for rural compulsory education and basic governmental services; 4. Serious disorder in the collection of the agricultural tax and agricultural specialty tax; 5. A rebound in farmers’ financial burdens. On top of all these issues, the most crucial one was that the rural tax and fee reform opened up a huge gap in the fiscal funds of county- and township-level governments, inhibiting the process of the reform. Take Anhui Province for an example. After the pilot reform, fiscal revenues decreased by CNY11.1 billion at the provincial level (CNY154.2 million for each county on average), CNY1.04 billion at the township level, and CNY700 million at the village level. The similar problem could also be spotted in other pilot areas. In fact, this problem was foreseen by the central government at the beginning of the reform, but the policymakers expected that local governments could take this chance to restructure government institutions and balance the fiscal revenues and expenditures by transforming government functions and downsizing the personnel. The financial difficulties posed by the reform and the resistance from the grassroots governments turned out to be contrary to the expectation. The reform

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faced strong opposition, which forced the central government to slow down the process while looking for solutions. Consequently, in 2001, the central government decided not to expand the pilot scale on a provincial basis but concentrated on solving the existing problems, especially the fiscal gaps. To this end, the central government announced a special transfer payment to local governments to ease their financial tensions and ensure smooth implementation of the reform. In 2000, the central government made a CNY1.1 billion transfer payment to Anhui Province, and this figure ascended to CNY1.7 billion in 2001. With the financial support of the central government, the Anhui provincial government continued the pilot reform throughout the province and other provinces followed suit by conducting the pilot program in 102 selected counties. Jiangsu government self-financed its own experimental reform in all counties within its administration. The central financial support effectively relieved local governments of their huge fiscal gaps resulting from the rural tax and fee reform, and smoothed the process of the pilot reform. In 2002, the central government decided to further broaden the scope of the pilot program to include Hebei, Inner Mongolia, Jilin, Heilongjiang, Jiangxi, Shandong, Henan, Hubei, Hunan, Sichuan, Chongqing, Guizhou, Shaanxi, Gansu, Qinghai, and Ningxia provinces, and allow Zhejiang and Shanghai to finance the reform by themselves and the rest 11 provinces to conduct partial reform in a total of 53 counties. At the same time, the central authorities explicitly proposed the “three guarantees” — to guarantee the reduction of farmers’ burdens; to guarantee the smooth operation of township agencies and village-level organizations; to guarantee the financial funding for rural compulsory education and increased transfer payments to local governments. On March 27, 2003, the State Council released Opinions on Promoting the Rural Tax and Fee Reform in an All-Round Way, which announced an all-round reform in rural taxes and fees and earmarked CNY30.5 billion transfer payment for this reform. By then, the rural tax and fee reform was promoted throughout the county. The focus of the reform during this period can be summarized as “three cancellations,” “two adjustments,” and “one reform.” The “three cancellations” refer to the cancellation of administrative charges and government funds and pools from rural residents, including overall township planning fees and public pools for rural education; cancellation of animal slaughter tax; and cancellation of uniform provisions on accumulative labor services and voluntary labor services.18 The “two adjustments” applies to the agricultural tax and the agricultural specialty tax: The agricultural tax was required to be collected based on the crop output in the normal year and the standard tax rate; the agricultural specialty tax continued to be imposed on special farm produce cultivated on lands that were not covered by the agricultural tax and for the overlapping areas, local governments could

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decide which tax should be levied. The “one reform” refers to the changes in the collection methods of village retention funds. Besides the above policies, the reform also stipulated that the agricultural tax rate should not exceed 7% and the surtax rate, 20%. In view of the impressive achievements made at the previous stage, the central government issued Opinions Concerning Several Policies on Promoting Farmers’ Income in 2004. It proclaimed the continued promotion of the rural tax and fee reform to consolidate the achievements of the preceding reform, relieve farmers of financial burdens, and create favorable conditions for unifying urban and rural tax systems and phasing out the agricultural tax. The announcement of this document marked a new stage of rescinding the agricultural tax in the rural tax and fee reform. In 2004, taxes on special farm produce were nullified except for tobacco, and the agricultural specialty tax on tobacco was replaced with a tobacco tax, which signified the complete abolishment of the agricultural specialty tax. At the same time, the agricultural tax was exempted or even cancelled in parts of the country. In 2004, the agricultural tax was exempted in Heilongjiang and Jilin provinces on a trial basis, the agricultural tax rates in 11 major grain production areas including Hebei and Inner Mongolia was cut by three percentage points, and in the rest provinces, by one percentage point. Later, some coastal provinces and cities, including Beijing, Shanghai, and Tianjin, decided on their own to revoke the agricultural tax with the support of the central government. Finally, in 2006, the Chinese government announced that the Regulations on Agricultural Tax were revoked, marking the end of the agricultural tax in China, whose roots can be traced back more than 2,600 years. It also meant that China’s efforts to reform rural taxes and fees had achieved remarkable results. The rural tax and fee reform is a great revolution in the Chinese history for it has laid a solid foundation for completely solving the “three rural issues” relating to agriculture, rural areas, and farmers, raising farmers’ incomes, accelerating rural economic and social development, and maintaining social stability and harmony. First, the rural tax and fee reform helped rationalize the relations in rural income distribution and alleviate farmers’ financial burdens.19 After the agricultural tax was rescinded in 2006, the burden on rural residents was reduced by around CNY125 billion, or CNY140 per capita, over the level of 1999.20 If the results of combating the “three arbitraries” were also considered, the reduction in burden will be even larger. Xiang studied the achievements of burden reduction in Jingshan County, Hubei Province after the tax and fee reform, and found that farmers’ burdens dropped by an average of 27. 79% per capita, or CNY61, compared to the level of 1999, with the highest being 56.7% and the lowest, 17.37%; if the reduction resulting from the cancellation of all sorts of arbitrary charges was

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also counted, the total burden lifted was above CNY50 million, over 40%. Next, the rural tax and fee reform as well as it complementary reforms, including reforms in rural institutional structure, rural compulsory education management, and rural fiscal regulation, trigged profound changes to not only rural ideologies, but also the rural society, economy, and grassroots government agencies.21 Last, through regulating government behaviors and reducing farmers’ burden, the reform also cemented the relationships between cadres and the masses and eased the tensions in the rural society to promote social harmony and stability and consolidate the rule of the CPC in rural areas. It should be noted that, considering the complexity of the “three rural issues,” the rural tax and fee reform has created large negative impacts on local government finances, putting county and village-level governments in an ever-worsening financial predicament, despite its achievements in alleviating the burden on farmers (see Fig. 19.2). This not only caused substantial underinvestment in rural education and infrastructure construction, but also posed potential threats of the revival of arbitrary charges and heavy burdens.22 Therefore, the Chinese government still faces long-term, arduous tasks of further perfecting the fiscal and tax management system and local governance structure, building a mechanism for ensuring basic funding for county-level governments, and promoting the development of rural public services, to make sure that the burdens on farmers do not rebound and achieve sound development of farmers, villages and agriculture. Fig. 19.2

Kernel density estimates of the fiscal difficulties of county-level governments

0.025

Kernel density

0.020 0.015 0.010 0.005 0 0 Kdensity Fiscal 2000

104

50

100

Fiscal revenues / expenditures (%) Kdensity Fiscal 2002

150

Kdensity Fiscal 2005

Tax and Fee Reforms

Fuel tax reform Apart from the rural tax and fee reform, the Chinese government has also enacted many similar reforms since the late 1990s, and the reform in transport and vehicle taxes, centering on the fuel tax reform, was one of them. Due to its wide scale, long time span, and complicated interest relationships involved, the fuel tax reform came under the spotlight. Driven by huge economic benefits, the practice of “three arbitraries” prevailed in the transport field, placing heavy financial burdens on enterprises and individuals. Apart from state-approved charges, many local governments forced various unjustified fees and fines on local residents. In 1997, the incomes from all sorts of fees and government funds were equal to 45% of total fiscal revenues of the same year, 45%–50% of which was charged on transport. Among all chargeable items of transport, 245 was established without proper authorization, accounting for 46.2% of all items and worth CNY30 billion.23 Moreover, the fact that toll rates were decided based on either the deadweight tonnage capacity of vehicles or operating incomes resulted in great tax inequity and the low efficiency of resource allocation. This together with the overstaffed administration and the resulting high collection costs entailed a reform in transport taxes. The fuel tax reform, spanning nearly 15 years, was a long and tortuous process. In fact, as early as 1994, the collection of fuel tax was proposed as an important resolution, but no substantial efforts were made afterwards. Worse still, the Highway Act passed in 1997 did not mention the imposition of fuel tax, and the absence of a legal basis complicated the fuel tax reform. This situation, however, was changed in October 1999 when the 12th Session of the Standing Committee of the 9th National People’s Congress approved the Highway Act Amendments, which clearly stated that “highway maintenance funds will be raised through taxation, and specific measures and procedures will be stipulated by the State Council.” In 2004, this provision was again clearly explicated when the Highway Act was further revised, creating a legal footing for the fuel tax reform. But the reform was not launched until a later time, for the government’s focus at that time was given to clamping down unlawful and unjustified fees and lowering unreasonable fee rates. During this period, only the vehicle purchase surcharge was transformed into a vehicle purchase tax. It was not until January 1, 2009 that the State Council formally enacted a tax on fuel consumption as a substitution for six fees — road toll, waterway maintenance fee, highway transport management fee, surcharge on road transport of passengers and cargos, waterway transport management fees, and surcharge on waterway transport of passengers and cargos, and also decided

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to gradually revoke the charges on secondary roads for which the government repays the construction loans. The reforms in transport and vehicle taxes, represented by the fuel tax reform have achieved remarkable results in combating the “three arbitraries,” relieving the burdens on the society, and promoting energy saving, pollution abatement, and effective resource allocation. First, the reforms in transport and vehicle taxes greatly contained the prevalence of the “three arbitraries” in the transport field, and within 2000 alone, the Ministry of Finance and the State Development Planning Commission cancelled a total of 238 unlawful and unreasonable fees, and reduced CNY14.5 billion of social burden.24 Second, the collection of fuel tax will raise the energy utilization rate, thus relieving the severe air pollution problem faced by China. Third, the fuel tax will effectively solve the congestion in toll roads, increase the utilization efficiency of highways and other similar high-quality resources, and promote the efficient allocation of fiscal resources by slashing the fee collection agencies and lowering collection costs.

Overall Evaluation The tax and fee reforms dating from the late 1990s are a momentous event in the history of China’s fiscal revenue system, considering its unprecedented scale and complicity. The success of this reform, especially in rural areas and fuel tax, has a far-reaching impact on the sustainable development of the Chinese economy and society.

From the perspective of government governance The modern government governance theory advocates hardening budget constraints to regulate government behaviors, optimize government functions, and raise the administrative efficiency for better development of an economic society. Through cleaning up the “three arbitraries,” the tax and fee reforms eradicated extrabudgetary and even extra-establishment revenues which were beyond the management of strict budgetary management, and converted fees and government funds with tax features into taxes under law-based administration, thus conducive to the legalized and standardized management of government revenues. Besides that, the reforms implemented the methods of “centralized collection and payment through the state treasury” and the “separate management over revenues and expenditures” to decouple revenues of governments at all levels from their spending. These measures are helpful in building a more standard government revenue system and hardening budget constraints, thus bring profound impacts on

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government behaviors. Hardening budget constraints helps regulate government behaviors, optimize government functions, and urge the government to exit from the competitive spheres, by which the “three arbitraries” and the misuse of funds can be wiped out at the source, the problems of heavy social burdens and economic disorder can be resolved, and the healthy and orderly development of the Chinese economy can be achieved. It also can create a “reversed transmission effect” to compel a reform in China’s government structure, encourage the construction of democracy and a legal system against corruption, and strengthen the government’s ruling ability to ensure the long-term national peace and stability. It should also be noted, however, that the current administration assessment system in China still centers on GDP, and governments at various levels are always under huge pressure of political promotion to purse economic growth at all expenses, and therefore they have a strong will to raise funds from diversified channels and increase public investment to better drive economic growth. Apart from that, the tax-sharing reform in 1994, through centralizing fiscal power while decentralizing administrative power, assigned heavy spending burdens but limited financial resources to local governments, putting them under huge fiscal pressure. Under such a circumstance, local governments were also highly motivated to seek extrabudgetary and extra-establishment revenues, leading to the rampant spread of the “three arbitraries,” the high proportion of nontax revenues in total fiscal revenues, and outstanding problems of land transfer fees and social security funds. So, the central government has to consider the interests of local governments while removing illegal fees and funds through the tax and fee reforms, by taking measures to improve the administration assessment system to contain the investment impulse of governments at all levels and transferring fiscal power and bond issue power to local governments to offer them a standard and legitimate financing channel. This will be conducive to regulating the governance structure of local governments, perfecting their incentive and restraint mechanisms, rationalizing government behaviors, and finally resolving all sorts of prominent problems in China’s fiscal revenue system.

Orientation of fee collection The tax and fee reforms did not mean a total cancellation of all fees, and taxation cannot completely replace fee collection which has its own necessity and rationality.25 Fees differ greatly from taxes in at least three ways: 1. The equity principles they abide by — fee collection requires the equivalence between fee payment and service providing, reflecting the “benefits-received principle” whereas raising funds for public services through general taxes implies no such a direct connection;

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2. Uses — revenues from fees are generally earmarked for specific purposes while tax revenues are used for financing government functions; 3. Purposes — fees are charged to decide the distribution of specific goods or services among competing users whereas taxes are just regular revenues for governments.26 Fees are useful in perfecting the price system and optimizing resource allocation as they contain the reasonable part of the price mechanism, that is goods or services will be supplied at least at cost to consumers, implying a lower demand level than the saturated demand, and also constitute the sources of information for the price mechanism. However, fees are still different from market prices by nature for that fee collection does not see profit maximization as its goal and instead it aims to correct externalities and eradicate the monopoly. In short, no matter from the perspective of public revenues or price information, the existence of fees is not only necessary but also reasonable, so the contributions of fees cannot be totally ignored, when conducting the tax and fee reforms.

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Chapter

Soft Landing

MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 3

A soft landing in economics is the process of an economy shifting from high growth to slow growth while inflation is curbed to a relatively low level. For China’s economic development over the past six decades, soft landing refers to the economic performance in the late 1990s, when the Chinese government successfully beat high inflation while maintained a stable economic growth. It is incomplete to understand this soft landing in China either from Keynesian theory or from Monetarist theory. In fact, the key to the successful soft landing is how well policy is designed to enhance productivity. Only a productivity-driven growth model can achieve stable economic growth while maintaining low inflation. Overall, China’s soft landing experience in the 1990s provides a significant reference from macroeconomic development in the new era.

Background Extensive economic growth during economic transition During China’s transition from a planned to a market economy between 1978 and 1992, its economy followed a dual-track system.1 On the one hand, although the old highly-centralized planned system was gradually broken down, its operation mechanism was still functioning; on the other, enterprises with diverse forms of ownership, which adopted the operation mechanism of the market economy, gradually sprang up. Hence, the new system coexisted with the old one and the two operation mechanisms worked synergistically. The growth of the non-state sector, however, was rather slow during this period, and the state economy remained in a dominant position, whether in terms of proportions in gross industrial output, aggregate fiscal revenues, and fixed-asset investment, or the occupying amount of working capital. The government had the final say on all matters relating to resource allocation, and its planning and administrative means still played a major role. The administrative appointment system with a fixed term decided that local government officials and operators of state-owned enterprises (SOEs) concentrated on the short-term increase in total supply rather than the long-term improvement of the supply ability through educational input and technological progress. Therefore, it is understandable why government-led extensive growth driven by capital construction projects had long been playing a big role in China’s economic development, provided that no economic collapse or social repercussion was caused. Against this backdrop, despite the direct positive impact on employment, capital construction projects suffered from limited growth in potential total supply,

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due to the slow technological progress and the long-term low efficiency in labor production, enterprise management, investment decision-making, and business and industrial structures.2 Naturally, in less than two decades, China underwent multiple violent economic fluctuations, coupled with high inflation.3 Thus, the government hurried to seek an effective macroeconomic regulation method that fitted the situations of China’s economic development.

Economic situations at the eve of soft landing After China launched its price system reform in the early 1980s, it experienced serious inflation twice in 1985 and 1988, with the former being the most representative since the Reform and Opening Up. The trigger of the 1985 inflation was the price deregulation under the price reform, and in September 1985, the inflation rate peaked over 10% for the first time since the Reform and Opening Up. Specifically, excessive aggregate social demand driven by oversize fixed-asset investment and rising costs resulting from the wage increase outracing the growth of labor productivity were both causes for the inflation. Moreover, dramatic expansion of capital construction, consumer demand, and money and credit supply also contributed to the economic overheating in 1986. According to the data released by the International Financial Statistics (IFS) on domestic credit and money supply (including M0, M1, and M2) in China between 1978 and 2007, domestic credit jumped from 13% to 31% between 1983 and 1984 and continued this growth rate in 1985; money supply also saw a steep rise since 1984, with M0 and M1 reaching a local peak in 1984 while M2, in 1985. Despite the above, Chinese scholars generally agreed that the inflation between 1984 and 1986 was driven by costs, namely the price reform. Indeed, during the price reform, the government raised the purchase prices of 18 key agricultural products (for example grains, cotton, and oil seed crops) and the producer prices of major industrial products (for example coal, iron ore, and cement). As goods prices and wages competed to rise, credit and money supply would inevitably shot up. To curb inflation, from November 1984 till October 1985, the State Council announced a series of macroeconomic regulation measures to control the scale of fixed-asset investment, reinforce price controls and supervision, and impose overall credit checks. Thanks to these efforts, the CPI inflation rate started to fall in early 1986 from 7.4% in March to 5.4% in April, and further dropped to below 4% in August 1986. However, the high inflation starting since 1985 spiralled out of control, while fiscal deficits, money supply, and revenue inflation got even worse due to inadequate macroeconomic regulation. Many deep-seated problems in economic operation

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revealed themselves, such as economic structural imbalance and intensified investment and consumption expansion. As can be seen from the CPI inflation rate, except for a brief decline between July and October 1986, it rebounded again in the second half of 1986. By 1987, China’s real GDP growth rate arrived at 11.6% and the year-on-year growth rate exceeded 11% in 1988. If examined from the point of view of retail price and total wage, the year-onyear growth rates were 18.5% and 22.1%, respectively in 1988. In July 1988, China’s CPI increased by 19.2% from a year early, and between August 1988 and June 1989, the CPI inflation rate frequently hit record highs and climbed to the highest since the Reform and Opening Up at 28.4% in February 1989. From 1989 onwards, China adopted a tight credit policy, but due to widespread inflation expectations and the inertia of inflation, high inflation was not kept down until the middle of 1990. Table 20.1 Real GDP growth rate in China, 1988–1993 (%) Secondary industry Manufacturing

Construction

Tertiary industry

14.52

15.25

7.99

13.16

3.07

3.77

5.06

-8.44

5.36

3.84

7.33

3.17

3.35

1.19

2.33

1991

9.18

2.40

13.85

14.39

9.56

8.87

1992

14.24

4.70

21.15

21.17

21.03

12.44

1993

13.96

4.70

19.87

20.09

18.00

12.19

Year

GDP

Primary industry

1988

11.28

2.54

1989

4.06

1990

In fact, following the high inflation of 1988, a three-year regulation and rectification campaign was initiated by the central government. Although the austerity measures successfully brought down the two-digit inflation, they exerted dramatic reverse impacts on China’s real economy. Table 20.1 reports the changes of the real GDP growth from 1988 to 1993. It showed that after the three years of economic regulation, the GDP growth rate dropped to 4.7% in 1990 and 7.7% in 1991. For a large developing economy like China, however, a low growth for three years in a row was unbearable. In 1992 when Comrade Deng Xiaoping paid an inspection tour to south China, he delivered a series of speeches to encourage people to promote economic reform, and consequently, China’s economy picked up momentum. The real GDP growth rate rose to 12.8% in 1992, which was even higher in coastal areas: 27% in Jiangsu, 17% in Zhejiang, 16.9% in Shandong, 16.3% in Fujian, and 14.4% in Shanghai. This marked the beginning of a new round of economic growth. High investment and

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growth not only appeared in the real economy but also was reflected in real estate and stock market prices, and average stock prices doubled in the Shanghai and Shenzhen stock markets. The high growth starting from 1992 was mainly driven by investment, especially the expansion of fixed-asset investment. As shown in Table 20.2, in 1992, the total volume of fixed-asset investment grew by 44.43% from last year (38% after accounting for inflation). The high speed growth of investment, however, also brought along with it many problems. First, inefficient overlapping investment directed more and more resources to processing industries, a considerable part of which produced goods that can only bring about economic benefits in a long run, whereas infrastructure and energy industries suffered from an investment deficiency, becoming a bottleneck in the economy. Second, prices of raw materials and means of production surged and by the end of December 1992, grain price in medium and large cities rose by 43.3%; the price of construction materials, 25.0%; and fuel price for civil uses, 69.9%. Led by upstream product price increases, the inflation rate rallied for the first time since 1990, and by the end of 1992, the CPI increased by 6.7%, and the cost of living index (CLI) grew by 8.2%, which was even higher in 35 medium and large cities, by 13.4%. In 1992, the exchange rate of renminbi against US dollar depreciated by 25% on average in the National Foreign Exchange Swap Center, and according to Chinese customs statistics, China’s trade surplus decreased by around USD4 billion in 1992, which could be explained by burgeoning domestic demand and inflation. In the first half of 1993, China’s economy still developed at an excessively fast speed, with the first-quarter growth rate reaching 14.1% and real investment increasing by 40%. As of March of the same year, the price of raw materials rose by 40%, the retail price index (RPI) increased year-on year by 10.2%, and the CLI of 35 medium and large cities was up year-on-year by 17%. The one-year deposit and loan interest rates were 7.6% and 8.6%, respectively; allowing for inflation, the real rates were –2.4% and –1.45%. Negative interest rates adversely impacted the growth of bank deposits. At the end of the first quarter of 1993, the growth rate of deposits was 14.1%, down by almost half from 27.1% in 1992, and even the absolute value of deposits in major state-owned banks went down in Jiangsu Province, Shandong Province, Shaanxi Province, Zhengzhou City, and Nanchang City. The rapid rise of financial disintermediation led to the rampancy of all kinds of fundraising activities. According to incomplete statistics, self-raised funds totaled CNY100 billion in the first quarter of 1993, contributing to the withdrawal of funds from intermediary financial institutions. By the second quarter of 1993, the economic growth rate still stood at 14.1%, the CPI rose to 13.9%, and the exchange rate of the US dollar against the Chinese yuan in the black market was 1 : 10.4

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Table 20.2 summarized the performance of major economic indicators between 1988 and 1995. It is clear from the table that China’s economy was notably overheated in 1993, which impelled the central government to take immediate measures to bring down the excessively high economic growth rate and inflation rate. But how to effective control inflation at the lowest possible expense of economic growth became the most important question for the Chinese government. Table 20.2 Major economic indicators, 1988–1993 Year

CPI Growth (%)

Fixed-asset investment (CNY1 billion)

Fixed-asset investment growth (%)

Imports & exports (USD1 billion)

Imports (USD1 billion)

Exports (USD1 billion)

1988

18.8

475.38

25.37

102.79

47.52

55.27

1989

18.0

441.04

–7.22

111.68

52.54

59.14

1990

3.1

451.70

2.42

115.44

62.09

53.35

1991

3.4

559.45

23.85

135.70

71.91

63.79

1992

6.4

808.01

44.43

165.53

84.94

80.59

1993

14.7

1,307.23

61.78

195.70

91.74

103.96

The Process of Soft Landing Ever since the economic overheating in the first half of 1993, the Chinese government put forth efforts in reducing violent economic fluctuations through policy regulation. After three years of adjustment, China had basically achieved the targets of economic soft landing by 1996. The 43 months of policy adjustment can be roughly divided into three phases. The first phase started in June 1993 and ended in November 1994, and it was a period of economic deceleration. In response to the economic overheating appearing in the first half of 1993, the central government took action to stabilize the economy against further fluctuations. It started from rectifying financial order and then expanded the regulatory work to all other aspects of the economy. While restoring financial order, prohibiting authorized inter-bank lending, fundraising, and the establishing of financial institutions, and strengthening price control and supervision over real estate and stock markets, the central government also strived to cool down the economy, curb inflation, and reinforce its control over money and credit supply. For instance, inflation-proof savings for three years or above were resumed in July 1993, and deposit and loan interest rates were raised by nearly 50% on May 15 and July 11, 1993 and have maintained a high level of 9%–10% ever since

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(Table 20.3). Moreover, the central authorities also strengthened management over investment projects, exercised strict control over institutional purchasing power, reinforced the collection and regulation of taxes, and set a deadline for treasury bond issuance. Table 20.3 Timeline and magnitude of interest rate adjustment, 1993–1996 No.

Date

One-year benchmark deposit interest rate (%)

One-year benchmark loan interest rate (%)

1

May 15, 1993

9.18

9.36

2

Jul. 11, 1993

10.98

10.98

3

Jan. 1, 1995

10.98

10.98

4

Jul.1, 1995

10.98

12.06

5

May 1, 1996

9.18

10.98

6

Aug. 23, 1996

7.47

10.08

The country successfully completed a wholesale reform in the aspects of fiscal and taxation systems, finance, exchange rates, commodity prices, and the grain purchase and sale system in 1994, and the economy was soon brought under control. During this process, the economic growth maintained a sustainable rate, and the real economy did not see a short-term sharp fall. In the first half of 1994, GDP grew by 11.6% on a year-on-year basis. Despite a high price level (the yearon year growth rate of retail prices was around 20%, for example), economic overheating was suppressed, which was especially reflected in the steady slide of some leading economic indicators. For instance, the monthly growth rates of fixed-assets investment in 1994 were lower, compared to those of 1993; prices of investment goods also came down from the second half of 1993; growth of steel prices fell off after March 1994. The second phase was from December 1994 through November 1995, during which soft landing had achieved its initial success. Although economic growth and price rise were somewhat cooling down, in absolute terms they were still overheating. The central government continued the tightening of fiscal and monetary policies and gave its priority to curbing inflation by, for example, securing grain and non-stable food supply and strengthening the supervision towards commodity prices and fixed-asset investment. After one-year efforts, in 1995, the economic growth rate fell back to 10.5%, almost within the “moderate growth” range; the growth rate of retail prices was down 7 percentage point at 14.8%, compared to the previous stage. The domestic financial situation also

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stabilized: M1 grew by 18% over the last year, a decline of 6 percentage points, and M2 rose by 30%, down by 4 percentage point from a year earlier. The annual money supply was obviously below the control target. The third phase, from December 1995 to December 1996, was a period of further building on the success of the last phase. The target of this period was to basically stabilize the economic growth rate and control the price increase within single digits. Through the joint efforts from all aspects, the Chinese economy met its intended target and achieved a soft landing. In 1996, the national economy was up by 9.7% from the last year to fall within the moderate growth range. Financial performance was basically stable and financial reforms were successfully carried out: M1 increased by 18.9% and M2, 25.3%, basically corresponding with economic growth. Inflation was further pressed down and the retail price rose by 6.1%, representing a drop of 8.7 percentage points from the previous year. This figure was not only within the control target of 10% set at the beginning of the year, but also remarkably lower than the economic growth rate. After three years of comprehensive macroeconomic regulation, the Chinese economy successfully accomplished its goal of soft landing. Fig. 20.1 depicts the growth of major economic indicators of China between 1993 and 1996, and by the end of 1996, these indicators came to be stable in the sample period, which was reflected in the following three aspects: 1. The national economy transitioned steadily from economic overheating to moderate growth. In 1996, China’s GDP was CNY6,779.5 billion and was up by 9.7% over the last year if calculated at comparable prices, 4.5 percentage points lower than the highest growth level in 1992, averaging over 1 percentage point per year, which was not dramatic and relatively stable. In accordance with social resources and regular market demand, the normal range of China’s economic growth should be 8%–10%, which the growth rates were already kept within. 2. Inflation was suppressed and the growth rate of commodities market prices dropped remarkably. In 1996, the retail price level rose by 6.1%, down 15.6 percentage points from the highest level in 1994, to achieve the control target of below 10% within just two years. 3. The gap between total social supply and demand was narrowed, and the supply-demand difference ratio (supply-demand difference / supply) went back to the normal range. Investment in fixed assets grew at a moderate speed, declining from 61.8% in 1993 to 18.2% in 1996. Money supply maintained a proper growth rate with M1 dropping to 18.9% in 1996 from a high level of over 40%. In agriculture, a series of bumper harvests was achieved, and grain output rose for two consecutive years in 1995 and 1996

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and recorded a total increase of over 6,000 tonnes in four years, which helped stabilize market supply and grain prices. The balance of payments was also improved with the huge trade deficit in 1993 replaced by consecutive years of trade surplus in 1994–1996. National foreign exchange reserves shoot up to USD105 billion in 1996, an increase of USD85.6 billion from 1992. The supply-demand difference ratio was back on the normal track of within 5% in 1995 and 1996 after three years of abnormal high levels. Fig. 20.1

Year-on-year growth rates of major economic indices, 1993–1996

(%) 40 35 30 25 20 15 10 5

1993 CPI

1994

Year

GDP

1995

1996 M1

Throughout this economic soft landing, the targets of China’s macroeconomic regulation had been perfectly clear, with the focus always laid on reforming the financial system and monetary policy, curbing inflation, strengthening control over fixed-asset investment and increasing agricultural supply, especially on controlling the expansion of fixed-asset investment and monetary creation. Moderately tight fiscal and monetary policies had been carried out over the three years of macroeconomic control, undistracted by the voices from some departments, local governments and enterprises to ease monetary policy and still managing to sustain moderate economic growth. It was due to the consistency and stability of the policies that targets of soft landing were successfully achieved.

Assessment of Soft Landing “Soft landing” is an overall policy target relating to curbing inflation, and it comprises two layers of meaning: First, to limit inflation to a moderately low

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level; second, to maintain sustainable economic growth. According to orthodox economics, these two goals cannot be achieved at the same time, especially during a period when price rises have accumulated for a long time and inflation is at a high level. The success of China’s soft landing in 1993 and 1996 implied that an analysis from the institutional level will be of high practical value for future policy making. In fact, from China’s Reform and Opening Up to the end of 1990s, the economy experienced overheating three times. But in the previous regulation attempts, the means of macroeconomic control was unvaried, regulatory policies were launched at wrong times, and goal conflicts existed in institutional arrangements. As a result, the economy went into a state where: “Whenever control is tightened, things are doomed; whenever control is relaxed, things run into chaos” (yi guan jiu si, yi fang jiu luan 一管就死，一放就亂). The three rounds of economic ups and downs inflicted huge costs on the Chinese economy. In the macroeconomic regulation from 1993 to 1996, the Chinese government drew lessons from previous experience and achieved notable results. In general, the success of this soft landing can be attributed to the following three factors.

Accurate analysis and grasp of the national economy Quick response to the leading indicators of economic overheating The Chinese government did not wait until economic problems revealed themselves but took decisive actions before economic overheating grew into an irreversible trend. From the second half of 1992 to the first half of 1993, China’s national economy showed slight traces of overheating: For example, the growth of fixed-asset investment shot up to above 60%, the real estate market was booming everywhere, and the financial realm got into a state of disorder, whereas the RPI, a measure of inflation, grew by merely 5.4% in 1992, far lower than the two-digit red line. The Chinese government, however, decided to adopt proactive measures to regulate economic order, especially financial order, after its analysis on some leading indicators, such as the sharp increase in new projects, the two-digit growth of the price index of investment goods, and the surge in money supply, which helped win sufficient time for the subsequent economic soft landing.5

Correct judgement on the causes of inflation The mainstream view on the causes of inflation in the 1990s was the “integrated inflation theory,” which generally took 1994 as the starting point. If we extend the time span to a longer time, it will be not hard to find that the underlying reasons

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for China’s inflation in the 1990s was a result of the government’s pursuit of output maximization on the basis of a resource misallocation-prone institution, under huge implicit pressure from inflation. This fact decided that the priority of fighting inflation should be optimizing the resource allocation mechanism and speeding up institutional reforms. From the perspective of economic system, China was under a transition economy in the 1990s when the inflation hit the country. Various modes of resource allocation coexisted and worked together, which was reflected in the false signals in resource allocation and the unstandardized formation mechanisms of resource supply and demand. For this reason, the conflicts in the supply-demand relationship developed on such a basis could not be solved by changing economic parameters.6 So, it was imperative to reform the unreasonable factors in the economic system and regulate and optimize the mechanisms of resource allocation. This can not only alter the structure of supply and demand, but also increase economic efficiency and ultimately promote economic growth by reducing institutional conflicts. In China’s past attempts of inflation control, a simple tight monetary policy was usually adopted. As economic relations were not been improved through perfecting the economic operation mechanism, the pressure from inflation arising from institutional and structural conflicts cannot be released in time.7 During this soft landing, however, the Chinese government shifted its policy focus from the control of overall volume to institutional reform, to eradicate the root causes. Consequently, not only was the pressure from inflation removed, but the economy was also greatly boosted thanks to the improvement of the economic operation system. The success of this economic soft landing proved that it was the reform rather than the moderately tight monetary policy that played a decisive role in realizing the soft landing. Although a moderately tight macroeconomic policy can also bring about some institutional changes, its primary focus is on quantity adjustment rather than institutional reform. As proved by Western macroeconomic theories, in the process of inflation control, quantity control is effective, easy to implement, and able to give instant results, but can hardly achieve the dual targets of high economic growth and low inflation. Therefore, adjustments to macroeconomic policies are the major drivers to China’s economic soft landing. China’s inflation in the 1990s reflected all kinds of conflicts in the economic operation. Its underlying reasons may be the inherent contradictions of the market mechanism, or the defects in the economic system. The theory established by overly simplifying the cause of inflation as only inherent conflicts of the market economy or accidental fluctuations of several economic variables may not be universally applicable. Thus, it can be concluded that: 1. The measures to fight inflation may vary in different countries and regions, or even at different stages of regulation

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in the same country and region; 2. The impacts of various policy measures on economic parameters are not confined to a certain fixed pattern.

Clear and coordinated macroeconomic control targets Macroeconomic control targets are the main basis of macroeconomic regulation and they determine the orientation and intensity of the later. During target setting, the macroeconomic control of this time well handled the relationships among the interrelated and inter-constraint policy targets. At that time, the Chinese government adopted internationally accepted economic indices and strove to control the inflation at a low level while maintaining sustainable and rapid economic growth. The core of the targets was to realize an ideal development model of high growth, high employment and low inflation. The reason why the macroeconomic control targets were said to be clear and coordinated is because the Chinese government, based on the reality of the national economy, balanced the goals of economic development, price stabilization, and employment expansion, and explicated the reasonable ranges of economic growth rate, inflation rate and employment rate in a timely manner. Moreover, to facilitate the implementation of the overall targets, several subtargets were put up in the form of economic indicators, including the fixed-asset investment rate, fiscal balance ratio, growth rate of money supply, and natural population increase rate. Overall targets coordinated with each other, and subtargets were subject to and serviced overall targets. In real operation, to combat inflation was made the primary target of the macroeconomic control and the key to balancing among the reform, development and stability of the economy. While stabilizing commodity prices, the Chinese government tried to maintain considerable economic growth and created more employment opportunities. It also linked the overall balance in economic aggregates to the optimization of industrial structure, and the control over demand expansion to the increase of effective supply. As for the operational effects, major indicators of the national economy stayed within their reasonable ranges and worked perfectly with each other. After the economic soft landing in 1996, China’s economy has maintained sound development momentum.

Structural optimization and enhanced policy coordination A distinct difference of this macroeconomic regulation from previous ones is its emphasis on optimizing the economic structure, increasing effective supply, and practicing a moderately tight macroeconomic policy. Generally speaking,

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inflation and economic overheating are the combined results of runaway economic aggregates and structural imbalance. Therefore, it is unquestionable that China’s macroeconomic regulation against economic overheating must start from controlling economic aggregates. However, this alone cannot achieve the final success, if without corresponding structural adjustment and institutional optimization.8 The sole control over economic aggregates will easily lead to a downturn in the real economy and can hardly be sustained. Once the control is relaxed, economic expansion will stage a comeback, resulting in violent economic turbulences. A prominent problem in China’s economic operation was the contradiction between economic aggregates and the economic structure.9 If economic aggregates were restrained, problems in the economic structure would be exposed; if the existing economic structure was maintained, economic aggregates could not be limited. In view of such a condition, the Chinese government not only strictly restrained economic aggregates to a proper level, but also initiated economic structural adjustment, during which relationships in three aspects were properly managed: 1). the mutual promoting and restraining relationship between investment and economic development; 2). the relationships among different industries and trades with the focus on the development of basic industries, agriculture, and pillar industries; 3). the coordination of regional economies, especially among eastern, central and western regions, by giving full play to local advantages. This strategy is still of paramount significance to the current economic development in China. In the process of China’s soft landing, the central government actively promoted the optimization of industrial structure and increased supply. Major measures included optimizing the investment structure and coordinating between fiscal and monetary policies. First of all, all measures aiming at optimizing the investment structure centered on industrial policies, which strove to both stifle immediate investment demand and increase long-term supply, namely to optimize the industrial structure while enhancing potential productivity to ensure moderate economic growth. Specific measures included: 1. Determining the priorities of economic development in state plans, strengthening the construction of basic industries, such as agriculture, energy, transportation, and communication, and recommending construction projects to commercial banks; 2. On the basis of investment plans, concentrating financial resources on construction projects that were at their final stages in accordance with the principle of “guaranteeing construction priorities, project completion, and final settlement” in order to form new production capacity;

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3. Allowing gradual repayment of capital and interest or giving even interest subsidies for construction projects relating to basic industries and infrastructure to encourage enterprises and local governments to divert their investments to these projects; 4. Giving additional support to national key construction projects in the aspects of capital allocation, land requisition, material supply, transportation, and external complements; 5. Implementing a special fund system; 6. Prioritizing underdeveloped regions in project arrangement; increasing the proportion of policy loans or giving prime-based loans to key national construction projects undertaken by underdeveloped regions, and granting subsidies to projects relating to basic industries and public welfare or even of competitive nature in order to reduce financing costs and increase competiveness; encouraging enterprises and governments in developed regions and foreign investors to make investments in less developed regions. Next, a moderately tight fiscal policy worked in coordination with policies of structural optimization. While increasing revenues while reducing expenditures and controlling the scale of debts, the Ministry of Finance also introduced the following six measures to complement economic adjustment and increase effective supply. 1. Concentrating more social funds through fiscal credit to finance the construction of basic industries; 2. Increasing the funds to technological development, technical renovation, interest subsidies, and new product and technology research, and promoting accelerated depreciation and investment tax credit, in accordance with the industrial and technological policies of the country, in order to support the adjustment of the investment structure; 3. Granting interest subsidies and special funds to support agricultural and rural development; 4. Promoting the guiding role of the investment orientation regulation tax on investments; 5. Offering interest subsidies to inflation-proof savings and implementing a moderately tight monetary policy; 6. Optimizing enterprises’ capital composition, incorporating the principal and interest resulting from the “loan for appropriation” reform into state capital funds, taking out part of the income tax turned over by SOEs located in the pilot cities of capital structure optimization to replenish their working capital, and offsetting the losses of banks in state-ordered mergers and bankruptcies of SOEs, with bad debt reserves under the condition of overall control over losses.

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Last, a moderately tight monetary policy was carried out to complement other policies. Concrete measures of the monetary policy comprised the following five aspects: 1. The central bank controlled money supply by determining the quantity of money in the economy according to targets of macroeconomic development. Through limiting the investment scale, the mechanism of reversed monetary transmission from excessive investment to money supply was weakened, so money supply basically grew at the same speed with economic development. 2. The central bank also adjusted interest rates and the rediscount rate according to the changes in the price level: increasing the two rates in times of high inflation while lowering them as soon as inflation decreased. By maintaining a balance between the price level and the deposit interest rate, the deposit interest rate and the loan interest rate, the loan interest rate and the bond rate, the bank strove to lessen fiscal burdens, lower enterprises’ financing costs, and boost economic growth. 3. In terms of credits, the bank imposed control over the total loan size in addition to adjusting the credit structure, and also introduced “designated loans” to key national projects and enterprises.10 4. While adjusting money supply through regulating loan and reloan sizes, the central authorities decided to reduce credit loans and enlarge the scope and amount of rediscount loans in order to control at the source the quantity of money entering into the economy. 5. Means of financial regulation were improved by introducing new indirect regulation tools, such as open market operations (OMOs). The expansion of treasury bonds created necessary conditions for OMOs. In 1996, the central bank started to trade treasury bonds in the open market as a new way to fine tune money supply.

Theoretical Implications The success of the economic soft landing marked a victory in China’s macroeconomic regulation, and also a milestone in the development of China’s macroeconomic theory. The most outstanding feature of this soft landing is its maintenance of economic growth and the simultaneous control of inflation, which poses a big challenge to the traditional Keynesian economics. As a result, many economists turned their eye to Friedman’s monetarism.11 According to Friedman, “inflation is always and everywhere a monetary phenomenon,” and changes in money supply affect national output in the short run and the price level over longer periods. In

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this sense, this success should be attributed to the regulation through monetary policy by the central bank. But if taking a closer look at the whole process, we will have deeper understanding towards those theories.

Limitations of monetarism Fig. 20.2 showed the changes in the inflation rate, money supply growth rate, and real GDP growth rate during China’s economic soft landing. As seen in the figure, the year-on-year quarterly growth rate of M1 was on a downward trajectory after hitting the peak in the first quarter of 1993 to reach the bottom at 14.15%, down by 10.25% on average per quarter, in the first quarter of 1994; during the same period, that of M2 declined by 10.36%, an average of 2.59% per quarter. Despite declining at different rates, both of them trended down. In the second and third quarters of 1994, the year-on-year quarterly growth rates of M1 and M2 rebounded, with that of M1 rising to 26.37%, less than half of the rate in the first quarter of 1993, and that of M2 shooting up to 31.8%, the highest level between 1993 and 1996. Here, the growth rate changes of M1 and M2 clearly diverged. The similar situation reappeared during the third quarter of 1994 to the fourth quarter of 1995, when the growth rate of M1 dropped from 26.37% to 8.19%, down by 3.64% on average per quarter, and that of M2 fell from 26.80% to 19.95% with an average quarterly decline rate of just 1.37%. Several important conclusions can be drawn from the above statistics. First, from 1993 and 1996, the year-on-year quarterly growth rates of M1 and M2 were dramatically different. According to the theory of monetary base and money multiplier, a possible explanation for such a divergence would be the variations in their respective money multipliers. Second, as shown in Fig. 20.2, the year-onyear quarterly growth rate of M1 changed in the similar way as the CPI inflation rate whereas that of M2 moved with the real GDP growth rate. For this reason, the decline in the inflation rate between 1993 and 1996 was probably related to the sharp decline in the M1 growth rate while the stability of economic growth during the same period may be connected with the stable growth of M2. To put it another way, the dramatic changes of M1 cannot explain the relatively stable GDP and the relative stability of M2 can hardly be used to understand the drop in the inflation rate. Considering the above, it is safe to say that the success in China’s macroeconomic regulation between 1993 and 1996 cannot be interpreted with the monetarist theory.

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Fig. 20.2

(%) 50

Year-on-year comparison of the quarterly data of major economic indicators, 1992–1997

40 30 20 10 0

1992

1993

1994

CPI

GDP

Year

1995

1996

1997

M0

M1 M2

Standard economic paradigm It has always been a puzzle for economists who follow the traditional economic paradigm to understand how high-speed growth can be maintained while inflation is strictly controlled. According to this theory, under constant potential total supply, the overexpansion of total demand will trigger inflation and the shrinking of total demand will lead to economic recession. How, then, can long-term stable economic growth under low inflation be realized? An analysis of China’s economic soft landing by constructing a theoretical model of “high growth–low inflation” may give the answer. For the convenience of explanation, we use Fig. 20.3 to show the changes in supply and demand. In Fig. 20.3, the economy realizes both short-term and longterm equilibrium at point E0, where real national income equals potential total supply Y0, and the price level is P0. If the supply of total labor force as well as labor productivity increases, potential (long-term) total supply will shift from S0 to S1. In theory, when potential total supply remains unchanged and the total demand curve rises to the upper right, the economy will move along the shortterm total supply curve. But, when the potential total supply increases, the shortterm total supply curve will shift in the same direction with the potential total

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Fig. 20.3

The equilibrium of supply and demand

P

S0

P0

E0

S1

E1

D0

O

Y0

D1

Y1

GDP

supply curve to the right. During this process, as long as the ratio of the price level of production factors to productivity remains the same, the intersection of shortterm total supply and potential total supply will stay at the same price level as the previous equilibrium. The causes for such a phenomenon are the improvement of economic drivers: more labor and capital inputs, more advanced technology and management, and above all, more reasonable institutional arrangements. All these factors make possible output increases under the same unit product cost. In the process, if total demand increases by the same margin, the equilibrium will shift from E0 to E1 at the same price level and without much changes in the unemployment rate. From the above analysis, it is clear that the key to an economic soft landing lies in how to boost higher production efficiency with a limited number of policies to raise short-term total supply. The good balance between inflation control and economic growth during China’s macroeconomic regulation in the 1990s could be ultimately attributed to the increases in economic efficiency. Only under an efficiency-driven economic growth model, can the economy operated at an annual growth rate of almost 11% but without sparking inflation. Starting from 1992, China’s economic reform shifted its focuses from amending the old system to creating a new, from adjusting the power structure through power devolution and profit relinquishment to innovating the system of SOEs, and from changing the macroeconomic regulation system to establishing a market-economy–

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based framework of overall macroeconomic control. Besides that, China’s opening up has reached an unprecedented level, in both depth and breadth. All these factors have induced efficiency and impetus for economic growth via institutional changes. More importantly, non-state economy made huge breakthroughs under the current economic system. It adopted a totally different ownership from the state economy: Competitive market players operated independently, responsible for their own profits and losses, in the pursuit of long-term maximum profits, and thus they focused more on technological advances, organizational innovation, labor quality promotion, and management efficiency improvement. This decided that the investment efficiency and production efficiency of non-state economy were higher than those of state economy in a certain period of time. Certainly, apart from the above reasons, there might be many other drivers for China’s successful economic soft landing. For example, Zhang and Clovis found that after the mid-1990s, inflation persistence in China underwent significant structural changes to drop dramatically, which was favorable for China’s soft landing.12 A later study conducted by them further pointed out that the real driving force for the decline in inflation persistence was a more perfect monetary policy system.13 But how to quantify these reasons is a task for future research.

New Keynesianism China’s economic soft landing in 1996 is an important application of the new Keynesian theory, especially the inflation dynamics theory based on the new Keynesian Philips curve. The new Keynesian Philips curve is derived from the sticky price theory of the supply side based on company price setting. This theory links macroeconomics with microeconomics and epitomizes the analytical methods of new Keynesianism. The new Keynesian Philips curve on the basis of microeconomy can be written as: πt = c0 + αfEtπt+1 + αyyt Here, c0 is the inflation rate at equilibrium (when the GDP gap is zero), and αf reflects the impact of inflation expectations on the current inflation rate at time t. Under this model, the pressure from the real variable (GDP gap) y on the current inflation rate is represented by αy: The large the value of αy, the higher leverage effect of the GDP gap on the inflation rate, or in other words, with other conditions the same, lower inflation will be at the expense of slower economic growth.

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However, in the process of inflation control, if there is proper institutional design and macroeconomic regulation, inflation expectation can be effectively contained, and therefore, the target of low inflation can still be achieved without massive slowdown in real economic output. In this sense, the economic soft landing in the mid- to late 1990s is indeed an application of the new Keynesianism. Recent studies, such as the research of Zhang and Clovis, have also proved this conclusion from both theoretical and practical levels.14

Inspirations for Current Economic Development Economic fluctuations and a soft landing From a long-term perspective, economic development will stabilize at the natural output level, but as Keynes quipped, “In the long run we are all dead.” Business cycles are the normality of economic growth, and also the problem that every country has to face. However, economic oscillations can be recognized and adjusted. To iron out business cycle fluctuations, the key is to bring out the stabilizing function of relevant factors. In the past, China’s economic fluctuations usually started with rapid growth and ended with severe contraction, basically following a cycle of “expansion— recession—recovery.” During economic expansion, high growth targets, the large economic scale and the rapid growth of fixed-asset investment will usually lead to an overheated economy where the economy becomes imbalanced and runs into a bottleneck with marked expansion of total demand, which will further raise fiscal deficits and commodity prices and the whole economy is placed under great tension. At this time, the government needs to formulate and implement proper measures to cool down the economy. During this process, if the government just jams on the brakes by sharply reducing the investment growth rate and money supply, the economy will fluctuate even wilder due to the huge difference between peak and valley values. On the contrary, a soft landing can gradually reverse the economy back to moderate growth by moderately lowering the investment growth rate and money supply. In this way, the difference between peak and valley values will be small and the economy can be cooled down while still maintaining a proper growth rate. The successful soft landing of China’s economy in the mid-1990s is of referential significance for China’s decade-long “deflationary expansion” in the new century,15 and is recognized as a Chinese paradigm of soft landing. This experience shows us the mechanism of China’s macroeconomic operation, reveals the special problems

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and institutional arrangements in China’s economy, and provides important references for policy adjustment in dealing with future economic fluctuations.

Lessons for future macroeconomic regulation For a considerable long period after the soft landing, China’s economy seemed to stay at the state of “growth–deflation” (namely, the deflationary expansion). Although the central government decided to relax monetary policy and both investment and consumption grew at high speeds, the price level remained unchanged and so did the excessive supply. This situation has changed a little in recent years, but the growth of domestic demand is still slow and to boost domestic demand remains a priority for the Chinese government. Fundamentally, this was caused by the continuous imbalance between investment and consumption. With a high investment rate and a low consumption rate, intermediate demand (the demand for investment goods) crowded out the final consumption demand of residents. At present, the ratio of investment to consumption is 38.5 : 61.5, far higher than that in developed countries, which is 20 : 80. To increase farmers’ income is the key to boosting domestic demand, but this is hard to achieve. Final consumption demand is the primary driver of sustainable economic growth. The long-term low proportion of consumption deprived investment its growth basis, and brought about overcapacity and distortions in the industrial structure, which would easily trigger an economic recession. Therefore, China has to rely on expanding domestic demand to develop its economy. There is still room for China’s investment and consumption demand to expand, large enough to support the steady growth of the national economy. As long as the Chinese government strongly promotes domestic demand and makes full use of potential resources, it is still possible to sustain the economic growth. Of course, the success of China’s economic soft landing has proved that steady economic development is inseparable from regulation from macroeconomic policies. In 1999, the Chinese government initiated both investment and consumption stimulation plans, which played a significant role in containing economic slowdown and preventing negative economic growth. To stimulate consumption can resist market sluggishness, promote a thriving market, and is also an inevitable route for the economic transition from low growth to high growth. In the process of economic soft landing, market slumps and rising prices coexisted, and the overstocking of commodities was obscured by inflation. As the economic growth rate declined within a reasonable range, the severity of overstocking fully revealed itself and price growth turned negative, leading to deflation. However, the Chinese economy did not show a rebound in 1997 as predicted, which was related

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to the negative impacts from the Asian financial crisis. A more direct reason was the decline in the growth rate of the collective industry, while the negative impact of the changes in the economic operational mechanism and the rapid transition of the economic system on total demand, especially consumption demand, was the root cause. The appearance of economic oscillations has both internal and external causes. The cyclical economic fluctuations are determined by internal reasons, which are primarily comprised of production conditions and market conditions. That means that the relationship between production and consumption runs through the whole process of economic operation, and is usually reflected in a contradictory movement of “adaptation—inadaptation—adaptation”: When the two match each other, they can vigorously boost economic growth; otherwise, economic growth can hardly be sustained. External reasons mainly include macroeconomic policies and institutional factors, such as relevant fiscal and monetary policies, and the economic system. Any mistakes in macroeconomic policies and any institutional defects will aggravate economic fluctuations. The alternate use of expansionary and contractionary policy will manifest as “expansion–contraction–expansion” in economic development and “boom– recession–boom” in economic operation if considering the effects of money supply and fixed-asset investment.16 The alternation of tight and loose money supply and high and low investment growth rates contribute to drastic ups and downs in GDP growth. Previous economic fluctuations in China were all violent, reflected in the marked rises and falls of the economic growth rate, which was related to the policy errors and institutional imperfection. A high growth target fuels economic overheating, reflected in strong economic rises; when economic overheating is difficult to sustain, tight macroeconomic policies will be launched to reduce money supply and fixed-asset investment, reflected in marked economic falls. Due to institutional imperfection, the problem of the continuous alternation of economic overheating and overcooling cannot be effective contained.

Conclusion In the face of constantly changing situations of the world economy, China’s economy has maintained a steady and rapid growth for over 20 years. One of the most notable event is the economic soft landing in the mid- to late 1990s, during which high growth and low inflation were achieved at the same time thanks to China’s correct macroeconomic regulation. However, it should also be noted that the bases of China’s economic growth are institutional adjustment and structural reform. Structural changes are a guarantee

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for the transformation of the economic growth pattern, which is a prerequisite for sustainable economic growth. During the transition to the market economy, China has maintained steady growth and social stability. The targets of economic growth cannot be set too high; otherwise the economy will be subject to violent ups and downs. Overall, through a thorough review of China’s successful economic soft landing, this chapter has provided more detailed information on the features of China’s economic development at different stages for government decision making, and experience of macroeconomic adjustments against unstable global economic and financial situations. In terms of macroeconomic policies, while stimulating economic growth by increasing government investments and bank credits, the government should focus on the coordination and coherence of fiscal, monetary, investment, industrial, and employment policies, and the recovery and boosting of market confidence. An important part of bolstering market confidence is to expand employment and lower the unemployment rate. Although promoting economic growth shares the same ultimate goal as improving the employment rate, there will be a time lag between releasing economic stimulus measures and realizing employment growth, considering the time needed for the transition from an economic slowdown to an economic takeoff. During this dynamic adjustment process, the government can make additional efforts to expand employment, further reinforcing the role of proactive government intervention in smoothing the business cycle. Specifically speaking, the government has to step up its macroeconomic control over capital-intensive sectors, encourage the involvement of SOEs in domestic and foreign asset acquisition, and promote the stable development of the real estate and capital markets. The focus of resource allocation should be given to the fields which can revitalize the economy and increase employment, and the past reliance on attracting foreign investment to create employment should be shift to increased reliance on raising government expenditure, stimulating domestic demand, and revitalizing the domestic market. In this way, with further implementation of macroeconomic policies at multiple levels, the impacts of external demand slowdowns on China’s economic development will be lessened and the steady and rapid growth of the Chinese economy will be maintained.

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Chapter

Unification of Exchange Rates

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On January 1, 1994, China substituted a single exchange regime for a dual-track system by unifying its official and swap exchange rates, marking the beginning of the Renminbi exchange rate regime reform.

Background During the planned economy period, the state used planned directives and administrative measures to artificially maintain a balanced foreign currency account. This arrangement caused the Renminbi exchange rate to gradually detach

from commodity prices, and the highly overrated exchange rate hardly played any role of economic regulation.

A meaningful Renminbi exchange rate regime was not established until the

1980s (see Fig. 21.1). In January 1, 1981, an internal settlement rate for imports, exports and incidental expenses1 ($1=¥2.80) was calculated based on the national

average currency exchange cost for exports2 ($1=¥2.53) plus 10% profits; and an

exchange rate for nontrade swap and settlement ($1=¥1.53) was also published.

On December 31, 1984, the posted rate set to be on par with the internal settlement price at $1=¥2.80, and the internal settlement price was abolished, denoting an end to the planned double exchange rate system. This was in fact the first unification of exchange rates in China.

In the next nine years, the Chinese government completed a string of auspicious

exploration about the exchange rate regime. The posted rate was irregularly

upgraded: 2.80→3.20→3.70→4.72→5.22→5.70→5.80, converging towards the real foreign exchange value. Moreover, a regulated floating exchange was adopted on April 9, 1991, which allowed the People’s Bank of China (PBC) to adjust the exchange

rate from time to time, based on the currency exchange cost of exports, balance of payments, and exchange rates of major world currencies in the international

market, to avoid excessive shocks to the economy caused by dramatic exchange rate revisions.

Meanwhile, foreign exchange swap markets3 boomed, and the swap rate

grew side by side with the official exchange rate to form a dual-track system. With the gradual easing of exchange control, the participants of foreign exchange swap markets expanded from state-run enterprises to include foreign-invested

companies and individuals, and the price mechanism shifted its pricing basis from internal deciding to public bidding. Correspondingly, the total size of foreign exchange swap escalated from USD4.2 billion in 1987 to USD25.11 billion in 1992.

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Fig. 21.1

Evolution of the Renminbi exchange rate and the corresponding regime in the 30 years after China’s Reform and Opening Up

1994: After the unification of exchange rates, a single managed floating exchange rate regime based on market supply was implemented; 1994–1997: Renminbi appreciated by 4.8% against the US dollar; after 1997: A fixed exchange rate regime against the US dollars ($1=¥1.53) after the Asian financial crisis

12

CNY/USD

10 8 6

1979–1985: A dual-track system of internal settlement rate and official exchange rate

June 21, 2005: A managed float system based on market supply against a basket of currencies

1985–1993: Coexistence of official exchange rate and swap rate

4 2

0 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 Year Internal settlement rate Swap rate

Official rate

Single managed float rate

Source: Yi, “ Evolution of Renminbi Exchange Rate Regime in the 30 Years after China’s Reform and Opening Up.”

It should be noted that the foreign exchange swap markets owed its existence to the foreign exchange retention system adopted since the Reform and Opening Up. This system was created to encourage exports and increase foreign earnings by giving certain autonomy to enterprises over foreign exchanges. The verification and distribution of exchange retention naturally generated the demand and supply of exchange swap. The foreign exchange swap market provided a place for enterprises, financial institutions and individuals to conduct off-board trading. With relatively less control, the swap rate of private sectors was more reliable than the official rate in reflecting real market supply, although the markets were not nationally networked and swap rates were adjusted at different time and space. For policymakers of the exchange rate reform in 1994, there were two issues that needed instant resolution: 1. The swap rate differed greatly from the official rate and the scale of exchange rate swap markets kept growing while that of official markets was diminishing. As the official rate was constantly overrated, export-

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oriented companies preferred to sell their retained foreign exchanges in swap markets rather than to commercial banks. Some companies had recourse to swap markets to evade the strict government control over the use of foreign exchanges. The ample demand and supply in swap markets further aggravated the gap between the swap rate and the official rate, and directly pumped up swap markets. On the eve of the reform, nearly 80% of the foreign exchange transactions had done in swap markets. Substituting a single market exchange rate for the dual rates had become inevitable. 2. The private sector owned more foreign reserves than the government. In the 1980s, China usually ran a trade deficit with only several billion of foreign reserves. The problem of foreign reserve deficiency was salient. In contrast, foreign exchange balance of the private sector piled up and outran official foreign reserves, as individuals and enterprises have been allowed to hold deposits and cash in foreign currency for quite some time. This, combined with the aforementioned wide discrepancy between the swap rate and the official rate, led to the unfavorable condition of official foreign reserves. How to increase the government’s foreign reserves through administrative system reform became another concern in the exchange rate reform design.

Exchange Rate Reform 1994 was labelled as the “year of reform” in China’s economic history. This is because in 1994, a series of complementary policies was released to help build the socialist market economy in fields such as foreign exchange control, finance and taxation, banking, enterprise organization, housing supply, and commodity prices.4 Among them, the most influential reform was the unification of exchange rates in the realm of foreign exchange regulation. The dual-track exchange rate system was a unique product of China’s transition from the planned economy to the market economy. It involved two phases: the coexistence of a posted rate and an internal settlement rate between 1981 and 1984, and of an official rate and a swap rate between 1987 and 1993. This system has played positive role in the early period of China’s Reform and Opening Up.5 Later on, with the advance of the economy, the market economy was soon scaled up to gradually edge out the planned economy in transactions,6 paving the way for the unification of exchange rates. By the latter half of 1993, foreign exchange transactions conducted in domestic swap markets took up almost 80% of all foreign exchange trading. In addition to that, the negotiation on the restoration China’s status as a signatory to General Agreement on Tariffs and Trade (GATT)7

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also required a single exchange rate regime, so the unification of exchange rates seemed inevitable.8 The creation of exchange rate reform plan, from the initial designing to the final confirmation, took about only three months, from the summer of 1993 through to the autumn. In July of the same year, Zhu Rongji, Vice Premier of the State Council, was appointed as President of the PBC, in charge of early reform planning and the subsequent implementation.9 As a result, to carry out the decisions of the State Council,10 the PBC proclaimed the Announcement of Further Reforming the Foreign Exchange Management System, introducing a string of major institutional reform measures in the fields of foreign exchange and foreign trade with effect from January 1, 1994. The measures included: unifying Renminbi exchange rates to implement a single managed floating system based on market supply; substitute the system of foreign exchange settlement and sale through banks for the practices of foreign exchange retention, delivery, and scale control to realize the free conversion of Renminbi under the current account;11 setting up an interbank foreign exchange market and improving the exchange rate regime. After unification, the Renminbi exchange rate was predominately decided by supply and demand in the foreign exchange market, reflected in the balance of payments. The PBC set the benchmark exchange rate to USD1 = CNY8.7, by calculating the weighted-average swap rates of 18 public swap centers on December 31, 1993. In April 1994, a standardized interbank foreign exchange market formally went into operation. The demand and supply of foreign exchanges were regulated through monetary and foreign exchange policies by the PBC to maintain the relative stability of the Renminbi exchange rate. So far, markets have been established as the main force in allocating foreign exchange resources.12 The 1994 foreign exchange regime reform has made encouraging progress, even exceeding the expectations of policy makers and scholars in certain aspects. No major fluctuations appeared in the market after the unification of exchange rates. Under a more market-oriented system, the Renminbi exchange rate became relatively stable with two-way fluctuations. By 1996, Renminbi appreciated by 5% against the US dollar.13 Next, foreign trade and foreign capital inflow escalated, contributing to years of favorable balance of trade with foreign reserves multiplied.14 Last, a unified and standardized foreign exchange market was established and Renminbi became convertible on the current account, linking China to the world economy and increase China’s involvement in international division of labor.15 The positive influence of the unification of exchange rates on perfecting the foreign exchange system and improving macroeconomic control even saved the Chinese economy from dreadful shocks from the Asian financial crisis in 1997. No wonder

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Zhou Zhengqing, Vice President of the PBC, remarked many years later, “To unify the two exchange rates during China’s transition from the planned economy to a market one is the most smooth and successful reform in the history of China’s financial reform.”16 The success of China’s foreign exchange reform also attracted attention around the world, and won praise for the Chinese government. For instance, the Far Eastern Economic Review ran an editorial on China’s foreign exchange reform on January 20, 1994, commenting that China’s abolishment of the official exchange rate was a good sign of building a more free and reasonable foreign exchange system, while also pointing out that what China truly needed to change was to respect the law of supply and demand. The International Monetary Fund (IMF) went so far as to refer to this reform as “a strategic decision” and said that the Chinese society sent another strong signal to the international community, lifting the world’s confidence towards the Chinese economy.17 Beneath the smooth surface of this reform, however, there was actually much turbulence. The huge gap between the official rate and the swap rate before the unification availed “official speculators” (guandao 官倒) plenty of arbitrage opportunities.18 The announcement at the end of 1993 to implement a unified exchange rate in the upcoming year thus stirred up huge repercussions inside and outside the market. It was estimated that the profits from foreign exchange spread were as high as CNY100 billion in 1993. However, the speculators’ source of wealth was cut off overnight with the release of the radical reform measures. “The vestedinterest group,” as Wu Jinglian recalled, “threatened the public by claiming that the unification of exchange rates would lead to great chaos and even the collapse of Renminbi; but the Chinese government still managed to complete the reform on time against the pressure and achieved overall good results despite some shortterm hiccups due to insufficient preparation.”19 It should be noted that although people hold an affirmative attitude towards the unification, no consensus has been reached on whether the timing was right, whether the conditions were mature enough, whether the institutional design was reasonable, how was the economic effects, and what were the short-term and long-term negative impacts on macroeconomic operation and regulation. Jing Xuecheng claimed that from the perspectives of macroeconomic conditions, market preparation, swap rates, and the intervention of PBC, conditions and time were ripe for unifying exchange rates, and the reform measures were appropriate.20 Hu Xiaolian emphasized the obvious pushing force of the exchange rate reform on China’s export-oriented economy, and also pointed out the wrongness to attribute domestic inflation to the reform and the increase of foreign reserves.21 Pei Ping indicated the irrelevance between the increased exports in the first half of 1994

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Unification of Exchange Rates

and the unification of exchange rates, through analyzing the reform process and relevant economic data.22 Sun Mingchun focused more on the role of the reform in making exchange rate stability an important target of monetary policy, which will complicate the formulation and implementation of monetary policy.23

Reform Result Analysis Positive effects of exchange rate unification Generally speaking, the exchange rate unification has two layers of positive effects: 1. confirming the market-oriented reform of the Renminbi exchange rate system; 2. establishing the role of exchange rates in macroeconomic regulation by improving balance of payments and foreign reserves. The first effect can be referred to as institutional effect while the second one, economic effect. On the level of institutional construction, the exchange rate unification of 1994 was of exceptional significance. As mentioned earlier, no matter a single exchange rate (through unification) or a managed float rate, they all had been proposed long before this reform. The reason why the 1994 reform caused a sensation and attracted prolonged attention from the academic circle is that this was the first time a market supply-based exchange rate regime was definitively proposed. In fact, the confirmation of the market-oriented development set the keynote of later Renminbi exchange rate regime reform and also laid a solid foundation for turning Renminbi into a convertible currency. On the economic level, this reform successfully met its targets of smoothly unifying exchange rates and increasing official foreign reserves. Moreover, as the transitions in swap centers accounted for over 80% of all foreign exchange transactions, it seemed that the official exchange rate depreciated by 50% at once, after adjusting the official rate to the market-based swap rate, but the whole reform process was very smooth without any panic selling and violent exchange rate fluctuations as speculated. With just a few months of adjustment, the new exchange rate system was able to run smoothly. Meanwhile, the unification of exchange rates also made impressive progress in stimulating exports and improving the balance of payments (see Table 21.1). In addition to that, various supporting measures of foreign exchange regulation also generated results, more rapid and spectacular than expected. With the replacement of foreign exchange retention, delivery, and scale control system with the mandatory selling and settlement system, foreign exchange funds were gradually transferred from enterprises, to commercial banks and then to the central bank, building up China’s official foreign reserves consistently (see Table 21.1).

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Certainly, the establishment of the unified interbank foreign exchange market contributed to this process. Table 21.1 Major items of China’s balance of payments, 1991–2010 (Unit: USD1 billion) Year

Current Account Balance

Balance of Foreign Trade

Capital Account Balance

Net Inflow of Direct Investment

Errors and Omissions

Foreign Reserves

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

13.3 6.4 –11.9 7.7 1.6 7.2 37.0 31.5 21.1 20.5 17.4 35.4 45.9 68.7 134.1 232.7 354.0 412.4 261.1 305.4

8.7 5.2 –10.7 7.3 18.1 19.5 42.8 43.8 30.6 28.9 28.1 37.4 36.1 49.3 124.8 208.9 307.5 348.9 220.1 232.1

8.0 –25.1 23.5 32.6 38.7 40.0 21.0 –6.3 5.2 1.9 34.8 32.3 52.7 110.7 101.0 52.6 95.1 46.3 180.8 226.0

3.5 7.2 23.1 31.8 33.8 38.1 41.7 41.1 37.0 37.5 37.4 46.8 47.2 53.1 105.9 102.9 143.1 121.7 70.3 124.9

–6.7 –8.3 –9.8 –9.8 –17.8 –15.6 –22.3 –18.7 –17.8 –11.9 –4.9 7.8 18.4 27.0 15.5 –0.6 11.6 20.9 –43.5 –59.7

21.7 19.4 21.2 51.6 73.6 105.0 139.9 145.0 154.7 165.6 212.2 286.4 403.3 609.9 818.9 1,066.3 1,528.2 1,946.0 2,399.2 2,847.3

Source: State Administration of Foreign Exchange.

Limitations in supplementary reform design The 1994 exchange rate reform was projected to install a single managed float regime based on market supply; however, according to the IMF, it was more of a conventional fixed peg or a crawling peg system most of the time. This divergence in opinion is, to a large extent, rooted in the supporting measures adopted during the exchange rate unification. Major supplementary measures included: enforcing a mandatory bank settlement and sale system; closing down foreign exchange swap centers and setting up a unified interbank foreign exchange market across the country; and

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introducing a managed float regime which vested the central bank with more

power and responsibilities. These measures had produced immediate effects and

met expected targets, but if examined more closely from a long-term, dynamic

perspective, this exchange rate unification had its limitations. To be specific, it was problematic in three aspects.

Massive buildup in official reserves The reform plan designed against deflation underestimated the impact of inflation and was ill-prepared for the sudden surge of official foreign reserves. The purpose

of substituting mandatory foreign exchange settlement and sale through banks for the arrangements of foreign exchange retention, delivery and scale control, and

a unified interbank foreign exchange market for scattered swap markets, was to

promptly centralize foreign reserves from the private sector to the central bank. This goal was, in fact, achieved quickly. Under the new system, the central bank

was responsible for clearing the market in case of market imbalance.24 Enterprises were compelled to sell foreign exchanges to commercial banks, which will be then sold to the central bank. When Renminbi faced the pressure of appreciation, even though with a low buying rate, the central bank can still manage to collect most of

the foreign exchanges in the market in virtue of the mandatory settlement and sale policy. As a result, not only was official foreign reserves accumulated, but the central bank was also equipped with necessary materials for its market intervention against Renminbi depreciation. On the other hand, when the Renminbi was expected to

appreciate, the central bank will post a high buying rate to stabilize the exchange rates, attracting banks and enterprises to sell their foreign exchange holdings in the market and even spurring the private sector to go short on Renminbi.

It was initially indisputable to design such a reform to centralize foreign

reserves, considering the economic situation and policy orientation at the time. When the economic situation had changed, to continue sticking to the original policy choices and institutional arrangements became pointless and even fatal.

After the outbreak of the Asian financial crisis in 1997, the Renminbi exchange rate

was basically pegged to the US dollar (see Fig. 21.1). Since then, China’s economic

operation showed two features. First, having been hit by deflation, commodity

prices continued the sluggish trend until 2002, although the economy grew at an average pace of 7.5%. Second, the level of economic openness was constantly raised as China became WTO’s 143rd member on December 11, 2001, aggravating

the problem of “double surplus” in current and capital accounts. In 2002, the actual

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utilized foreign direct investment (FDI) in China amounted to USD52. 74 billion, surpassing the U.S. as the global leader of FDI. It is precisely around 2002 that the growth of China’s foreign reserves rapidly accelerated (see Fig. 21.2). At the same time, the Renminbi exchange rate was increasingly questioned and criticized by the governments and public of many countries around the world, first in Japan, followed by the EU, the United States, and some developing countries. Fig. 21.2

China’s foreign reserves, Jan. 1993–Jun. 2011

3,500

USD1 billion

3,000 2,500 2,000 1,500 1,000

Jan. 2011

Jan. 2010

Jan. 2009

Jan. 2008

Jan. 2007

Jan. 2006

Jan. 2005

Jan. 2004

Jan. 2003

Jan. 2002

Jan. 2001

Jan. 2000

Jan. 1999

Jan. 1998

Jan. 1997

Jan. 1996

Jan. 1995

Jan. 1994

0

Jan. 1993

500

Source: State Administration of Foreign Exchange, various years.

Judging from the domestic and international economic situations in 2002, to continue the foreign exchange management measure of mandatory settlement and sale would inevitably hike up China’s foreign reserves under the single fixed peg to the US dollar, as this arrangement will add to inflationary expectations, not to mention that an open market will facilitate the inflow of international capital. With a high buying rate, the central bank not only expedited the transfer of foreign currencies from the private sector to the central bank, but also encouraged the short selling of foreign exchange, completely evacuating the holdings of foreign reserves in businesses and individuals. As shown in Fig. 21.2, prior to the unification of exchange rates, China’s official foreign reserves totaled USD21.2 billion, and it steadily rose to USD212.2 billion by the end of 2001. After that, it switched to a fast growth track: breaking USD500 billion in September 2004, USD1,000 billion in October 2006, USD2,000 billion in April 2009, and finally arriving at USD3,197.5 billion by the end of 2011. The excessively large foreign reserves not only created more appreciation pressure

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Unification of Exchange Rates

for the Renminbi, making the goal of achieving external balance even more difficult, and it also entailed massive money supply and increased the difficulty of sterilization for the central bank, aggravating domestic inflation and upsetting internal balance.

Imperfect foreign exchange market The exchange rate in the interbank foreign exchange market, affected by the mandatory settlement and sale system and the intervention from the central bank, was in fact not fully determined by market forces. Although China adopted a market supply–based exchange rate regime, the business sector was long excluded from the wholesale foreign exchange market, which was dominated by financial institutions like commercial banks. Under the arrangement of mandatory bank settlement and sale, enterprises were forced to trade foreign exchanges with banks in the retail market. In this sense, the so-called “market rate” can hardly reflect the real supply and demand of the business sector in the market. Moreover, as the central bank was vested with the power to stabilize the Renminbi exchange rate, it frequently intervened in interbank foreign exchange transactions and thus played a deciding role in forming the exchange rate. In this way, the impact of commercial banks on exchange rate formation was also eclipsed. Clearly, the Renminbi exchange rate regime had a low level of marketization, and the exchange rate formed in the interbank market was not a market clearing rate. Naturally, with such as an exchange rate, resources cannot be reasonably allocated. Similarly, the government cannot use the exchange rate as an effective economic lever or policy tool in macroeconomic regulation. While establishing a unified interbank foreign exchange market across the country, the unification of exchange rates shut down over 100 foreign exchange swap centers. But as mentioned above, foreign exchange swap centers in the early 1990s were very similar to the free market system in both market agents and price mechanism. If they can be networked across the country to act as over-the-counter (OTC) markets existing in parallel with the interbank market and affected the interbank exchange rate with the highly market-oriented swap rate, exchange rate distortions caused by unreasonable institutional arrangements will probably be contained. Of course, this also requires changes to the mandatory settlement and sale system; otherwise, the swap markets with only the household sector might have quickly contracted.

Inelastic exchange rate Under the so-called managed float regime, the central bank assumed, whether intentionally or otherwise, too much responsibilities and duties in exchange rate

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regulation, leading to a lack of exchange rate flexibility with more management than floating. Statistics from the IMF on the exchange rate regimes of 186 member countries reported in 2008 were shown in Fig. 21.3. Countries or regions that operated a managed float accounted for 23.7%, second largest after those that operated conventional fixed pegs, whose share was 36.6%. In fact, China was excluded from the statistics on managed floating even after its unification of exchange rates, due to tight and extensive intervention of its central bank, and was categorized into either the conventional fixed pegs or crawling pegs. Fig. 21.3

Exchange rate regime in IMF member states Currency board arrangements 7.0%

Conventional fixed peg arrangements 36.6%

Exchange arrangements with no separate legal tender 5.4%

Pegged exchange rates within horizontal bands 1.6%

Managed floating 23.7%

Crawling pegs 4.3%

Independently floating 21.5%

Sources: 1. “Recent Economic Developments,” in IMF staff reports, 2008.

2. IMF, International Financial Statistics, 2008.

The managed float, by definition, is meant to allow the exchange rate to float in the market, but is subject to occasional interventions from monetary authorities to resist excessive fluctuations. When the central bank, however, interpreted the normal range as an extremely narrow band (within 0.3%, for example), occasional interventions will become regular. The more the central bank manipulates the exchange rate, the more distorted the economic activities of microeconomic agents. Consequently, the market basis of exchange rate formation will be largely undermined.

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Since the central bank dictated the exchange rate trend and fluctuations, the public was prone to blame the bank for the performance of the Renminbi exchange rate. The build-up pressure from exchange rate regulation compelled the central bank to be more and more conservative in decision making. It seems, today, that the increasing prudence of the PBC in making external macroeconomic policies not only caused the Renminbi exchange rate regime to miss the best reform opportunity, but also stiffened its management over the exchange rate: Whenever the economy was hit by external shocks from financial crises, it would make the switch to the rigid peg to the US dollar (see Fig. 21.1 and Fig. 21.4). Fig. 21.4

Timeline of Renminbi exchange rate reform, 2005–2011

10.0

July 21, 2005: Exchange rate regime reform

9.5 9.0

CNY/USD

8.5 8.0 7.5

May 2005: Raised the upper daily fluctuation limit to 0.5%

July 2008: Against the backdrop of the global financial tsunami, the Renminbi exchange rate was once again pegged to the US dollar, stabilized at 6.82–6.84

June 19, 2010: PBC announced further reform to the exchange rate regime to allow more flexibility

7.0 6.5 Jul. 2011

Jan. 2011

Jul. 2010

Jan. 2010

Jul. 2009

Jan. 2009

Jul. 2008

Jan. 2008

Jul. 2007

Jan. 2007

Jul. 2006

Jan. 2006

Jul. 2005

Jan. 2005

6.0

Source: State Administration of Foreign Exchange.

Theory and Policy Discussions The dilemma of developing countries After the breakdown of the Bretton Woods System, the international monetary system entered the age of Jamaica system. Exchange rate regimes in various countries underwent the transition from centralized artificial system design to decentralized free selection, facing a wide range of options from the existing arrangements of float, fixed, or something in between, to new explorations including regional currency and dollarization; this generated a series of important theoretical and policy research topics. For developing countries, the toughest decision to make is which exchange rate regime they should adopt after the opening up of their economies.

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Whether there is any theoretical or real superiority between float and fixed

exchange rates remains unclear, pending more decisive evidence. For emerging

market economies, due to the undevelopment of financial markets, “domestic currency cannot be used to borrow abroad or to borrow long term, even

domestically” — that is the hypothesis of the “original sin” of emerging markets.25

The “original sin” renders their financial systems fragile: As domestic enterprises are forced to either borrow foreign currencies to finance projects that will generate

domestic currency, setting up a currency mismatch, or take out domestic short-term

loans to finance long-term projects, inducing a maturity mismatch, a depreciation of local currency or an increase of interest rate will elevate the borrowing cost.

Moreover, as exchange rate movements will cause balance-sheet effects in the presence of the “original sin,” neither enterprises nor governments desire to

see exchange rate movements, making it difficult for the exchange rate to float.

When hit by speculative attacks, government intervention is impossible: It cannot use deprecation to relieve pressure on businesses, nor increase interest rates to safeguard domestic currency. They thus find themselves in a dilemma of balancing between internal and external policies. So, it is evident that exchange rate regimes,

whether floating or fixed, cannot avoid the “original sin” and its subsequent adverse consequences.26

Developing countries are often fear of high exchange rate variability and tend to

allow domestic currency to float within a narrow range against a foreign currency (usually the US dollar) — the “fear of floating” theory.27 They worry about not

only the contractionary effects of devaluation but also potential harms to their

international competitiveness and export efforts from appreciation. Of course, apart from economic reasons, political concerns also play a part.28

Fixed and float exchange rate systems have their own strengths but also

weaknesses for developing economies. For example, under a turbulent international financial environment, a rigid fixed exchange rate, once deviating from the actual

economic situations at home and abroad, will become the target of speculative attacks. From the Mexican financial crisis in 1994 through Argentina’s massive

debt default in the 21st century to the recent European sovereign debt crisis, the fixed rate regime ceased to function in country after country. The view that fixed

exchange rates avail to stabilize the economy endorsed by the conventional theory is challenged by reality. The pegged exchange rate system and fast capital flow become an extremely instable policy portfolio for developing countries.29

For another example, following the trend of economic globalization and financial

liberalization, international capital movement becomes increasingly large in both

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scale and speed, easily giving rise to frequent and violent volatility in the foreign

exchange market. Hedging against exchange rates will entail high costs, and the risks from derivative dealing are also hard to deal with. On top of that, hedging

is not applicable to all situations, and investment activities, such as long-term investment and investment in kind or human resources, are vulnerable to currency

risk due to a lack of effective risk management measures. In fact, financial markets in most developing countries are underdeveloped, so there are limited options of

hedging tools. So decisionmakers of those countries often found themselves on the horns of a dilemma: whether or not to run a float regime.

A possible solution presented by theory researchers is to have no exchange rate

— dollarization. This arrangement, however, will not only deprive the domestic authorities of an independent national monetary policy, as well as responsibilities

of setting reserve requirements and acting as lender-of-last resort against domestic

financial system, but also take away the seigniorage of fiat money. For this reason, countries with a large economic scale or a developed macroeconomic control mechanism are not suitable for dollarization. This is clearly the case for China.

The “in between” arrangement, which takes in accounts both reliability and

flexibility, may induce external speculative attacks, ultimately evolving into a financial crisis. This view is called the “vanishing intermediate exchange rate”

theory, also known as “two poles” or “hollowing out” theory.30 Proponents of

this theory believe that only “a pure float or a hard fix, such as a currency board or a monetary union, are sustainable. All the intermediate cases of exchange rate

regimes, including adjustable pegs and managed floats, were viewed as ultimately

condemned to disappear.”31 The logic behind this hypothesis is that if real market operation observed by market participants is consistent with the exchange rate

regime proclaimed by the government, then this regime is claimed to be verifiable and thus creditable; but as intermediate arrangements are complex and hard to be verified, their credibility will be worse than a pure peg or a hard fix.

As indicated in Fig. 21.3, if added together, countries with independent float,

conventional peg, currency board, and no separate legal tender accounted for over

70% of all IMF member countries. This evinces that intermediate regimes including managed float is the only option for a handful of countries. More interesting

conclusions can be drawn by comparing with the statistics of 2004. For example, by the end of 2004, the proportion of independent float was 18.7%; conventional

peg, 21.9%; managed float, 27.3%.32 Apparently, the “two poles” regimes became more and more welcomed and the intermediate arrangements were gotten rid by most countries and regions.

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Policy dilemma between internal and external balance under an open economy Robert Mundell proposed the “impossible trinity” of financial policy goals under an open economy when studying international economic issues. The basic idea is that a country can only choose at most two among the following three policy objectives — a fixed exchange rate, an independent monetary policy, and free capital movement.33 That is to say, if a country opens its capital account in response to economic globalization, then to maintain a stable exchange rate regime, it has to forgo the power to independently formulate a domestic monetary policy. In other words, if a country is incapable of implementing an effective monetary policy, for example, the central bank lacks independence or is incapable of resisting political pressure to operate monetary policy with an inflation tendency, it should abandon independent control of monetary policy while liberalizing its capital account and implementing a pegged exchange regime. Allowing the central banks of countries with better performance to decide the monetary policy may end up with more benefits than losses. This is the prescription given by many economists to most countries, especially emerging markets, for designing the financial system. But economic realities have posed challenges to this hypothesis from all angles. One of such doubts comes from the general discussions ensuing from the Asian financial crisis. In retrospect, people founded that long-term implementation of a rigid exchange rate regime may be an important reason for the late response of some governments towards the crisis. A fixed exchange rate is indeed favorable for keeping the inflation rate low, but as the demand for financial products denominated in local currency drops, it will exert tremendous pressure on the hard currency reserves of monetary authorities. If such an exchange rate arrangement is continued, the disadvantageous situation cannot be reversed through effective macroeconomic policies. As a result, the swelling of speculation will surely to push up the marginal cost of a rigid exchange rate, eventually depleting foreign reserves and forcing policymakers to give up the goal of exchange stability.34 This will easily trigger off a financial crisis and place the national financial security in peril. Certainly, the interpretation of exchange stability should also have been renewed. As with the rules of monetary policy, stable exchange rates do not mean rigidness. The level of exchange rate, after all, must serve to satisfy internal and external balance of a country, which is the prerequisite of exchange stability. As internal and external balance is subject to multiple factors, the exchange rate, despite its longterm stability, entails short-term adjustments. Moreover, whether the exchange rate is pegged or floating should be a question of regime choice rather than policy

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choice. Yet, as the ultimate goal of exchange rate policies, to secure stability while allowing considerable fluctuations is probably a more ideal situation. Another opposition is based on practical experience. Take China as an example. In the early days, the Chinese leaders opted for autonomy in monetary policy and exchange stability at the expense of free capital flow. As it turned out under capital control, the goal of a fixed exchange rate was achieved, while that of an independent monetary policy was not.35 When the current account surplus decrease, to maintain a stable exchange rate, reserve coverage of money supply will dwindle, leading to a decrease in the total release of the monetary base, offsetting the effects of expansionary policy. Moreover, as strict capital control is hard to realize in reality, the autonomy in monetary policy also suffers. For example, capital flight can decrease the supply of foreign exchange, creating devaluation expectation, and to stabilize the exchange rate, the central bank has to sell foreign reserves, which will thus reducing the supply of monetary base. In fact, the ineffectiveness of China’s monetary expansion since the Asian financial crisis in 1997 can be ascribed, to a certain extent, to the lack of monetary policy independence. China’s practice in macroeconomic policy since the 21st century has proven that a realistic policy choice of realizing both internal and external balance probably can shatter the fetters of the “impossible trinity” by craving out a middle ground of macrofinancial goals. Simply put, the middle path is “a partially free capital movement + a partially fixed exchange rate + a partially independent monetary policy.” Some of the policy goals are active choices while others are made against will. Managed float, for example, belongs to the former. In terms of capital mobility, with the increased opening up of the Chinese economy, foreign exchange control is gradually relaxed and capital movements become increasingly free: Among the over 30 capital and financial transaction items, capital flow of around one third is totally free; another one third, significantly less restricted; the rest remains strictly restricted. In addition to that, the difficulty of capital control is escalating. As most of the transactions on balance of payments are simultaneously capital and financial transactions, it is not easy to tell them apart, so capital and financial transactions are often wrongly placed under the current account on purpose to evade capital control. Furthermore, international organizations like WTO deem foreign exchange control as a nontariff barrier, and will impose moral condemnation and pressure from public opinions on violating countries, forming an unfavorable external environment for cooperation and development. In view of this, capital liquidity in China, although improved by a large margin, has not fully met the policy goals considering the partial liberalization of the capital account.

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The original intention of the PBC was to gain full autonomy in the formulation and implementation of a monetary policy, immune from external interference and distractions. With a basically fixed Renminbi exchange rate and a partly free capital movement, reinforced by constant, strong appreciation expectation, the rapid piling up of foreign reserves made it impossible to have the monetary policy totally free from external impacts. Also, China’s realities including its economic scale and social institution reject the arrangements of dollarization and currency board which give up an independent monetary policy, so to maintain partial dependence of monetary policy is a forced choice for China’s central bank.

Brief Evaluation of the Follow-Up Reform of Renminbi Exchange Rate Regime On July 21, 2005, the PBC announced a shift to a managed float regime based on market supply and demand with reference to a basket of weighted currencies, inaugurating a new era of Renminbi appreciation starting from a rate of CNY8.11 against the US dollar. China’s Foreign Exchange Trade System has played a central role in forming the exchange rate through publishing central parity rates for the yuan against major currencies, including the US dollar, euro, Japanese Yen, Hong Kong dollar, and British pound. As of May 21, 2007, the floating range of the trading prices of the US Dollar against the Renminbi in the interbank spot foreign exchange market was expanded from 0.3% to 0.5%. In August 13, foreign exchange account limits were removed and the mandatory settlement and sale system was superseded by a voluntary settlement and sale arrangement, following the issuance of the Notice on Retaining the Foreign Exchange Incomes under Current Items by Domestic Institutions Themselves. The control over banks’ foreign exchange positions was gradually freed up and foreign exchange regulation was transitioning from “stricter control on outflows than inflows” to the other way around. Besides that, structural and unsymmetrical measures to open up the capital account were constantly rolled out. All these initiatives were deemed as the reigniting of the exchange rate regime reform (see Fig. 21.4), as well as further perfecting of the institutional framework established after the exchange rate unification in 1994. According to Chinese monetary authorities, the main purpose of this exchange rate reform was to perfect the formation mechanism of Renminbi exchange rate, which was manifested in three aspects.36 First, the exchange rate must float on the basis of market supply and demand and act as a price signal. Second, the floating range of the exchange rate should be adjusted based on current account items, mainly trade of balance, to retain the merits of managed float. Third, the exchange rate should be pegged to a currency basket rather than a certain currency.

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As for the reform guidelines, they are best generalized by the PBC spokesman’s answers in the press conference on further reforming the Renminbi exchange rate regime. The reform, the spokesman noted, “as part of China’s independent policy initiatives, has been progressing in an orderly manner,” and it sought to improve the “managed floating regime for the Renminbi exchange rate,” following a “proactive, gradual and controllable process,” in order to give greater play to the role of market supply and demand, enhance exchange rate flexibility, and “maintain the Renminbi exchange rate basically stable at an adaptive and equilibrium level.”37 This quote not only underlines the need for a proactive, gradual reform, but also makes clear the policy target of a managed float. Although the Renminbi exchange rate regime has been constantly improved since 2005, it still fails to address the limitations left over from the exchange rate unification of 1994. The main deficiencies in the current exchange rate regime include: First, the market basis for exchange rate formation is still underdeveloped. The China Foreign Exchange Trade System was established in 2007 to offer a standardized and effective electronic trading platform for the interbank exchange rate market with two trading options of centralized price bidding or bilateral price inquiry. It supports spot, forward, swap transactions of Renminbi and nine foreign currency pairs, supplemented by the services of trading analysis, straightthrough data processing, and instant messaging.38 This system, however, remains at its preliminary stage. Statistics from the Bank for International Settlements (BIS) indicate that the daily average volume of foreign exchange transactions around the world exceeded USD4 trillion, but this figure was just around CNY10 billion in China, impairing China’s autonomy in deciding its own exchange rate. Acting as the interbank exchange market, the China Foreign Exchange Trade System set a high threshold for market access. As a result, market makers are not broadly representative, which is actually a leftover problem from previous reform, although non-bank members have also been admitted to the system and the mandatory settlement and sale policy has been superseded by a voluntary arrangement. Moreover, the product chain of foreign exchange trade is incomplete. Spots constitute a large share while forwards and swaps have little room for development and the development of exchange forwards, options and structural derivatives is falling far behind, not to mention the absence of supplementary arrangements with the market of interest rate products, for example, treasury bonds.39 Second, China’s exchange rate adjustments with reference to a basket of currencies are suspected to have under-the-table arrangements, aggravating the dominance of management over floating. The policy objectives of being “reasonable and balanced” and “basically stable” are vaguely expressed and the selection

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of the currency basket and the weight assigned to each currency are kept secret, much less to say that referencing the yuan to several currencies does not mean the exchange rate is strictly pegged to that basket, adding to the chances of under-thetable operations in exchange rate formation. From the perspective of the market, under-the-table arrangements can discourage investors from having a clear, stable expectation, but with the expansion of the PBC’s discretionary power in monetary and exchange rate policies, the resultant problem of “dynamic inconsistency” will become salient, substantially discounting the credibility of the exchange rate regime. This will further reinforce the intervention from the central bank in the market and the intermediate exchange rate arrangement may die away due to its lack of credibility and verifiability.40 Third, the exchange formation mechanism and its supporting measures fail to defuse the momentum of going long on the Renminbi. One of the objectives of the exchange rate reform in 2005 was to rectify exchange distortions and realize a twoway floating Renminbi under the premise of basic stability. This target, however, has not been achieved so far. As shown in Fig 21.4, the Renminbi exchange rate entered a period of “one-way movements” against the US dollar after the exchange reform,41 which continued until 2008 when it was pegged again to the US dollar as with 1997, with the only difference that the duration of this time was shorter, returning to the track of “one-way fluctuations” on June 2010 after the central bank proposed to enhance the exchange rate elasticity.42 Although the most criticized policy of mandatory settlement and sale of foreign exchanges left over from the 1994 reform was finally nullified in 2007, this move lagged way behind what it should have been. Meanwhile, regulations on commercial banks’ foreign exchange holdings, restrictions on the fluctuation range of actual transaction prices, and “invisible control” over market makers by the administrative department subdued transactions in the foreign exchange markets.43 In other words, the Renminbi exchange regime continues to be plagued by the same old problems, such as rigid exchange rates and distorted behaviors of market players. So, China is still facing surging foreign reserves and pressure on Renminbi appreciation even after the exchange rate reform in 2005.

Summary Exchange rate decides the exchange ratio between two currencies and is the value of a country’s currency against other currencies. It is an important macroeconomic policy tool for an open economy. The changes in the exchange rate regime will inevitably arouse great attention from interested parties, as foreign exchange

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fluctuations will entail corresponding adjustments in relative prices at home and abroad, thus giving exchange polices the taint of politics and externality. Unification of exchange rates in 1994 is deemed as the start of the Renminbi exchange rate regime reform under the socialist market economy. The single, managed float regime based on market supply and demand as a result of the reform is still in use today. The reform targets were projected to adjust the official rate to the market-oriented swap rate, and accelerate official foreign reserves. To this end, a series of complementary policies were also announced, including mandatory bank settlement and sale of foreign exchanges, conditioned convertibility of Renminbi under the current account, establishment of an interbank foreign exchange market, and improvement of the exchange rate formation mechanism. The exchange rate unification progressed smoothly with both expected targets being accomplished and also made remarkable results in foreign trade. After the unification, large devaluation of Renminbi speculated by many did not appear in the market and neither did violent fluctuations of the market rate. Better still, from 1994 to 1997, the Renminbi exchange rate was basically stable and displayed twoway floating, implying that the market basis of exchange rate formation was well developed. The exchange rate played a role of price signal after the unification, pumping up China’s foreign trade and investment with consecutive trade surplus and multiplied foreign reserves. The more reasonable exchange rate regime favored China’s integration into the world’s economy, elevating China’s opening up to the outside world for better participation in international division of labor. However, there was a serious defect in the reform design. The aim of implementing a mandatory settlement and sale system and substituting a unified interbank foreign exchange market for the scattered swap centers was to rapidly centralize foreign exchange positions to the central bank from the private center. This reform plan, however, devised under the pressure of depreciation, underestimated the impacts of Renminbi appreciation and was ill-prepared for the surge in foreign reserves. Around 2002, with drastic changes in internal and external balance, Renminbi faced a great appreciation pressure, from both economic and politic areas, and China’s foreign reserves entered a period of rapid expansion. The exchange rate regime was conspicuously absent: The single peg against the US dollar revived following the Asian financial crisis in 1997 and continued until the restart of the exchange rate reform in 2005. A seriously rigid regime again triggered off exchange rate distortions, and the institutional dividends from the exchange rate unification of 1994 were almost depleted. Meanwhile, the substitution of a unified interbank foreign exchange market for swap centers was also problematic. The arrangement of mandatory foreign exchange settlement and sale and frequent interventions from the central bank,

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together with undiversified participants in the interbank foreign exchange market, caused a low degree of marketization of the so-called “market rate,” limiting its usefulness as an economic lever and policy tool. It is a pity that the swap market, which was highly marketized, was deprived of its positive role in building a sound market basis for exchange rate formation due to simple closedown. In addition to that, the central bank assumed more responsibilities in exchange rate regulation than it should, placing it under the criticism of the whole society. As the pressure gradually piled up, the central bank became more conservative in the decision making process of major policies in the exchange rate regime reform, thus missing favorable reform opportunities. The result was that the Renminbi exchange rate regime was severely in lack of elasticity and the managed float, the outcome of the exchange rate unification, received unanimous disapproval. According to the exchange rate regime choice theory, it is indeed hard for developing countries to decide their own exchange rate regime in the context of the Jamaica agreement. Not only is it because there is no clear-cut advantage of one against another between fixed and floating exchange rates, but because no escape is provided for developing countries to avert problems like the “original sin” and the “fear of floating,” thus putting themselves under potential shocks and challenges from international financial crises. Dollarization, as generally believed, is the best solution to those countries, but it is clearly not suitable for China. The managed float established after the exchange rate unification is an intermediate arrangement between fixed and floating regimes. But as far as verifiability is concerned, intermediate arrangements cannot be easily verified due to its complexity in system design, thus lacking credibility and sustainability. In other words, the managed floating is going to vanish, as believed by some theorists. Experience of exchange rate regime selection in various countries seems to support this opinion. For any open economy, the choice of exchange rate regime must be considered side by side with capital account openness and monetary policy independence. This is what Krugman termed as the “impossible trinity.” It seems that China’s current policy selection of “a partially fixed exchange rate + partially free capital flow + a partially independent monetary policy” in maintaining both domestic and external economic balances, breaks the shackles of the “impossible trinity” by carving out a middle road of realizing macrofinancial policy goals. But its sustainability and applicability remain to be seen. In the face of ascending internal and external pressure, the reform of Renminbi exchange rate regime was reinstalled in July 2005. Aiming at perfecting the exchange rate formation mechanism, this reform initiated a shift from a single peg to a basket peg and emphasized on the market basis of exchange rate formation and the regulation of the central bank. But impacted by the later global financial

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crisis, the Renminbi was once again pegged against the US dollar between July 2008 and June 2010, before going back to the track of increasing elasticity. Despite improvements in foreign exchange management and the exchange rate formation mechanism made by the central bank, for example ending the mandatory settlement and sale system and expanding the floating range of exchange rate, leftover problems from the exchange rate unification in 1994 have not been solved yet. The Exchange rate was still seriously distorted, foreign reserves maintained a fast-growing momentum, and the pressure for Renminbi appreciation was still large. The exchange rate regime reform in 2005 is, in some ways, far from ideal, incomparable to the exchange rate unification in 1994. Therefore, the reform of China’s exchange rate regime still has a long way to go.

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Notes Chapter 15 1. Coase, “The Problem of Social Cost.” 2. Zhang, “Bad Debts in State-Owned Banks in the Transition Economy.” 3. Kornai, Highway and Byways: Studies on Reform and Postcommunist Transition, 142. 4. Qian and Wan.” Soft Budget Constraints and Micro-Fundamentals of Financial Crisis.” 5. Shi, “On the Endogenous Nature of Non-performing Loans of State-Owned banks of China: An Analytical Framework Based on the Dual Soft-budget Constraint Theory.” 6. Chen, et al., “Empirical Analysis on the Impacts of Soft Budget Constraints on the Vulnerability of China’s Banking System.” 7. Fan, et al., “Independence of China’s Central Bank and the Political Economic Cycle.” 8. Zhang and Wan, “China’s Business Cycle: Based on an AD-AS Model.” 9. Gurley and Shaw, Money in a Theory of Finance. 10. Tobin, “Commercial Banks as Creators of ‘Money’.” 11. Kaldor, The Scourge of Monetarism. 12. Moore, “A Simple Model of Bank Intermediation.” 13. Lavoie, “Credit and Money: The Dynamic Circuit, Overdraft Economics, and Post Keynesian Economics.” 14. Pollin, “Two Theories of Money Supply Endogeneity: Some Empirical.” 15. McCallum, Monetary Economics, Theory and Policy; Bofinger, Monetary Policy: Goals, Institutions, Strategies, and Instruments. 16. Ning, Endogenous Money Supply: Theoretical Hypothesis and Empirical Evidence. 17. Wan and Xu, “Endogeneity of Money Supply and Efficiency of Monetary Policy.” 18. Sun, Logic of Endogenous Money Supply. 19. Wang and Shu, “On the Movement of China’s Money Market: Endogeneity, Adjustment Lags and Dynamics.” 20. Zhao and Zhou, “Research on the Relationship between Fiscal Expenditure and Inflation Based on Provincial Panel Data.”

Chapter 16 1. 2. 3. 4. 5. 6. 7. 8.

Data from this chapter is, unless otherwise stated, sourced from Dong, ed., The Economic History of the People’s Republic of China; Wang, The History of Industrial Economy of China. Liu, “Causes and Solutions to Interenterprise Triangular Debts,” 31. Fan, “Interenterprise Debts and Macroeconomic Fluctuations.” Dong, ed., “The Economic History of the People’s Republic of China,” Volume 2, 317. Liu, “Causes and Solutions to Interenterprise Triangular Debts.” Dong, ed., “The Economic History of the People’s Republic of China,” Volume 2, 387. Wang, “The History of Industrial Economy of China,” 202–3. Zhao, “Journey to Reform.”

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9. Liu, “Causes and Solutions to Interenterprise Triangular Debts.” 10. This case study is based on Ma, “Tackling from the Source and Keeping up the Good Work: A Record of the Clearance Exercise of ‘Triangular Debts’ in Northeast China,” and Wang, “Attack the Root Cause: ‘Triangular Debt’ Clearance Pilot Program in Liaoning Province.” 11. Qu, “Economic Oscillations: Credit-Augmented Structural Analysis.”

Chapter 17 1. Fan and Zhang, The Outline of Macroeconomic Theory on Public Ownership. 2. Huang, “Analysis of Macroeconomic Concepts”; Huang, “Macroeconomic Regulation and Money Supply.” 3. Fan and Zhang, The Outline of Macroeconomic Theory on Public Ownership, 419–436. 4. Ibid, 421. 5. Ibid, 436. 6. Huang, “Macroeconomic Regulation and Money Supply.” 7. Ibid. 8. Huang, “Analysis of Macroeconomic Concepts,” 735–36. 9. Huang, Introduction to the Overall Fiscal-Credit Balance, 104. 10. Wu, A Coursebook on Economic Reform in Contemporary China, 339. 11. National Bureau of Statistics of the People’s Republic of China, China Statistical Abstract 2010, 109. 12. Wu, A Coursebook on Economic Reform in Contemporary China, 340. 13. Zou, China’s Economic Transformation, 50. 14. National Bureau of Statistics of the People’s Republic of China, China Statistical Abstract 2010. 15. Lubman, comp., PRC Legal Document Collection: Banking, Finance & Exchange Control, 6. 16. Yi, China’s Currency, Banking and Financial Market: 1984–1993, 59–60. 17. Ibid, Table 10.1. 18. Zou, China’s Economic Transformation, Table 7.1. 19. Wu, A Coursebook on Economic Reform in Contemporary China, 343. 20. Wu, ed., Major Events in China’s Financial Reform and Opening Up, 110. 21. Zou, China’s Economic Transformation, 127; Wu, A Coursebook on Economic Reform in Contemporary China, 343. 22. Zhang, Construction and Evolution of China’s Financial System, Table 8.3. 23. Zhang, “The Dilemma of Whether to Maintain Marketization or Keep Financial Control.” 24. Zhang, Construction and Evolution of China’s Financial System, 259. 25. Wu, ed., Major Events in China’s Financial Reform and Opening Up, 266. 26. Zou, China’s Economic Transformation, 127. 27. Li, et al., Structural Issues in China’s Financial Development, 260–62; Huang, Economics of Money and Finance, Table 11.3. 28. Huang, Economics of Money and Finance, 326–27. 29. Zhang, Construction and Evolution of China’s Financial System, 59–62. 30. Zhang, “The Dilemma of Whether to Maintain Marketization or Keep Financial Control” 31. Ibid.

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32. Naughton, The Chinese Economy: Transitions and Growth, 96. 33. National Bureau of Statistics of the People’s Republic of China, China Statistical Abstract 2010, 19. 34. World Bank, China 2020: Development Challenges in the New Century, 4–5. 35. Zhang, Chronicle of China’s State-Owned Enterprise Reform, 348–58. 36. Naughton, The Chinese Economy: Transitions and Growth, 301. 37. Wu, A Coursebook on Economic Reform in Contemporary China, 350. 38. Fan and Zhang, The Outline of Macroeconomic Theory on Public Ownership. 39. Zhang, “Peasants, Government and the Rural Credit System in China: A Long-Term Perspective.” 40. Lu, Restless Hand: The Evolution of China’s Stock Market System, 9–16. 41. Naughton, The Chinese Economy: Transitions and Growth, 453–54. 42. Ibid, 97. 43. Zhang, “The Dilemma of Whether to Maintain Marketization or Keep Financial Control.” 44. Naughton, The Chinese Economy: Transitions and Growth, 450. 45. Zhang, “The Marketization Dilemma Facing China’s Financial Reform: An Analysis Based on the Hainan Case.” 46. Zhang, “The Dilemma of Whether to Maintain Marketization or Keep Financial Control.” 47. World Bank, China 2020: Development Challenges in the New Century, 32. 48. Heffernan, The Modern Banking, 308. 49. Zhang, “The Dilemma of Whether to Maintain Marketization or Keep Financial Control.” 50. Zhang, “Mystery of the Capital Funds in China’s Stated-Owned Banks.”

Chapter 18 1.

Fang, “Review of Economic Governance and Rectification Between 1988 and 1991 and Outlook for Future Economic Operation.” 2. Shang, Wu, and Luo, Bank Credit Management and Monetary Supply, 211. 3. Shang, Finance in Contemporary China, 112–14. 4. Ibid, 258. 5. Xiao, Analysis on the Evolution of Credit System in China’s Commercial Banks, 87–9. 6. Shang, Wu, and Luo, Bank Credit Management and Monetary Supply, 208–50. 7. Scholars from various parts of the country have written about the chaos caused by designated loans, for example, Xu, “Some Thinking on Designated Loans”; Liu and Liu, “Designated Loans: Misunderstandings bout Banks’ Credit Management”; Chen, “Negative Impacts of ‘Designated Loans’ ”; Zhao and Lei, “Discussions on ‘Designated Loans’ ”; Zhang, “Improving ‘Designated Loans’ Management to Service Economic Adjustments”; Zhou, “Several Questions about the Release of ‘Economic Activation Funds’ ”; Yang and Yang, “To Further Improve the Activation Effects of ‘Designated Loans’.” 8. Luo and Li, “ ‘Designated Loans’ Management Urgently Needs to be Perfected.” 9. Tang, Problems of China’s Credit Policies, 124–25. 10. Chen, “Problems of and Solutions to ‘Designated Funds Management’.” 11. Huang, Macroeconomic Regulation and Money Supply, 165–66, 221–26. 12. McKinnon, Money and Capital in Economic Development; Shaw, Financial Deepening in Economic Development.

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13. Nurkse, Problems of Capital Formation in Underdeveloped Countries. 14. McKinnon, Money and Capital in Economic Development; Shaw, Financial Deepening in Economic Development. 15. McKinnon, The Order of Economic Liberalization: Financial Control in the Transition to a Market Economy. 16. Park, “Financial Repression and Liberalization.” 17. Hellmann, Murdock, and Stiglitz, “Financial Restraint: Toward a New Paradigm.” 18. Huang, Collected Works of Huang Da, 777–78. 19. Aoki, Comparative Institutional Analysis, 210–33.

Chapter 19 1. Xie, 30-Year Review of China’s Fiscal Reform. 2. Guo and Zhao, Fiscal Theory and Policy: Discussions on Several Major Issues. 3. Ibid. 4. Extra-establishment revenues refer to revenues outside the purview of the state budget [and extrabudgetary revenue] and collected by local governments, government agencies, enterprises, or administrative units according to set rules or specific purposes. —ed. (Cheng and Brosseau, eds., China Review 1993.) 5. Gao, Tax for Fee Reform: Opinions from Economists; Research on Problems in China’s Tax and Fee Reforms. 6. Xie, 30-Year Review of China’s Fiscal Reform. 7. Li, Sun, and Song, Tax for Fee Reform. 8. Xie, 30-Year Review of China’s Fiscal Reform. 9. Li, Sun, and Song, Tax for Fee Reform. 10. Xie, 30-Year Review of China’s Fiscal Reform. 11. Xiang, Out of the Vicious Circle of “Huang Zongxi law”: Investigation and Research on China’s Rural Tax and Fee Reform. 12. Xie, 30-Year Review of China’s Fiscal Reform. 13. Gao, Tax for Fee Reform: Opinions from Economists; Research on Problems in China’s Tax and Fee Reforms. 14. Xie, 30-Year Review of China’s Fiscal Reform. 15. Guo and Zhao, Public Economics. 16. For more details about the rural tax and fee reform, please see Xie, 30-Year Review of China’s Fiscal Reform. 17. Xiang, Out of the Vicious Circle of “Huang Zongxi law”: Investigation and Research on China’s Rural Tax and Fee Reform. 18. Xie, “Ten Years of Reform in Rural Taxes and Fees.” 19. Zhou and Chen, “The Policy Effect of Tax-and-Fee Reform in Rural China: A Difference-in-Differences Estimation”; Xu, Liu, and Liu, “Impacts of Farmers’ Organizations on Rural Public Financing: A Hindrance or Booster? — Inspirations from the Changes in Farmers’ Burdens After Rural Tax and Fee Reform.”

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20. Xie, 30-Year Review of China’s Fiscal Reform. 21. By the end of 2001, the number of townships was reduced by 4,580, down 10.24% from 1999, and the number of administrative villages decreased by 28,172, less 3.82%, in response to the policies from the central and provincial governments to streamline township institutions and downsize staff in administrative and public institutions (Zhu, Zhang, and Yan, “Tracking Research Report on the Pilot Reform of Rural Taxes and Fees and the Reform of Rural Management System”). 22. Jia and Bai, “Fiscal Bailouts to County- and Village-Level Governments and Innovations of Fiscal System”; Wang and Zhao, “Empirical Analysis on the Impacts of Rural Tax and Fee Reform on the Fiscal Power of Township and Village Governments in Western and Central China”; Jia, Guo, and Ning, “Fiscal Decentralization, Government Governance Structure, and Fiscal Bailouts to County- and Village-Level Governments.” 23. Xie, 30-Year Review of China’s Fiscal Reform. 24. Ibid. 25. Guo and Zhao, Fiscal Theory and Policy: Discussions on Several Major Issues. 26. For more information about the features of fees and its distinctions from taxes, please refer to Guo and Zhao, Public Economics.

Chapter 20 1. 2. 3. 4.

Zheng, et al., “Before and After the ‘Soft Landing’.” Dai, “Emphasize ‘Soft Investment’ to Achieve A ‘Soft Landing’.” Zhang, “The Nature of Inflation Inertia in China and Its Implications on Monetary Policy .” Statistics of the CPI and GDP growth rate is from Wind Information, and others are from Almanac of China’s Finance and Banking, 1993. 5. In 1992, 56,364 new projects were launched, up by 23.6% from the last year; the price index of investment goods reached 15.6% in 1992, and in the first half of 1993, the steel price rose by 61.8%, compared to the same period last year; the money supply in the first half of 1993 grew by 68.3% over the same period last year. 6. Jiang, “Adjustments of China’s Economic Structure through Economic Means After the ‘Soft Landing’ and Its Significance.” 7. Zhou, el al., “The Role of Macroeconomic Regulation in the Economic ‘Soft Landing’.” 8. Liu, “Analysis on the Success of the ‘Soft Landing’.” 9. Zheng, “A Stable and Booming Economy, the Soft Landing Is Successful.” 10. For more details on “designated loans,” please refer to Chapter 18. 11. Luo, “The Effects of Money Quantity Control.” 12. Zhang and Clovis, “China Inflation Dynamics: Persistence and Policy Regimes.” 13. Ibid. 14. Zhang and Clovis, “Modeling China Inflation Persistence.” 15. Li, “Empirical Analysis on China’s ‘Soft Landing’.” 16. Meng, “China’s Economic Fluctuations After the ‘Soft Landing’.”

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Chapter 21 1.

The internal settlement rate is the par rate of exchange used by the country to adjust its imports and exports. It was designed to develop foreign trade by encouraging exports and limiting imports, and urging internal economic accounting in foreign trade enterprises to prepare for the reform of the foreign trade system (Chen, International Finance). 2. The currency exchange cost for exports, also known as the “export currency exchange ratio,” is the ratio of the Renminbi denominated costs of exports to net foreign exchange earnings from exports. The lower the export cots and the more the foreign exchange earnings, the less the currency exchange cost for exports and the better the country’s export trade. 3. China’s first foreign exchange swap center was founded in 1985 in Shenzhen, and by 1987, swap centers were all over major cities across China. In 1988, Shanghai opened the first public foreign exchange swap market, introducing the fair bidding principle. By the end of 1993, there were a total of 121 swap centers in China, among which 18 were public centers. 4. In November 1993, the Third Plenary Session of the 14th Central Committee of the Communist Part of China (CPC) passed the Decisions on Several Issues Relating to the Building of a Socialist Market Economy, specifying the goals of building a socialist market economy proposed at the 14th National Congress and designing an overall plan for further reform. It clearly put forward the task of “reforming the foreign exchange control system, and developing a managed floating system based on market supply and standardized foreign exchange markets to turn Renminbi into a convertible currency. 5. Xia, “Origin and Reasons of Renminbi Exchange Rate Unification.” 6. Mao, Mao Yushi Talks About the Economy: From Microeconomy to Macroeconomy. 7. The dual-track system was the major barrier in the restoration of China’s GATT status. It was forbidden by GATT and IMF to practice biased exchange rates or adopt a multiple exchange rate regime in member countries. Thus, to facilitate the restoration negotiation, the dual-track system must be reformed (Lou and Gao, “Institutional Breakthroughs in the Reform of Foreign Exchange Management Reform”). As GATT would be replaced by the World Trade Organization (WTO) on January 1, 1995, China had to make its final push before the Uruguay Round to be held in July 1994, if it wished to join in the WTO as a contracting party of GATT. 8. Chen, “ ‘China’s Rejoining of GATT’ and the Foreign Exchange System Reform”; Tao, “On the Unification of Renminbi Exchange Rates”; Wang, “Renminbi Exchange Rate and New Foreign Trade System”; Yang, “Unification Is Bound to Happen, and Devaluation Is Round the Corner: Forecasts for Renminbi Exchange Rate Changes.” 9. Zheng, “30 Years after China’s Reform and Opening Up: A Review of Foreign Exchange Management Reform in 1994.” 10. It refers to the decisions made in the Notice of Further Reforming the Foreign Exchange Management System issued by the State Council on October 1, 1993 to people’s governments of all provinces, autonomous regions, and municipalities directly under the central government and all ministries and commissions of and departments directly under the State Council. 11. On December 1, 1996, Renminbi became completely current account convertible.

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Notes

12. Hu, “Estimation of China’s Exchange Rate Regime Reform in 1994.” 13. Yi, “Best Option for China’s Exchange Rate Regime.” 14. By the end of 1993, China’s foreign reserves was USD21.2 billion, but it was nearly doubled by the end of 1994 at USD51.6 billion, and then went beyond USD100 billion in 1996, next to only that of Japan and Germany. 15. Chen, “China’s Foreign Exchange System Reform Turns Renminbi into a Convertible Currency.” 16. Zhou, “Review and Outlook of China’s Financial Reform: Several Issues Concerning the Deepening of Financial Reform.” 17. Chen, “China’s Foreign Exchange System Reform Turns Renminbi into a Convertible Currency.” 18. At that time, the official exchange rate of Renminbi against USD was 5.8. The swap rate once skyrocketed to 12 in Shanghai in June 1993. Although the swap rate fell gradually between 8.8 and 9, resulting from a series of intervention measures to tighten the economy, the gap with the official rate was still large. 19. Southern Weekly, “Premier Zhu Rongji of the People’s Republic of China.” 20. Jing, “Remarks on the Unification of Renminbi Exchange Rates.” 21. Hu, “Estimation of China’s Exchange Rate Regime Reform in 1994.” 22. Pei, “The Effects of Exchange Rate Unification on Improving China’s Exports and Imports.” 23. Sun, “Impacts of Foreign Exchange Management Reform on China’s Monetary Policy.” 24. For more detailed information, please refer to “Process and Orientation of the Foreign Exchange Reform,” Series No. 17 of “Reform Review After 30 Years,” 21st Central Business Herald, 2008. Members from China Finance 40 Forum, including Zhong Wei, Mei Jianping, Li Fu’an, Xu Gang, and Yin Jianfeng, also participated in this discussion. 25. Hausmann et al., “Why Do Countries Float the Way They Float?”; Eichengreen, Toward a New Financial Architecture: A Practical Post-Asia Agenda. 26. Wang, “New Trends of Financial Theory Development.” 27. Calvo and Reinhart, “Fear of Floating.” 28. Poirson, “How Do Countries Choose Their Exchange Rates.” 29. Chen, International Finance. 30. Wang, “New Trends of Financial Theory Development.” 31. James, Marsh, and Sarno, eds., Handbook of Exchange Rates. 32. Chen, International Finance. 33. James, Marsh, and Sarno, eds., Handbook of Exchange Rates. 34. Chen, Modern Finance Theory. 35. Wang, “Research on the Validity of China’s Currency.” 36. Hu, “Progress and Experience of China’s Foreign Exchange Management System Reform.” 37. Spokesperson of the PBC Answers Questions on Further Reforming the RMB Exchange Rate regime, http://www.mianfeiwendang.com/doc/da95f1a682d7221bd957e3b5, accessed May 23, 2016. 38. The information is sourced from http://www.chinamoney.com.cn. 39. Chen, et al., “Progress, Challenges, and Prospect of Renminbi Exchange Rate Reform.” 40. Please refer to the analysis on the intermediate arrangements in the section “Theory and Policy Discussions” of this chapter.

163

Notes

41. Because of this, the IMF categorized the Renminbi exchange rate regime between July 2005 and July 2008 as a “crawling peg.” 42. In fact, there was nothing new about the exchange rate reform in 2010 except for ending the fixed peg to the US dollar and getting back on the track of the exchange reform of 2005. 43. Chen, et al., “Progress, Challenges, and Prospect of Renminbi Exchange Rate Reform.”

164

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Chen Shoudong 陳守東, Tian Yanfen 田艷芬, and Zhao Dakun 趙大坤. “Yusuan ruan yuesu dui wo guo yinhang tixi cuiruo xing yingxiang de shizheng fenxi” 預算軟約束對我國銀行體系脆弱性影響的實證分析 [Empirical Analysis on the Impacts of Soft Budget Constraints on the Vulnerability of China’s Banking System]. Contemporary Economics 當代經濟, (11) (2008). Fan Fangzhi 范方志, Li Haihai 李海海, and Su Guoqiang 蘇國強. “Zhongguo zhongyang yinhang duli xing yu zhengzhi jingji zhouqi” 中國中央銀行 獨立性與政治經濟週期 [Independence of China’s Central Bank and the Political Economic Cycle]. Journal of Social Sciences 社會科學, (11) (2005). He Ping 何平, and Yin Xiaobin 殷小斌. “Zhongguo guoyou yinhang gaige de bijiao zhidu fenxi” 中國國有銀行改革的比較制度分析 [Comparative Institutional Analysis on State-Owned Banks’ Reform in China]. Economic Theory and Business Management 經濟理論與經濟管理, (5) (2010). Huang Da 黃達. Jinrong xue 金融學 [Economics of Money and Finance]. Beijing: China Renmin University Press, 2003. Ning Yong 寧詠. Neisheng huobi gongji: Lilun jiashuo yu jingyan shishi 內生貨幣供給： 理論假說與經驗事實 [Endogenous Money Supply: Theoretical Hypothesis and Empirical Evidence]. Beijing: Economic Science Press, 2000. Shi Huaqiang 施華強. “Zhongguo guoyou shangye yinhang buliang daikuan neisheng xing: Yige jiyu shuangchong ruan yueshu de fenxi kuangjia” 中國國有商業銀行不良貸款的內生性：一個基於雙重軟約束的分析框架 [On the Endogenous Nature of Non-performing Loans of State-Owned banks of China: An Analytical Framework Based on the Dual Soft-budget Constraint Theory]. Journal of Financial Research 金融研究, (6) (2004). Song Wei 宋瑋, and Huang Yanfen 黃艷芬. “Woguo lilü shichang hua gaige yu huobi gongji neisheng xing ruohua zhi guanlian xing fenxi” 我國利率 市場化改革與貨幣供給內生性弱化之關聯性分析 [Correlation Analysis on the Market-Oriented Reform of China’s Interest Rate Market and the Weakening Endogeneity of Money Supply]. Economic Theory and Business Management 經濟理論與經濟管理, (1) (2006). Sun Boyin 孫伯銀. Huobi gongji neisheng de luoji 貨幣供給內生的邏輯 [Logic of Endogenous Money Supply]. Beijing: China Financial Publishing House, 2003.

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Wan Jieqiu 萬解秋, and Xu Tao 徐濤. “Huobi gongji de neisheng xing yu huobi zhengce de xiaolü” 貨幣供給的內生性與貨幣政策的效率 [Endogeneity of Money Supply and Efficiency of Monetary Policy]. Economic Research Journal 經濟研究, (3) (2001). Wang Xi 王曦, and Shu Yuan 舒元. “Zhongguo huobi shichang yunxing: Neisheng xing, tiaozheng shizhi, yu dongtai” 中國貨幣市場運行：內生性、調整 時滯與動態 [On the Movement of China’s Money Market: Endogeneity, Adjustment Lags and Dynamics]. China Economic Quarterly 經濟學（季 刊）, 2(3) (April 2003). Zhang Jie 張傑. “Zhuangui jingji zhong de guoyou yinhang daizhang” 轉軌經 濟中的國有銀行呆賬 [Bad Debts in State-Owned Banks in the Transition Economy]. Journal of Financial Research 金融研究, (5) (1999). Zhang Yin 張茵, and Wan Guanghua 萬廣華. “Zhongguo de jingji zhouqi: Yige ADAS moxing de shijiao” 中國的經濟週期：一個AD-AS模型的視角 [China’s Business Cycle: Based on an AD-AS Model]. World Economic Papers 世界經 濟文匯, (2) (2005). Zhao Wenzhe 趙文哲, and Zhou Ye’an 周業安. “Jiyu shengji mianban de caizheng zhichu yu tonghuo pengzhang guanxi yanjiu” 基於省際面板的財政支 出與通貨膨脹關係研究 [Research on the Relationship between Fiscal Expenditure and Inflation Based on Provincial Panel Data]. Economic Research Journal 經濟研究, (10) (2009). Zhong Wei 鐘偉, and Wan Yuanyuan 宛圓淵. “Yusuan ruan yuesu he jinrong weiji lilun de weiguan goujian 預算軟約束和金融危機理論的微觀構建 [Soft Budget Constraints and Micro-Fundamentals of Financial Crisis]. Economic Research Journal 經濟研究, (8) (2001). English materials: Bofinger, P. Monetary Policy: Goals, Institutions, Strategies, and Instruments. New York: Oxford University Press, 2001. Coase, Ronald H. “The Problem of Social Cost”. Journal of Law and Economics, 3(1) (1960): 1-44. Gurley, J. G., and E. S. Shaw. Money in a Theory of Finance. Washington, DC: Brookings Institution, 1960. Kaldor, Nicholas. The Scourge of Monetarism. Oxford; New York: Oxford University Press, 1982. Kornai, J. Resource. “Resource-Constrained versus Demand-Constrained Systems.” Econometrica, 47(4) (1979). Kornai, J. Highway and Byways: Studies on Reform and Postcommunist Transition. Cambridge, MA: The MIT Press, 1995.

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Lavoie, M. “Credit and Money: The Dynamic Circuit, Overdraft Economics, and Post Keynesian Economics.” In Money and Macro Policy, ed. M. Jarsulic. Dordrecht: Kluwer-Nijhoff Publishing, 1984. McCallum, B. T. Monetary Economics, Theory and Policy. New York: Macmillan, 1989. Moore, B. J. “A Simple Model of Bank Intermediation.” In Journal of Post-Keynesian Economics, Fall,12(1) (1989). Pollin, R. “Two Theories of Money Supply Endogeneity: Some Empirical.” Journal of Post Keynesian Economics, Spring, 13 (1991). Tobin, James. “Commercial Banks as Creators of ‘Money’.” In Banking and Monetary Studies, ed. Dean Carson. Homewood, Ill.: Richard D. Irwin, 1963: 408-19.

Chapter 16 Chinese materials:

Dong Fureng 董輔礽, ed. Zhonghua renmin gongheguo jingjishi 中華人民共和國經 濟史 [The Economic History of the People’s Republic of China]. Beijing: Economic Science Press, 1999. Fan Gang 樊綱. “Qiye jian zhaiwu yu hongguan jingji bodong (shang xia)” 企業間債 務與宏觀經濟波動（上，下） [Interenterprise Debts and Macroeconomic Fluctuations], Part I & II. Economic Research Journal 經濟研究, (3–4) (1996). General Office of the State Council of the People’s Republic of China. “Guanyu quanguo qingli ‘sanjiao zhai’ qingkuang de baogao” 關於全國清理“三 角債”情況的報告 [Report on the Nationwide Clearance of “Triangular Debts”]. Gazette of the State Council of the People’s Republic of China, No.4, 1993. Liu Wen 劉文. “Qiye jian ‘sanjiao zhai’ de chengyin ji duice” 企業間“三角債” 的成因與對策 [Causes and Solutions to Interenterprise Triangular Debts]. China Industrial Economics 中國工業經濟研究, (7) (1991). Ma Yi 馬義. “Zhiben qingyuan, zaijiezaili — Dongbei diqu qingli ‘sanjiao zhai’ jishi” 治本清源，再接再厲—東北地區清理“三角債”記事 [Tackling from the Source and Keeping up the Good Work: A Record of the Clearance Exercise of “Triangular Debts” in Northeast China]. Outlook Weekly 瞭望周 刊, (37) (1991). Qu Qiang 瞿強. “Jingji bodong — Fujia xinyong de jiegou xing jieshi” 經濟波 動——附加信用的結構性解釋 [Economic Oscillations: Credit-Augmented Structural Analysis]. Journal of Financial Research 金融研究, (1) (2009). Wang Haibo 汪海波. Xin Zhongguo gongye jingji shi 新中國工業經濟史 [The History of Industrial Economy of China]. Beijing: Economy and Management Publishing House, 2001.

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Wang Lijuan 王麗娟. “Wei you yuantou qing qi lai — Liaoning sheng qingli ‘sanjiao zhai‘ shidian jishi” 唯有源頭清起來——遼寧省清理“三角債”試點紀實 [Attack the Root Cause: “Triangular Debt” Clearance Pilot Program in Liaoning Province]. China Finance 中國金融, (10) (1991). Wu Jinglian 吳敬璉. Dangdai Zhongguo jingji gaige jiaocheng 當代中國經濟改革教程 [Understanding and Interpreting China’s Economic Reform]. Shanghai: Shanghai Far East Publisher, 2010. Zhao Ziyang 趙紫陽. Gaige licheng 改革歷程 [Journey to Reform]. Hong Kong: New Century Press, 2009.

Chapter 17 Chinese materials:

Fan Gang 樊綱, Zhang Shuguang 張曙光, et al. Gongyouzhi hongguan jingji lilun dagang 公有制宏觀經濟理論大綱 [The Outline of Macroeconomic Theory on Public Ownership]. Shanghai: Shanghai Joint Publishing Company, 1990. Fan Gang 樊綱. “Lun gaige guocheng” 論改革過程 [On Reform Process]. In Zhongguo de guodu jingjixue 中國的過渡經濟學 [China’s Transitional Economics], ed. Sheng Hong 盛洪. Shanghai: Shanghai Joint Publishing Company and Shanghai People’s Publishing House, 1994. Huang Da 黃達. Caizheng xindai zhonghe pingheng daolun 財政信貸綜合平衡導論 [Introduction to the Overall Fiscal-Credit Balance]. Beijing: China Renmin University Press, 1984. ———. “Hongguan jingji guannian bianxi” 宏觀經濟觀念辨析 [Analysis of Macroeconomic Concepts]. Huang Da wenji 黃達文集 [Collected Works of Huang Da]. Vol.2. Beijing: China Renmin University Press, 1993a. ———. “Hongguan tiaokong yu huobi gongji” 宏觀調控與貨幣供給 [Macroeconomic Regulation and Money Supply]. Social Sciences in China 中國社會科學, (5) (1993b). ———. Jinrong xue 金融學 [Economics of Money and Finance]. 2nd edition. Beijing: China Renmin University Press, 2009. Li Jian 李健, et al. Zhongguo jinrong fazhan zhong de jiegou wenti 中國金融發展中 的結構問題 [Structural Issues in China’s Financial Development]. Beijing: China Renmin University Press, 2004. Lu Yi 陸一. Xian bu zhu de shou — Zhongguo gushi tizhi jiyin yanhua shi 閒不住的 手——中國股市體制基因演化史 [Restless Hand: The Evolution of China’s Stock Market System]. Beijing: CITIC Press, 2008.

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National Bureau of Statistics of the People’s Republic of China 國家統計局. Zhongguo tongji zhaiyao 2010 中國統計摘要2010 [China Statistical Abstract 2010]. Beijing: China Statistics Press, 2010. World Bank. 2020 nian de Zhongguo: Xin shiji de fazhan tiaozhan 2020年的中國：新世 紀的發展挑戰 [China 2020: Development Challenges in the New Century]. Beijing: China Financial and Economic Publishing House, 1997. Wu Jinglian 吳敬璉. Dangdai Zhongguo jingji gaige jiaocheng 當代中國經濟改革教程 [A Coursebook on Economic Reform in Contemporary China]. Shanghai: Shanghai Far East Publishers, 2010. Wu Xiaoling 吳曉靈, ed. Zhongguo jinrong gaige kaifang da shiji 中國金融改革開放大 事記 [Major Events in China’s Financial Reform and Opening Up]. Beijing: China Financial Publishing House, 2008. Yi Gang 易綱. Zhongguo de huobi, yinhang he jinrong shichang: 1984–1993 中國的貨 幣、銀行和金融市場:1984–1993 [China’s Currency, Banking and Financial Market: 1984–1993]. Shanghai: Shanghai Joint Publishing Company and Shanghai People’s Publishing House, 1996. Zhang Dicheng 章迪誠. Zhongguo guoyou qiye gaige biannianshi 中國國有企業改革 編年史 [Chronicle of China’s State-Owned Enterprise Reform]. Beijing: China Workers Publishing House, 2006. Zhang Jie 張傑. Zhongguo jinrong zhidu de jiegou yu bianqian 中國金融制度的結構與 變遷 [Construction and Evolution of China’s Financial System]. Taiyuan: Shanxi Economic Press, 1998. ———. “Zhongguo guoyou yinhang de zibenjin mituan” 中國國有銀行的資本 金謎團 [Mystery of the Capital Funds in China’s Stated-Owned Banks]. Economic Research Journal 經濟研究, (1) (2003). ———. “Nonghu, guojia yu Zhongguo nongdai zhidu: Yige changqi shijiao” 農 戶、國家與中國農貸制度：一個長期視角 [Peasants, Government and the Rural Credit System in China: A Long-Term Perspective]. Journal of Financial Research 金融研究, (2) (2005). ———. “Zhongguo jinrong gaige de “shichang hua beilun” —— Jiyu Hainan anli de fenxi” 中國金融改革的“市場化悖論”——基於海南案例的分析 [The Marketization Dilemma Facing China’s Financial Reform: An Analysis Based on the Hainan Case]. Journal of Financial Research 金融研究, (8) (2007). ———. “Shichang hua yu jinrong kongzhi de liangnan kunju: Jiedu xin yi lun guoyou yinhang gaige de jixiao” 市場化與金融控制的兩難困局：解 讀新一輪國有銀行改革的績效 [The Dilemma of Whether to Maintain Marketization or Keep Financial Control]. Management World 管理世界, (11) (2008).

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Zou Zhizhuang 鄒至莊. Zhongguo jingji zhuanxing 中國經濟轉型 [China’s Economic Transformation]. Beijing: China Renmin University Press, 2005.

English materials:

Heffernan, Shelagh. The Modern Banking. Chichester: John Wiley & Sons, Inc., 2005. Lubman, Stanley, comp. PRC Legal Document Collection: Banking, Finance & Exchange Control. 1997. Naughton, Barry. The Chinese Economy: Transitions and Growth. Cambridge, MA: MIT Press, 2007.

Chapter 18 Chinese materials:

Chen Lan 陳蘭.“ ‘Diandai’ zijin guanli zhong de wenti ji jiejue tujing” “點貸” 資金管理中的問題及解決途徑 [Problems of and Solutions to “Designated Funds Management]. Southwest Finance 西南金融,(11) (1989). Chen Wanhe 陳萬和. “Shilun ‘diandai’ de fu xiaoying” 試論“點貸”的負效應 [Negative Impacts of “Designated Loans”]. Shanghai Finance 上海金融, (9) (1990). Fang Xiangdong 方向東. “1988-1991 nian zhili zhengdun huigu ji dui weilai jingji yunxing de zhanwang” 1988-1991年治理整頓回顧及對未來經濟運行的展 望 [Review of Economic Governance and Rectification Between 1988 and 1991 and Outlook for Future Economic Operation]. Economic Theory and Business Management 經濟理論與經濟管理, (6) (1991). Huang Da 黃達. Hongguan tiaokong yu huobi gongji 宏觀調控與貨幣供給 [Macroeconomic Regulation and Money Supply]. Beijing: China Renmin University Press, 1997. ———. Huang Da wenji 黃達文集 [Collected Works of Huang Da]. Beijing: China Renmin University Press, 2005. Liu Xilin 柳西林, and Liu qingquan 劉清泉. “Diandai: Yinhang xindai guanli de wuqu” 點貸：銀行信貸管理的誤區 [Designated Loans: Misunderstandings bout Banks’ Credit Management]. Financial Management Sciences 金融管理 科學, (3) (1995). Luo Zongming 羅宗明, and Li Kaizhi 李開治. “ ‘Diandai’ zijin guanli jidai wanshan” “點貸”資金管理亟待完善 [“Designated Loans” Management Urgently Needs to be Perfected]. Southwest Finance 西南金融,(4) (1990). Shang Ming 尚明, ed. Dangdai Zhongguo de jinrong shiye 當代中國的金融事業 [Finance in Contemporary China]. Beijing: China Social Sciences Press, 1989.

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Shang Ming 尚明, Wu Xiaoling 吳曉靈, and Luo Lanbo 羅蘭波. Yinhang xinyong guanli yu huobi gongying 銀行信用管理與貨幣供應 [Bank Credit Management and Monetary Supply]. Beijing: China Renmin University Press, 1992. Tang Shuangning 唐雙寧. Zhongguo xindai zhengce wenti 中國信貸政策問 題 [Problems of China’s Credit Policies]. Chengdu: Sichuan People’s Publishing House, 2000. Xiao Zhou 肖舟. Zhongguo gongshang yinhang xindai zhidu bianqian yanjiu 中國工 商銀行信貸制度變遷研究 [Analysis on the Evolution of Credit System in China’s Commercial Banks]. Beijing: China Science Publishing, 2008. Xu Huiping 徐輝平. “Dui diandai de sikao” 對點貸的思考 [Some Thinking on Designated Loans]. Finance and Economy 金融與經濟,(2) (1990). Yang Kuiyi 楊揆一, and Yang Tao 楊濤. “Jinyibu tigao ‘diandai’ zijin de qidong xiaoying” 進一步提高“點貸”資金的啟動效應 [To Further Improve the Activation Effects of “Designated Loans”]. Southwest Finance 西南金融,(4) (1990). Zhang Xiguang 張錫光. “Fuwu jingji tiaozheng, gaijin ‘diandai’ guanli” 服務經濟 調整，改進“點貸”管理 [Improving “Designated Loans” Management to Service Economic Adjustments]. Southwest Finance 西南金融,(8) (1990). Zhao Zhiyong 趙智勇, and Lei Ming 雷鳴. “Shilun ‘zijin diandai’ ” 試論“資金點 貸” [Discussions on “Designated Loans”]. China Urban Finance 中國城市 金融,(1) (1990). Zhou Zemin 周澤明. “Guanyu toufang ‘qidong zijin’ de jige wenti” 關於投放“啟 動資金”的幾個問題 [Several Questions about the Release of “Economic Activation Funds”]. Finance and Trade Economics 財貿經濟, (8) (1990).

Translated materials:

Aoki, Masahiko. Bijiao zhidu fenxi 比較制度分析 [Comparative Institutional Analysis]. Shanghai: Shanghai Far East Publisher, 2001. McKinnon, Ronald I. Jingji fazhan zhong de huobi yu ziben 經濟發展中的貨幣與資 本 [Money and Capital in Economic Development]. Shanghai: Shanghai People’s Publishing House, 1997. Shaw, Edward S. Jingji fazhan zhong de jinrong shenhua 經濟發展中的金融深化 [Financial Deepening in Economic Development]. Shanghai: Shanghai Joint Publishing Company, 1988. Nurkse, Ragnar. Bufada guojia de ziben xingcheng 不發達國家的資本形成 [Problems of Capital Formation in Underdeveloped Countries]. Beijing: The Commercial Press, 1986.

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English materials:

Hellmann, T., K. Murdock, and J. Stiglitze. “Financial Restraint: Toward a New Paradigm.” In The Role of Government in East Asian Economic Development: Comparative Institutional Analysis, eds. M. Aoki, H. Kim, and M. OkunoFujiwara. Oxford: Oxford University Press, 1997: 163–207. McKinnon, Ronald I. The Order of Economic Liberalization: Financial Control in the Transition to a Market Economy. Baltimore and London: Johns Hopkins University Press, 1991. Park, Y. C. “Financial Repression and Liberalization.” In Liberalization in the Process of Economic Development, ed. L. B. Krause and K. Kihwan. Berkeley: University of California Press, 1991.

Chapter 19 Chinese materials:

Deng Lianfan 鄧連凡. Zhongguo shuifei gaige de xianzhuang yu duice 中國稅費改革的 現狀與對策 [Current Situation and Countermeasures of China’s Fee and Tax Reforms]. Beijing: China Democracy and Law Press, 2001. Gao Peiyong 高培勇. “Fei gai shui”: Jingjixue jie rushi shuo “費改稅”：經濟學界如 是說 [Tax for Fee Reform: Opinions from Economists]. Beijing: Economic Science Press, 1999. ———. Zhongguo shuifei gaige wenti yanjiu 中國稅費改革問題研究 [Research on Problems in China’s Tax and Fee Reforms]. Beijing: Economic Science Press, 2004. Guo Qingwang 郭慶旺, and Zhao Zhiyun 趙志耘. Caizheng lilun yu zhengce: Dangqian ruogan zhongda wenti tantao 財政理論與政策：當前若干重大問 題探討 [Fiscal Theory and Policy: Discussions on Several Major Issues]. Beijing: Economic Science Press, 1999. ———. Gonggong jingjixue 公共經濟學 [Public Economics]. Beijing: Higher Education Press, 2006. Jia Junxue 賈俊雪, Guo Qingwang 郭慶旺, and Ning Jing 寧靜. “Caizheng fequan, zhengfu zhili jiegou yu xianji caizheng jiekun” 財政分權、政府治理結 構與縣級財政解困 [Fiscal Decentralization, Government Governance Structure, and Fiscal Bailouts to County- and Village-Level Governments]. Management World 管理世界, (1) (2011). Jia Kang 賈康, and Bai Jingming 白景明. “Xian xiang caizheng jiekun yu caizheng tizhi chuangxing” 縣鄉財政解困與財政體制創新 [Fiscal Bailouts to Countyand Village-Level Governments and Innovations of Fiscal System]. Economic Research Journal 經濟研究, (2) (2002).

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Li Shuangcheng 李雙成, Sun Wenji 孫文基, and Song Yiwu 宋義武. Fei gai shui 費改 稅 [Tax for Fee Reform]. Beijing: China Audit Press, 2000. Wang Bing 王賓, and Zhao Yang 趙陽. “Nong cun shuifei gaige dui zhong xi bu xiangzhen caili yingxiang de shizheng fenxi”農村稅費改革對中西部鄉鎮 財力影響的實證分析 [Empirical Analysis on the Impacts of Rural Tax and Fee Reform on the Fiscal Power of Township and Village Governments in Western and Central China]. Management World 管理世界, (11) (2006). Xiang Jiquan 項繼權. Zou chu “Hong Zongxi dinglü” de guaiquan: Zhongguo nongcun shuifei gaige de diaocha yu yanjiu 走出“黃宗羲定律”的怪圈：中國農村稅 費改革的調查與研究 [Out of the Vicious Circle of “Huang Zongxi law”: Investigation and Research on China’s Rural Tax and Fee Reform]. Xi’an: Northwest University Press, 2004. Xie Xuren 謝旭人. Zhongguo caizheng gaige sanshi nian 中國財政改革三十年 [30-Year Review of China’s Fiscal Reform]. Beijing: China Financial and Economic Publishing House, 2008. Xu Zhigang 徐志剛, Liu Mingxing 劉明興, and Liu Yongdong 劉永東. “Nongmin zuzhi dui cunzhuang gonggong rongzi de yingxiang: Chezhou haishi zhutui? — Nongcun shuifei tizhi gaige qianhou nongmin fudan bianhua de qishi” 農民組織對村莊公共融資的影響：掣肘還是助推？—— 農村稅 費體制改革前後農民負擔變化的啟示 [Impacts of Farmers’ Organizations on Rural Public Financing: A Hindrance or Booster? — Inspirations from the Changes in Farmers’ Burdens After Rural Tax and Fee Reform]. China Economic Quarterly 經濟學（季刊）, (3) (2009). Zhou Li’an 周黎安, and Chen Ye 陳燁. “Zhongguo nongcun shuifei gaige de zhengce xiaoguo: Jiyu shuangchong chafen moxing de guji” 中國農村稅 費改革的政策效果：基於雙重差分模型的估計 [The Policy Effect of Taxand-Fee Reform in Rural China: A Difference-in-Differences Estimation]. Economic Research Journal 經濟研究, (8) (2005). Zhu Shouyin 朱守銀, Zhang Haiyang 張海陽, and Yan Hui 閻輝. “Nongcun shuifei gaige shidian he xiangcun guanli tizhi gaige genzong yanjiu baogao” 農 村稅費改革試點和鄉村管理體制改革跟蹤研究報告 [Tracking Research Report on the Pilot Reform of Rural Taxes and Fees and the Reform of Rural Management System]. Review of Economic Research 經濟研究參考, (4) (2003).

English materials:

Cheng, Joseph Yu-shek, and Maurice Brosseau, eds. China Review 1993. Hong Kong: The Chinese University of Hong Kong, 1993.

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Chapter 20 Chinese materials:

Dai Qibin 戴啟斌, and Wang Zhongyu 王忠宇. “Zhuzhong ‘ruan touru’ shixian ‘ruan zhuolu’ ” 注重“軟投入”實現“軟著陸” [Emphasize “Soft Investment” to Achieve A “Soft Landing”]. Bank and Enterprises 銀行與企 業, (94) (1989). Diao Yongzuo 刁永作. “ ‘Ruan zhuolu’ de jingjixue sikao” “軟著陸”的經濟學思 考 [“Soft Landing” from a Perspective of Economics]. Research on Financial and Economic Issues 財經問題研究, (5) (1997). Jiang Shiyin 江世銀. “ ‘Ruan zhuolu’ hou yunyong jingji shouduan dui woguo jingji jiegou de tiaozheng jiqi yiyi” “軟著陸”后運用經濟手段對我國經濟 結構的調整及其意義 [Adjustments of China’s Economic Structure through Economic Means After the “Soft Landing” and Its Significance]. Social Science Research 社會科學研究, (4) (1997). Li Lingyan 李靈燕. “Zhonguo jingji ‘ruan zhuolu’ de shizheng fenxi” 中國經濟 “軟著陸”的實證分析 [Empirical Analysis on China’s “Soft Landing”]. Economic Reform 經濟改革, (2) (1999). Liu Hanbo 劉寒波. “Dui ‘ruan zhuolu’ chenggong yuanyin de fenxi” 對“軟著陸” 成功原因的分析 [Analysis on the Success of the “Soft Landing”]. Economic Review 經濟縱橫, (4) (1998). Liu Wei 劉偉. “Jingji ‘ruan zhuolu’ yu fei guoyou jingji” 經濟“軟著陸” 與非國 有經濟 [Economic “Soft Landing” and Non–State-Owned Economy]. Economic Research Journal 經濟研究, (4) (1998). Luo Yuding 駱玉鼎. “Huobi shuliang tiaokong de zuoyong” 貨幣數量調控的作用 [The Effects of Money Quantity Control]. Journal of Finance and Economics 財經研究, (5) (1999). Meng Benman 蒙本曼. “ ‘Ruan zhuolu’ hou Zhongguo de jingji bodong”“軟著 陸”后中國的經濟波動 [China’s Economic Fluctuations After the “Soft Landing”]. Economics Research 經濟學研究, (1) (2003). Zhang Chengsi 張成思. “Zhongguo tongzhang guanxing tezheng yu huobi zhengce qishi” 中國通脹慣性特征與貨幣政策啟示 [The Nature of Inflation Inertia in China and Its Implications on Monetary Policy]. Economic Research Journal 經濟研究, (2) (2008).

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Zhang Zhuoyuan 張卓元. “Zhongguo jingji youwang shixian ‘ruan zhuolu’ ” 中國 經濟有望實現“軟著陸” [China’s Economy Is Expected to Achieve a “Soft Landing”]. Economic Research Journal 經濟研究, (10) (1995). Zheng Jingping 鄭京平. “Wen zhong qu hao ‘ruan zhuolu’ chenggong” 穩中趨 好“軟著陸”成功 [A Stable and Booming Economy, the Soft Landing Is Successful]. Statistical Research 統計研究, (1) (1997). Zheng Zexiang 鄭澤香, Zheng Jingping 鄭京平, and Zhang Yingxiang 張英香. “ ‘Ruan zhuolu’ qianhou” “軟著陸”前後 [Before and After the “Soft Landing”]. China Statistics 中國統計, (8) (1997). Zhou Shaopeng 周紹朋, Wang Jian 王健, and Wang Haibo 汪海波. “Hongguan tiaokong zhengce xietiao zai jingji ‘ruan zhuolu’ zhong de zuoyong” 宏 觀調控政策協調在經濟“軟著陸”中的作用 [The Role of Macroeconomic Regulation in the Economic “Soft Landing”]. Economic Research Journal 經 濟研究, (2) (1998).

English materials:

Abeysinghe, Tilak, and Gulasekaran Rajaguru. “Quarterly Real GDP Estimates for China and ASEAN4 with a Forecast Evaluation.” Journal of Forecasting, 23(6) (2004): 431-47 Zhang, C., and J. Clovis. “China Inflation Dynamics: Persistence and Policy Regimes.” Journal of Policy Modeling, 32(3) (2010): 373-88., ———. “Modeling China Inflation Persistence.” Annals of Economics and Finance,10(1) (2009): 89–110.

Chapter 21 Chinese materials:

Chen Dongqi 陳東琪, Zhang Anyuan 張岸元, and Wang Yuan 王元. “Renminbi huilü gaige de jingcheng, tiaozhan he qianjing” 人民幣匯率改革的進程、 挑戰和前景 [Progress, Challenges, and Prospect of Renminbi Exchange Rate Reform]. Macroeconomics 宏觀經濟研究, (12) (2008). Chen Quangeng 陳全庚. “ ‘Fu guan’ yu woguo waihui guanli tizhi gaige” “複關” 與我國外匯管理體制改革 [“China’s Rejoining of GATT” and the Foreign Exchange System Reform]. Price Theory & Practice 價格理論與實踐, (12) (1993). ———. “Zhongguo waihui tizhi gaige shi renminbi chengwei ke duihuan huobi” 中國外匯體制改革使人民幣成為可兌換貨幣 [China’s Foreign Exchange System Reform Turns Renminbi into a Convertible Currency]. Studies of International Finance 國際金融研究, (8) (1996).

175

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Chen Yulu 陳雨露. Xiandai jinrong lilun 現代金融理論 [Modern Finance Theory]. Beijing: China Financial Publishing House, 2000. ———. Guoji jinrong 國際金融 [International Finance], 3rd edition. Beijing: China Renmin University Press, 2008. Hu Xiaolian 胡曉煉. “Yi jiu jiu si nian Zhongguo waihui tizhi gaige de jiben gujia” 一九九四年中國外匯體制改革的基本估價 [Estimation of China’s Exchange Rate Regime Reform in 1994]. Comparative Economic & Social Systems 經濟 社會體制比較, (3) (1995). ———. “Woguo waihui guanli tizhi gaige de lichen he jingyan” 我國外匯管理體制 改革的歷程和經驗 [Progress and Experience of China’s Foreign Exchange Management System Reform]. China Finance 中國金融, (4) (2008). Jing Xuecheng 景學成. “Renminbi huilü binggui pingshu” 人民幣匯率並軌評述 [Remarks on the Unification of Renminbi Exchange Rates]. New Finance 新 金融, (4) (1994). Lou Jiwei 樓繼偉, and Gao Jianhong 高劍虹. “Waihui guanli tizhi gaige de zhidu xing feiyue” 外匯管理體制改革的制度性飛躍 [Institutional Breakthroughs in the Reform of Foreign Exchange Management Reform]. Zhongguo jingji 50 ren kan 30 nian: Huigu yu fenxi 中國經濟50人看三十年：回顧與分析 [Chinese Economists 50 Forum Series on 30 Years of China’s Economic Reform: Review and Analysis], ed. Wu Jinlian 吳敬璉. Beijing: China Economic Press, 2008. Mao Yushi 茅于軾. Mao Yushi tan jingji: Cong weiguan dao hongguan 茅于軾談經濟： 從微觀到宏觀 [Mao Yushi Talks About the Economy: From Microeconomy to Macroeconomy]. Taiyuan: Shanxi Publishing Group, and Shanxi Economic Press, 2008. Pei Ping 裴平. “Huilü binggui dui gaishan woguo jinchukou zhuangkuang de xiaoyong” 匯率並軌對改善我國進出口狀況的效用 [The Effects of Exchange Rate Unification on Improving China’s Exports and Imports]. Economic Research Journal 經濟研究, (11) (1994). Southern Weekly 南方週末. “Gongheguo zongli Zhu Rongji” 共和國總理朱鎔基 [Premier Zhu Rongji of the People’s Republic of China]. March 6, 2003. Sun Mingchun 孫明春. “Lun waihui guanli tizhi gaige dui woguo huobi zhengce de yingxiang” 論外匯管理體制改革對我國貨幣政策的影響 [Impacts of Foreign Exchange Management Reform on China’s Monetary Policy]. Economic Research Journal 經濟研究, (8) (1994). Tao Xiang 陶湘. “Huashuo renminbi huijia binggui” 話說人民幣匯價並軌 [On the Unification of Renminbi Exchange Rates]. Export-Oriented Economy 外向經 濟, (4) (1994).

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Wang Fang 王芳. “Jinrong lilun fazhan de xin quxiang” 金融理論發展的新趨 向 [New Trends of Financial Theory Development]. The Journal of World Economy 世界經濟雜誌, (5) (2002). Wang Hongju 汪紅駒. “Zhongguo huobi youxiao xing yanjiu” 中國貨幣有效性 研究 [Research on the Validity of China’s Currency]. Doctoral Thesis of China Renmin University, 2001. Wang Linsheng 王林生. “Renminbi huilü yu xinxing waimao tizhi” 人民幣匯率與 新型外貿體制 [Renminbi Exchange Rate and New Foreign Trade System]. Probe 探索, (4) (1993). Xia Jun 夏軍. “Renminbi huilü binggui de youlai ji yuanyin” 人民幣匯率並軌的由 來及原因 [Origin and Reasons of Renminbi Exchange Rate Unification]. Teaching and Research 教學與研究, (2) (1994). Yang Fan 楊帆. “Binggui shizaibixing, xiatiao weiqibuyuan — Renminbi huilü zoushi yuce” 並軌勢在必行，下調為期不遠——人民幣匯率走勢預測 [Unification Is Bound to Happen, and Devaluation Is Round the Corner: Forecasts for Renminbi Exchange Rate Changes]. International Economic Operation 國際經濟合作, (2) (1993). Yi Gang 易綱. “Gaige kaifang sanshi nian lai renminbi huilü tizhi de yanbian” 改革 開放三十年來人民幣匯率體制的演變 [Evolution of China’s Exchange Rate Regime in the 30 Years after the Reform and Opening Up]. In Zhongguo jingji 50 ren kan 30 nian: Huigu yu fenxi 中國經濟50人看三十年：回顧與分 析 [Chinese Economists 50 Forum Series on 30 Years of China’s Economic Reform: Review and Analysis], ed. Wu Jinlian 吳敬璉. Beijing: China Economic Press, 2008. ———. “Renminbi huilü zhidu de zuijia xuanze” 人民幣匯率制度的最佳選擇 [Best Option for China’s Exchange Rate Regime]. China Reform 中國改革, (8) (2010). Zheng Shuangqing 鄭雙慶. “Zhongguo gaige kaifang sanshi nian: Yi jiu jiu si nian waihui guanli tizhi gaige de huigu” 中國改革開放三十年：一九九四年外 匯管理體制改革的回顧 [30 Years after China’s Reform and Opening Up: A Review of Foreign Exchange Management Reform in 1994]. Wen Wei Po 文 匯報, November 28, 2008. Zhou Zhengqing 周正慶. “Zhongguo jinrong gaige de huigu yu zhanwang: Guanyu shenhua jinrong gaige de jige wenti” 中國金融改革的回顧與展望：關於深 化金融改革的幾個問題 [Review and Outlook of China’s Financial Reform: Several Issues Concerning the Deepening of Financial Reform]. Seminar given at Southwestern University of Finance and Economics, October 10, 2005.

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178

Index administrative fees 93–94, 98–99 agricultural tax 93, 100–103 arrangements, under-the-table 151–52 Asian financial crisis 87, 130, 135, 137, 141, 148–49, 153 asset-liability ratio 10, 23 Bank of China (BOC) 2, 4–5, 11–13, 20, 40, 48, 68, 72, 75, 134 banking system centralized 72 two-tiered 4–5, 10 capital construction 22, 28–32, 34, 43, 111 central bank relending 12 China Foreign Exchange Trade System 151 China Merchants Bank (CMB) 4 Chinese Economic Reform 21, 35, 39, 58, 60, 63–65 coffers, private 96 commodity prices 14, 25, 27, 51, 115, 128, 134, 136, 141 consumer price index (CPI) 40, 49, 51–52, 113, 125 credit difference control 72, 74–75 credit funds management 10, 71, 76, 78, 82, 84 credit quotas 5, 9, 52 debts, interenterprise 20, 36 designated loans 67–71, 75, 77–87, 89, 123 dollarization 145, 147, 150, 154 dual-track system 110, 134–35 economic indicators, major 114, 116 economic overheating 22–24, 69, 78, 111,

114–16, 118, 121, 130 economic reform 4, 21, 23–24, 35, 39–44, 49–50, 53–54, 56, 59–65, 73, 75, 77, 112, 126 exchange rate 22, 87, 113, 115, 133–39, 141–53, 155 fixed 146, 148–49, 154 market 136 official 134–36, 138–39, 153 Renminbi 113, 134–35, 137, 141–43, 145, 150–153 exchange rate distortions 143, 153 exchange rate flexibility 144, 151 exchange rate formation 143, 151–52, 154 exchange rate reform 135–36, 138, 140, 145, 150, 152–55 exchange rate regimes 134, 137, 144–47, 152–54 exchange rate unification 133, 135–45, 147, 149–51, 153–55 extrabudgetary funds 93–94, 97–98 extractive capacity, fiscal 49, 54, 56 fee collection 94, 96–97, 99–100, 107–8 fiscal deficits 16–17, 111, 128 fiscal overdraft 12–13, 22 Five-Year Plan period 25 fixed-asset investment 21–23, 26, 31, 35, 69–70, 110–111, 113–15, 117, 128, 130 foreign direct investment (FDI) 142 foreign exchange market 137, 140–141, 143, 147, 150, 152–54 foreign exchange swap centers 134–37, 139–40, 143, 153–54 foreign exchanges 12, 16, 87, 135–38, 140–

179

Index

143, 145, 149, 152 foreign reserves 136–42, 148–50, 152–53, 155 official 136, 139, 141–42, 153 fuel tax reform 105–6 GDP gap 127 General Agreement on Tariffs and Trade (GATT) 136 government intervention 5, 9–10, 16, 18, 88–89, 146

149 monetary policy 5, 13, 18, 43, 49, 51, 78, 115, 117, 121, 123–24, 130, 139, 148–50 contractionary 42, 44, 49, 86, 130 expansionary 14 tight 119, 122–23 money supply 2, 5–6, 8, 10, 14–17, 39, 43–45, 48–49, 111, 116, 118, 120, 123, 128, 130 endogeneity 14–18, 134–35, 138–39 open market operations (OMOs) 5, 123

household savings 38, 40–41,44-45 48-53, 55–58, 60-63, 65-66 Industrial and Commercial Bank of China (ICBC) 4–5, 20, 22, 33–34, 74–75 inflation expectations 112, 127–28 interest rates benchmark 17–18, 53 loan 41–42, 46–48, 51, 53, 113–14, 123 interest subsidies 122 International Monetary Fund (IMF) 138, 140, 144 Keynesianism, new 127–28 Keynesian government interventionism 88 Keynesian Philips curve, new 127 loans, non-performing 4, 6–7, 10 loans based on deposits 74, 77–78 managed float 144, 147, 149–51, 154 mandatory settlement and sale 141–43, 150–153, 155 market economy 2–3, 5–7, 9, 92–94, 110, 119, 131, 136, 146 marketization 62, 143, 154 maximum credit ceiling 5 monetary base 8–10, 12, 15–16, 25, 124,

180

People’s Bank of China (PBC) 2, 4–6, 8, 12, 20, 40–43, 46–53, 68–79, 82–85, 134, 137–38, 145, 150, 152 pegs conventional 147 crawling 144 power devolution and profit retention 2, 21–22, 40, 93, 126 rate swap 134–36, 138 internal settlement 134–36 Reform and Opening Up 2, 10, 13, 16, 69, 72, 82, 99, 111–12, 118, 135–36 Renminbi exchange rate regime 134–35, 143, 145, 151, 154 reserve ratio, required 8–9, 75 reserve requirement system 75 retail price index (RPI) 24–25, 40, 43–45, 48, 56, 59, 113, 118 reversed monetary expansion 2–11, 13–18 savings, inflation-proof 46–47, 114, 122 sector, private 135–36, 141–42 state-owned enterprises (SOEs) 2–4, 6–10, 16, 20–23, 26–27, 29–36, 40, 51, 54,

Index

62, 68, 84, 87, 110, 122 SOE reform 17, 51, 58 soft budget constraints 2, 4, 8–10, 12, 16, 18 soft landing 57, 109, 111, 113–15, 117, 121, 123, 125, 127, 129, 131 state-owned banks 2–4, 6–10, 12, 16–17, 49, 51, 56 tax and fee reforms 91–93, 95, 97–108 rural 101–2 three arbitraries 92–99, 103, 105–7 tiger in the cage 38–39, 46–47, 51–54, 57– 58, 60–66 transfer payment 100, 102 triangular debts 19–21, 23–25, 27–36, 70–71 working capital arrears 31–32, 34–35 working capital loans 23, 31, 35, 71, 75, 82

181

Reveals the Unique Milestones in China’s Public Finance Development Major Issues and Policies in China’s Financial Reform Volume 3 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 3 chronicles the issues that appeared between the late 1980s and the 1990s, as China transitioned from a planned economy to a market economy. While old institutions had been dismantled, new institutions to manage the expanding economy were still being constructed. This intervening period then saw the rise of problems such as uncontrolled money expansion driven by state-owned enterprises’ demands, persistent interenterprise arrears, and high personal savings rate. “Designated loans,” tax and fee reforms, and exchange rate reforms were introduced by the central government to counter these problems and help complete the new institutions. A “soft landing” for the overheated economy was eventually achieved in the mid-1990s to maintain stable growth and controlled inflation.

Editors in Chief Chen Yulu is the Deputy Governor of People‘s Bank 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